You are considering the beginning of a portfolio. You want to keep it simple how

Question

You are considering the beginning of a portfolio. You want to keep it simple however, by only having it contain two assets. Unfortunately, you have narrowed it down to FOUR, not two. So, now you are going to do the final cuts using an expected return analysis. You believe the best way to determine the state of the economy is to use the consumer confidence index (CCI). Those values, along with the returns on each of your four securities are included in the following table.

You feel that any CCI value less than 80 is a contractionary period. Alternatively, and CCI value more than 86 is an expansionary period. Anywhere in between is a normal period.

If you believe that next year will be characterized by a 10% chance of an expansion, a 60% chance of a contraction, and a 30% chance of a normal period, what is the expected return of each?

EXPECTED RETURNS

Year Stock A (percent) Stock B (percent) Stock C (percent) Stock D (percent) Consumer Confidence Index 1 11.1 4.2 5.3 3.2 78.5 2 12.4 7.1 8.4 2.5 83.1 3 13.8 5.9 9.1 9.1 85.2 4 6.2 11.2 2.1 6.2 73.3 5 -3.1 8.3 -5.4 6.9 77.3 6 -2.0 12.4 .9 7.1 80.2 7 7.1 15.3 11.2 7.9 83.3 8 8.7 12.1 8.2 8.1 86.1 9 10.3 1.1 15.3 9.2 90.4 10 11.6 4.5 12.0 6.2 87.4

Explanation / Answer

Two stock to be selected

1. Stock B

2.Stock A

Expected Return Year Stock A (percent) Stock B (percent) Stock C (percent) Stock D (percent) Consumer Confidence Index Chances of State of economy Stock A (percent) Stock B (percent) Stock C (percent) Stock D (percent) 1 11.1 4.2 5.3 3.2 78.5 0.6 6.66 2.52 3.18 1.92 2 12.4 7.1 8.4 2.5 83.1 0.3 3.72 2.13 2.52 0.75 3 13.8 5.9 9.1 9.1 85.2 0.3 4.14 1.77 2.73 2.73 4 6.2 11.2 2.1 6.2 73.3 0.6 3.72 6.72 1.26 3.72 5 -3.1 8.3 -5.4 6.9 77.3 0.6 -1.86 4.98 -3.24 4.14 6 -2 12.4 0.9 7.1 80.2 0.3 -0.6 3.72 0.27 2.13 7 7.1 15.3 11.2 7.9 83.3 0.3 2.13 4.59 3.36 2.37 8 8.7 12.1 8.2 8.1 86.1 0.1 0.87 1.21 0.82 0.81 9 10.3 1.1 15.3 9.2 90.4 0.1 1.03 0.11 1.53 0.92 10 11.6 4.5 12 6.2 87.4 0.1 1.16 0.45 1.2 0.62 3.3 20.97 28.2 13.63 20.11 Expected Return of next year =20.97/3.3 =28.2/3.3 =13.63/3.3 =20.11/3.3 6.35 8.55 4.13 6.09

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