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Risk Averse Situation: Investing in an Economy

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 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.

Solution Preview

If I was risk averse, and the overall stability of the two economies were essentially the same, I would definitely invest in the second economy. Why? Most financial experts always state (especially in today's volatile world), diversification, diversification, diversification. And, since no one really knows definitely knows when a bull or bear market will either start or stop and for what type of stock(s) they will affect, diversification is key. Let me say this as ...

Solution Summary

This solution discusses which economy to invest in when put in a risk averse situation.