Consider the following two, completely separate, economies. Te 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.
A risk adverse investor would choose the economy in which stock-returns are independent because the risk can be diversified away in a large portfolio.
To determine which economy to invest in, we need to consider the concept of diversification and the impact it has on risk.
In the first economy, where all stocks move together, there is no diversification benefit. This means that regardless of how many stocks you invest in, their prices will all rise or fall together. This increases the level of risk since there is a higher chance of losing money if the economy experiences a downturn.
On the other hand, in the second economy, where stock returns are independent, there is a potential for diversification benefits. When stocks are independent, the price movement of one stock should not impact the prices of other stocks. As a result, by investing in a portfolio of independent stocks, you can reduce your overall risk through diversification.
So, as a risk-averse investor, you would choose the second economy, where stock returns are independent. By investing in a diversified portfolio of independent stocks, you can potentially lower the overall risk compared to investing in the first economy where all stocks move together.
In summary, the second economy is more favorable for investment due to the potential diversification benefits, while the first economy increases the overall risk with no diversification advantage.