1 answer

You are a risk-averse investor who is considering investing in one of two economies. In the...

Question:

You are a risk-averse investor who is considering investing in one of two economies. 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. Which economy would you choose to invest in? Explain.


Answers

A risk averse investor should invest in the second economy. This is because the correlation of one stock with other is zero. hence the standard Deviation of portfolio would be lower, Lower the correlation lower is the risk or standard deviation of portfolio.
In first economy the stocks are perfectly correlated. Hence the standard deviation or risk is higher as correlation is higher or close to 1.

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