Quiz on Creating Portfolio of Financial Companies

Class,

By our initial conversations, I simply assume that all of you have are familiar with or in some way experienced the financial meltdown of 2008-2009, especially in the housing sector. What the likely scenario for most of you is lower valuations of your property, or lower portfolio investment value, with some recovery in the last few years. However, you are still lucky. The financial companies issuing mortgages for inflated house prices or underwriting debt backed by worthless mortgages are still paying a big price for such failures.

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That takes us to the second week’s discussion topic, which relates to the subject of risk and diversification. In chapter 6, you start reading about portfolio composition and the importance of putting together a diversified portfolio, risk aversion, risk diversification, etc. However, the book also states that simply putting together stocks with high correlation, regardless of number of stocks, will not achieve desired diversification, because you would still be exposed to similar industry risk, despite owning companies that are not similar at all.

The question is, is this assumption correct when it comes to creating a portfolio with companies in the same industry, such as the financial industry? Can you put together a portfolio of diverse financial companies, such as Wells Fargo (WFC), Citi (C), JP Morgan Chase (JPM) and Bank of America (BAC) all in the same industry, yet so different in what they do, and be confident that you have achieved diversification in your portfolio?

You might just dismiss it by saying they are all banks and all banks have suffered and someone with a portfolio consisting of just financial companies would not be even slightly diversified; however, I would like to point to the contrasting paths of now defunct Bear Sterns, Washington Mutual and the definitely much more prosperous Chase and Wells Fargo, same industry but no exact correlation in their performance.

Start by looking at the development of the stock prices for Wells Fargo, Citi, Chase and Bank of America. How have they performed in the past, and most recent years? How have they performed compared against each other? Again, the question is, can you achieve a diversified portfolio by holding companies in the same industry, the financial industry? Your book at different chapters says mostly no, but feel free to argue against that.

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