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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 stocks move 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.
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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 stocks move 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.

by Chief OxJuly 10, 2020

Investing in Economies when Risk-Adverse

            Someone who is risk-adverse, attempts to minimize the amount of risk that they are taking. A risk-adverse individual looks at the amount of risk that would be taken in any situation, but it is most commonly associated to situations involving finances. The best way to understand the concept of being risk-adverse is to look at the decision making process in a specific situation. Take the game show “Deal or No Deal.” The concept of this show is that you select cases with varying amounts with the potential to win $1,000,000. As the contest selects cases and eliminates possible sums in the case that they selected the banker makes on offer on the case. Say for instance the board has $500, $5,000 and $500,000 left as options for the amount in the case and the banker offers $15,000. If the contestant is risk-adverse they would choose to take the $15,000 and leave with something, rather than take the chance that their case had $500,000 and leave with only $500. In the mind of the risk-adverse contestant the banker’s offer is only a risk of $15,000 while the option to keep playing is a risk of $499,500. This means that when a risk-adverse individual is looking at two separate economies and determining which economy should be invested in, the risks must be determined and calculated for each individual economy. In this specific situation there are two separate economies. Due to the fact that the expected return is the same in both economies we must look at how the prices move individually and in relationship with each other.

            In the first economy that could be invested in, stocks move together. This means that when stock prices are high, all stock prices are high. On the other hand if stock prices are low, then all stock prices are low. This means that investment made at this time has significant highs and lows. Therefore, if money is invested into this economy the profit is only made when the prices are high (when all other stocks are high). The second economy that could be invested in, the stock prices move independent of each other. This means that if one stock is high another may be low and vice versa. This economy lends itself to making profit at all times.

            The profit that is made will be the same regardless of the economy that is invested in as the expected return and volatility of the stocks are the same for both economies. This means that the decision for the risk-adverse investor boils down to the risk in obtaining the returns. To understand the risk it is helpful to look at the economies in relationship to the example provided above with the game show. The decision of deciding which economy to invest in is very similar to the contestant’s decision as to whether or not they should take the banker’s offer. The first economy is like opting to open another case rather than take the banker’s offer. At any given point in time the investor will make all the profit or lose all the profit. The second economy on the other hand is like the decision to take the banker’s offer. At any given point of time there is stock that is at its high and stock that is at its low. This means that profit can be ensured at any given point in time. This is much more low risk and is the safe option for the risk-adverse individual.

            Another way to look at the two different economies is to compare the stocks to light switches. Investing in either economy the investor is looking to make a profit, or light. In the first economy when one switch is on, they all are on giving the investor light (or profit). However, when one switch is off they all are off meaning the investor has no light (or profit). In the second economy, any given switch can be on or off at any time. This means that while the light may not be as bright at any given point of time, the investor still has some light to work with. Therefore, as a risk-adverse investor, investing in the second economy is being the best option as the risk is minimized compared to the first economy.

Investing in Economies when Risk-Adverse

            Someone who is risk-adverse, attempts to minimize the amount of risk that they are taking. A risk-adverse individual looks at the amount of risk that would be taken in any situation, but it is most commonly associated to situations involving finances. The best way to understand the concept of being risk-adverse is to look at the decision making process in a specific situation. Take the game show “Deal or No Deal.” The concept of this show is that you select cases with varying amounts with the potential to win $1,000,000. As the contest selects cases and eliminates possible sums in the case that they selected the banker makes on offer on the case. Say for instance the board has $500, $5,000 and $500,000 left as options for the amount in the case and the banker offers $15,000. If the contestant is risk-adverse they would choose to take the $15,000 and leave with something, rather than take the chance that their case had $500,000 and leave with only $500. In the mind of the risk-adverse contestant the banker’s offer is only a risk of $15,000 while the option to keep playing is a risk of $499,500. This means that when a risk-adverse individual is looking at two separate economies and determining which economy should be invested in, the risks must be determined and calculated for each individual economy. In this specific situation there are two separate economies. Due to the fact that the expected return is the same in both economies we must look at how the prices move individually and in relationship with each other.

            In the first economy that could be invested in, stocks move together. This means that when stock prices are high, all stock prices are high. On the other hand if stock prices are low, then all stock prices are low. This means that investment made at this time has significant highs and lows. Therefore, if money is invested into this economy the profit is only made when the prices are high (when all other stocks are high). The second economy that could be invested in, the stock prices move independent of each other. This means that if one stock is high another may be low and vice versa. This economy lends itself to making profit at all times.

            The profit that is made will be the same regardless of the economy that is invested in as the expected return and volatility of the stocks are the same for both economies. This means that the decision for the risk-adverse investor boils down to the risk in obtaining the returns. To understand the risk it is helpful to look at the economies in relationship to the example provided above with the game show. The decision of deciding which economy to invest in is very similar to the contestant’s decision as to whether or not they should take the banker’s offer. The first economy is like opting to open another case rather than take the banker’s offer. At any given point in time the investor will make all the profit or lose all the profit. The second economy on the other hand is like the decision to take the banker’s offer. At any given point of time there is stock that is at its high and stock that is at its low. This means that profit can be ensured at any given point in time. This is much more low risk and is the safe option for the risk-adverse individual.

            Another way to look at the two different economies is to compare the stocks to light switches. Investing in either economy the investor is looking to make a profit, or light. In the first economy when one switch is on, they all are on giving the investor light (or profit). However, when one switch is off they all are off meaning the investor has no light (or profit). In the second economy, any given switch can be on or off at any time. This means that while the light may not be as bright at any given point of time, the investor still has some light to work with. Therefore, as a risk-adverse investor, investing in the second economy is being the best option as the risk is minimized compared to the first economy.

            Another way to look at the two different economies is to compare the stocks to light switches. Investing in either economy the investor is looking to make a profit, or light. In the first economy when one switch is on, they all are on giving the investor light (or profit). However, when one switch is off they all are off meaning the investor has no light (or profit). In the second economy, any given switch can be on or off at any time. This means that while the light may not be as bright at any given point of time, the investor still has some light to work with. Therefore, as a risk-adverse investor, investing in the second economy is being the best option as the risk is minimized compared to the first economy.

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Chief Ox

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