The topics of the chapters this week are learning to measure risk and understand

Question

The topics of the chapters this week are learning to measure risk and understanding the relationship between risk and the cost of capital. The cost of capital for a project is the rate of return that shareholders could expect to earn if they invested in equally risky securities. One way to estimate the cost of capital is to find securities that have the same risk as the project and then estimate the expected rate of return on these securities. We will also look at historical rates of return earned from past investments, especially concentrating on those earned from risky rather than safe securities. Next, we will learn how to measure the risk of a portfolio and study past history to find out how risky it is to invest in the stock market. Finally, we will look at the concept of diversification which means not "putting all yours eggs in one basket." Lastly, we will distinguish between the risk that can be eliminated by diversifying and the risk that cannot be eliminated. Diversification is a strategy designed to reduce risk by spreading the portfolio across many investments. Selling umbrellas is a risky business; you would make plenty when it rains but could lose your shirt in a heat wave. Selling ice cream is no safer; you do well in the heat wave, but business is poor in the rain. However, if you invested in both businesses, you could make an average level of profit come rain or shine. This week's assignment is to watch the video about the Power of Diversification located in the Week 3 Video Folder. Next, build a personal portfolio of 7-10 firms either equally invested or investment spread unevenly. List the firms you have chosen and the reason for your choices and how diversification played a role in your choices. You may need to review the Power Point slides located in the Course Document section and also the chapters in your book. 250 post required.

Explanation / Answer

In order to take advnatage of diversifivcation we choose two compaies from each sector.

We would take exposure to the below sectors

1. IT or Information technology sector - We would choose Apple and Accenture as the two companies

2. Finance sector - Citibank and Bank of America

3. Retail Sector - Walmart and Best buy

4. Pharma Sector = Pfizer and Johnson and Johnson

5. Oil and Gas - Exxon Mobil and British Petroleum

These would be the 10 companies and the five sectors that I would choose

The reasons are as below:

1. In the IT sector, I would choose one manufacturer and one service provider and hence it would acts as diversification within the sector

2. In the financial sector, I would choose the two big banks as if there recovery in the economy, the banking sector will do well

3. In the retail sector, I would choose the above two companies since they would act as cushion if the economy contracts instead of expansion

4. The Pharma companies are also added as defensives and are considered to do will in both expanding and contracting economies

5. The recent surge in oil prices after reaching an all time low would provide opportunities as commodity prices are set to rebound.

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