Question

You are a​ risk-averse investor who is considering investing in one of two economies. The expected return and volatility of all stocks in both economies is the same. In the first​ economy, all stocks move together long - in good times all prices rise​ together, and in bad times they all fall together. In the second​ economy, stock returns are independent long - one stock increasing in price has no effect on the prices of other stocks. Which economy would you choose to invest​ in? Explain.
​(Select the best choice​ below.)A. A risk averse investor would choose the economy in which stocks move together because the uncertainty is much more​predictable, and you have to predict only one thing.B. A risk averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together.C. A risk averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio.D. A risk averse investor is indifferent in both cases because he or she faces unpredictable risk.

Answer 1

Answer:

C. A risk averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio.

Explanation:

if stock prices move together, (positive correlation), the volatility of the portfolio will be higher. Higher volatility means higher risk. This is the case with the first economy.

In the second economy however, the stocks are independent of each other meaning there is zero correlation between stocks and hence the portfolio volatility will be much lesser.

As a risk-averse investor you will prefer the portfolio with lower volatility for the same expected return.