Diversification and Asset Pricing

In an essay, address the following: • John Wilson is a portfolio manager at Austin Associates. For all his clients, Wilson manages portfolios that lie on the Markowitz efficient frontier. Wilson asks Mary Regan, CFA, a managing director at Austin, to review the portfolios of two of his clients, the Eagle Manufacturing Company and the Rainbow Life Insurance Co. The expected returns of the two portfolios are substantially different. Regan determines that the Rainbow portfolio has a higher return and therefore concludes that the Rainbow portfolio must be superior to the Eagle portfolio. o Do you agree or disagree with Regan’s conclusion that the Rainbow portfolio is superior to the Eagle portfolio? Justify your response with reference to the capital market line. o Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater nonsystematic risk than Eagle’s portfolio. Define nonsystematic risk and explain why you agree or disagree with Wilson’s remark.

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