Your friend is facing an important decision. She was recently hired by a large b

Question

Your friend is facing an important decision. She was recently hired by a large bank, First Global, as a junior associate. Her primary responsibility is reviewing loan applications for completeness and conducting an initial analysis of the credit information. She is very knowledgeable about loans; however, she has come to you with a dilemma. The decision she is facing does not involve a work-related task, rather it involves questions regarding how she should set up her retirement account. She wants to get started investing early in life as she understands the power of compound interest, but she is unclear about where she should allocate her money. She has heard that you have a solid understanding of investments, particularly the risk and return of securities. She has narrowed her options down to three choices and would like your input. The first option is to invest in a mutual fund that is comprised of a wide variety of common stock from large, domestic firms. The second option is to invest in a low-risk government security, such as U.S. Treasury bills (T-bills). The third option is to invest in the common stock of First Global. Your friend is very worried about losing her money and would like to keep her investment choice simple. For that reason she is considering choosing to invest in First Global common stock as she has calculated an average return for the stock that seems acceptable. Currently, your friend has £5,000 to invest.

3. After careful consideration, you believe that your friend should hold a portfolio, rather than a single investment. You recommend investing in both the common stock mutual fund and the government security. You believe that 80% of the portfolio should consist of the mutual fund and 20% should consist of the government security. Based on the calculations you completed in the previous question, what is the expected return of the portfolio? What is the standard deviation of the portfolio if the variance of the mutual fund is 0.076, the variance of the government security is 0.010 (assuming this is the risk-free asset), and the covariance between the mutual fund and the government security is -0.0037? What reasoning could you provide to your friend as to why to have a portfolio rather than just a single investment? Why would you not recommend investing only in the stock of First Global?

Explanation / Answer

option 1 Taking on only to solve in one single security

Only in Mutual Fund:- A person investing in mutual funds genrally gets moderate results as the funds are managed by experts and hence the chance of value reduction is less mutual funds are moderately risk oriented and provide good; results

Only in stock of company :- Investing in the equity is relative has a high risk, though the results can also be high in this scenario.

Only in G sec:- this is a security with least amount of risk involved with fixed income over the period of time , however the returns that come are less than the other market securities.

Compared with above option investing with the view of creating a portfolio and investing is the smart way of getting higher returns as this shall mitigate or reduce the risk and provide high returns .

The standard deviation of the portfolio shall be SQRT{(Wa*Std Deva)2+(Wb*Std Devb)2+2wawbStd DevaStd Devb}. Since the g sec is a risk free assset and thus the StD Dev is zero for this security in this case the standard deviation shall be SQRT(0.8*0.8*.076+0.2*0.2*.10+2*0.2*0.8*-0.0037)= SQRT(0.051456)= 0.2268

Note: Square of standard deviation is equal to variance)=0.2205

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