Mike has decided that it is time he put his money to work for him. He has accumulated a substantial nest egg in a savings account at a local bank, but he realizes that with less than 3% interest he will never reach his goals. After doing some research he withdraws the money, opens an account at a local brokerage firm, and buys 500 shares of a large blue chip manufacturing company and 600 shares of a well known retailing firm. From the beginning, his broker emphasizes that his portfolio is not sufficiently diversified with just two stocks. Over time, the broker convinces
Mike to sell the shares of the two stocks to purchase stock in other companies. Two years later, Mike owns stock in 14 different companies and views his portfolio as well diversified. His cousin, Ed, who has recently graduated from business school, looks at his portfolio and comments, “ You are not very well diversified, as 10 of the stocks you own are considered technology stocks.” Mike tells Ed that he followed his broker’s recommendations and sold his original stocks to purchase the new stocks in order to attain a diversified portfolio. Ed comments that the brokerage firm where Mike does business is noted as a specialist in technologies. Mike is disappointed because he thought he was getting good advice toward building a well diversified portfolio. After all, Mike followed his broker’s advice to the letter, and why would his broker give a client bad advice?
a. Comment on Mike’s broker’s ethics in recommending the sale of the original stocks to purchase a portfolio weighted so heavily toward technologies. Include in your discussion reasons why the broker may have followed the course of action that he did.
b. To achieve diversification, what other course of action could Mike have taken that would not involve buying individual stocks in a variety of companies?