Alex Sharpe's Portfolio Solution Essay

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Context: Alex Sharpe currently invests her children’s educational savings in Vanguard 500 Index Fund, which tracks the performance of S&P 500 and is passively managed. However, she is now considering switching her investment strategy to a more active one to achieve better outcomes. Hasbro, a toy manufacturer, and Reynolds, a tobacco firm, have come into Sharpe’s sight and she wants to choose one of them and invest a small proportion of equity funds in it. In order to select a more appropriate investment target, the following issues should be taken into consideration by Sharpe: 1) What are the risk-return characteristics of each stock 2) What are the impacts of either stock to the overall risk-return profiles of the equity…show more content…
2. Perform a regression of each stock's monthly returns on the Index returns to compute a beta for each stock. How does this relate to your answer in question 1? Regression analysis of Reynolds and Hasbro’s returns on market index’s returns shows that Reynolds has a much lower beta coefficient than Hasbro (0.736 compared with 1.42). It is a supporting evidence for our calculation in question 1. Lower beta means that Reynolds is less positively correlated with the market as a whole. So it is obvious that its contribution to overall portfolio’s variance will also be smaller. Take a deeper look at the regression outcome, we found that Intercepts of both stocks have quite large p-value (0.225 for Reynolds and 0.659 for Hasbro). It indicates that those test statistics are not significant enough to reject the null hypothesis that intercept of Reynolds and Hasbro are 0. A more important thing is p-value for beta coefficient. Although Reynolds’s p-value is 0.0285, meaning that null hypothesis that beta is zero will not be rejected for a level of significance at 1%. However, we normally consider a 5% level of significance, so it is enough to reject null hypothesis and Reynolds’s beta is really different from 0. For Hasbro, p-value is far small enough to reject null hypothesis

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