A financial advisor has recommended two possible mutual funds for investment: Fund A and Fund B. The return that will be achieved by each of these depends on whether the economy is good, fair, or poor. A payoff table has been constructed to illustrate this situation.
(a) Draw a decision tree to represent this situation.
(b) Perform the necessary calculations to determine which of the mutual funds is better. Which one should you choose to maximize the expected value?
(c) Suppose there is a question about the return of Fund A in a good economy. It could be higher or lower than $10,000. What value for this would cause a person to be indifferent between Fund A and Fund B (i.e., the EMVs would be the same)?
This solution illustrates how to draw a decision tree; how to compute the expected value of each alternative; and how to compute the conditional value which would make an investor indifferent to each choice.