Consider the following conversation and discuss how is each comment flawed or co

Question

Consider the following conversation and discuss how is each comment flawed or correct, and what would you tell these people to straighten them out?

Helen says: “When forming a portfolio, I would want to choose stocks from different industries. If I choose 4 stocks from different industries my portfolio will be diverse. I would

then expect to have performance similar to the market portfolio as measured by the S&P 500.”

Sophia’s reply is “If you want to replicate the market, you’re better off buying a mutual fund like the Vanguard 500 Index fund. It is managed by a professional stock picker, and therefore will always do better than the S&P 500 for the same level of risk.”

Explanation / Answer

1) FLAWED: chosing stocks from four different industries will create a portfolio with individual stocks performing differently in market conditions but it is not reasonable to expect it to replicate the performance of S&P 500 because it has a portfolio of 500 stocks which make it diverse in the true sense, which cannot be expected to be replicated by a portfolio of 4 stocks only.

2)while other aspects of the statement are clear it is not true to assume the mutual fund will beat the market that is give better performance for the same level of risk. better performance is associated with higher levels of risk as well.

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