Question: Consider the following two, completely separate economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocksmove together in good times all prices rise together and in bad times they all fall together. In the second economy, stock returns are independent one stock increasing in price has no effect on the prices of other stocks. Assuming you are risk averse and you could choose one of the two economies in which to invest, which one would you choose? Explain.
Investing in an Economy
As an investor it is important to know how much risk you are willing to take on when investing in an economy or a specific organization. Investors who want to deal with negligible amounts of risk are said to be risk averse. This means that they would prefer to invest in something that has very little risk and can guarantee them a reasonable return on their investment. For example, take a situation where there is $200 guaranteed or $600 if a four is selected out of a traditional deck of fifty-two playing cards and $0 if a four is not selected. The investor averse to risk would select the guaranteed $200 rather than take the risk of not getting the $600 as there is only a little over seven percent chance a four will be selected.
In order to determine which economy an adverse investor would select to invest in it is important to understand each economy. Both economies have relative returns of thirty percent on investment then regardless of which economy the investor choses to invest in he will still receive a thirty percent return on his investment. Because of this it is important to look at how the investment reacts in relationship to each economy.
The investment in the first economy the stocks all rise together and fall together. This means that if stocks are doing well then as an investor you will receive good returns on the investment. However, if the stocks are down then the return on investment will also be decreased. This means that regardless of the diversification found in a portfolio an investor’s return on investment will be high or will be low. An economy such as this does not allow for high return on investment with select stocks as they all move together.
The second type of economy that is being considered is an economy where stock returns are independent of each other. When stocks are independent of each other an investor can receive high return on investment for one stock even though the return on investment might be lower for another stock. This type of economy allows for unlimited possibilities of portfolio diversification and a variety of stocks that yield high returns on investment at various times.
Being an investor that is averse to risk, I would select investing in the second economy rather than the first economy. I would do this for two main reasons. Firstly, as an investor who is averse to risk I want my return on investment to be relatively stable and do not want to invest in risk that will give me “all or nothing”. With the first economy all of the stocks are either up or down. This means that my return on investment would either be high or low but not stable (Brigham, & Houston, 2009). However, the second economy does allow for this stability in return on investment. This stability is created by the ability to diversify my portfolio, which is the second reason I would select the second economy.
The second economy lends itself to stocks whose returns on investment are independent of each other. This means that by selecting a variety of stocks I can keep my return on investment relatively stable (Sullivan, &Sheffrin, 2003). This would be done by selecting stocks that have a history or trend of cyclical time periods with high and low returns. By choosing stocks that have opposite cycles I am able to reduce my risk and ensure that I always have stock that is yielding high return at any given point in time. For example, if I choose to invest in three stocks the second economy would yield a thirty percent return year round as the stocks are all cyclical, however if I had chosen the first economy then I would have a thirty percent return from all three stocks at once and little to show for the remaining two-thirds of the year.
Overall, portfolio diversification is an essential key to reducing risk when making an investment. For any investor who is averse to risk this is the best option to ensure a more stable return and lower risk. While a portfolio high in one kind of stock may yield a higher return is also much more risky than having a portfolio that is evenly balanced and yielding a moderate amount over an extended period of time.
Sullivan, A., &Sheffrin, S.M. (2003). Economics: principles in action. Upper Saddle River, NJ: Pearson Prentice Hall.