Diversification of Alternative Investments Order Instructions: APA is critical for this paper, and it is important that the writer use a journal article to justify the answer and properly cite it.
Details are also critical it is important the writer outline the important facts in the response.
Enron employees were heavily invested in Enron stock through their 401(k) plans. While companies frequently provide a match in the form of company stock, employees are typically free to move the money to an alternative investment. This was true at Enron as well, but most employees chose to leave their money in company stock.
Many investment experts contend that despite all of the legal and ethical lapses by those in charge of Enron, they were responsible for inflicting suffering on relatively few employees when the company failed. It was not the company’s fault if employees did not choose to diversify.
Do you agree with this statement?
Justify your answer using at least one journal article. Be sure to use APA formatting for the citation.
Diversification of Alternative Investments Resources
• Article
• Sharpe, W. (2007). Expected utility asset allocation. Financial Analysts Journal, 63(5), 18–30. Retrieved from Business Source Premier database.
Although the traditional method for performing asset allocation analysis is to use the mean-variance approach, this article introduces a new model. Although it involves using a more complex utility function, the author believes that it will result in a substantial increase in payoffs.
• Markowitz, H. (1952). Portfolio selection. Journal of Finance 7(1), 77–91. Retrieved from Business Source Premier database. (Seminal Paper)
Markowitz presents his theories on the two stages of portfolio selection; first, using observation and experience to analyze the future performance of stocks, and second, using this analysis to select stocks for the portfolio.
• Sharpe, W. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425–442. Retrieved from Business Source Premier database. (Seminal Paper)
This model describes the use of risk to predict capital asset prices and market behavior and the authors conclude that most investors prefer investments that have lower rates of return, but also lower risk.
• Linter, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47(1), 13–37. Retrieved from Business Source Premier database. (Seminal Paper)
In this paper, the author outlines his theory on how investors can create a portfolio that minimizes the risk while maximizing the profit.
• Domain, D., Louton, D., & Racine, M. (2007). Diversification in portfolios of individual stocks: 100 stocks are not enough. Financial Review, 42(4), 557–570. Retrieved from Business Source Premier database.
The authors explore the concept of determining ending wealth in portfolios and find that greater shortfall risk reduction occurs proportionally to an increase in the number of stocks in the portfolio.
• Eun, C., Huang, W., & Lai, S. (2008). International diversification with large- and small-cap stocks. Journal of Financial & Quantitative Analysis, 43(2), 489–523. Retrieved from Business Source Premier database.
Despite the fact that most companies diversify their portfolios with international large-cap stocks, this research finds that in actuality, small-cap stocks had significantly higher gains.
Diversification of Alternative Investments Sample Answer
Abstract
Diversification generally means the reduction of non-systematic risks by spreading out the risks when investing by the diversified range in stock portfolios. For example, investing in large cap stocks as well as small cap stocks, real estate bonds and also having some cash in the bank. (Markowitz, 1959)
Enron Corporation was an American multinational company that had its headquarters in Houston, Texas. It had revenues over $111 billion in early 2000 before its bankruptcy in December 2 the year 2001. Over 20,000 employees were rendered jobless besides most all their investments in the company were also wiped out.
It was very hard to imagine that a giant corporation like Enron could go under. I can’t blame the employees for putting all their hopes in Enron only that if they could have diversified their investments to other small cap investment opportunities or in bond issues or even in other savings accounts then they could have at least salvaged part of their investments. (Eun, Huang & Lai, 2008)
The capital asset pricing model (CAPM) calculates an average expected rate of the cost of capital or return for each investment and the rate of risks involved. According to this model, the investments average cost of capital is relatively lower if it basically offers better diversification returns for a particular investor has the overall market portfolio minus the required benefit for risk contribution.
Projects that have higher risks (market beta) will generally have higher rates of expected returns for them to be attractive to investors while less risky projects also have lower expected rates of return. This is the relationship that CAPM model portrays.
Enron returns were very high as one of the leading corporations at the time of its peak in 2000; it was one of the most stable companies financially in the USA.
Beta is used as a rate of measuring the risks in investments portfolios. A company’s Beta of 2 means that the volatility of a company changes by 2% when the market’s benchmark changes by 1%. (Fama & French, 2004)
For example, using the CAPM formula, if the risk free rate is currently 3% and the current expected rate of return is 7%, the CAPM formula states that;
r1 = 3% + (7% – 3%) x beta = 3% + 4% x beta (Black, Jensen and Scholes, 1972, p.79)
= rf +(x (rm) –rf) x beta where rf and rm are the risk free rate and the expected market rate of return respectively. If the project or company has a beta of 0.5 then its cost of capital is equal to 3% plus 4% x 0.5 = 5% while a project with a beta of 2 is supposed to have a cost capital of 3% plus 4% x 2 = 11%. These means that a company that has a beta of 2 must have an expected average rate of return of 11% or more. If the expected return is less than 11% then the investment is not viable hence the project should be discarded. (French, 2003)
To conclude, the employees of Enron should have definitely calculated the nature and level of risks that their investments were exposed to and diversified their portfolios to reduce the impact of risks involved but they were blinded by the success of Enron that made them to be assured of their investments. It was a wrong decision and the more successful a company is the more the investments need to be diversified.
Diversification of Alternative Investments References
Black, F., Jensen, M.C. and Scholes, M. (1972) “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in the Theory of Capital Markets. Michael C. Jensen, ed. New York, NY: Praeger, 79–121.
Eun, C., Huang, W., & Lai, S. (2008). International diversification with large- and small-cap stocks. Journal of Financial & Quantitative Analysis, 43(2), 489–523. Retrieved from Business Source Premier database.
Fama, E. F, French, K. R (2004). “The Capital Asset Pricing Model: Theory and Evidence”. Journal of Economic Perspectives 18 (3): 25–46.
French, C. W. (2003). “The Treynor Capital Asset Pricing Model” Journal of Investment Management 1 (2): 60–72.
Markowitz, H. (1959) Portfolio Selection: Efficient Diversifications of Investments. Cowles Foundation Monograph No. 16. New York, NY: John Wiley & Sons, Inc. pp. 77 – 91.
