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 independent—one stock increasing in prices 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. The first one is risky, but it also sounds terribly unstable. There must be something seriously strange going on with the economy to have the stocks be forced to move together, or else the government is exercising far too much power. In terms of overall risk, I would take the second, because though the short-term risk is higher, the long-term risk of losing everything when the economy collapses due to all the regulations is greatly reduced. In choosing between two economies, an investor who is risk-averse shall choose the second economy over the first economy which all stocks move together. In the first economy, all stocks move together meaning their correlation’s is perfectly positive (equal to 1). This means that it is useless to invest in any stocks; however diversified the portfolio is, because all these stocks will either rise together or fall together. It is then wise to invest money in the second economy where correlation is low. Having a diversified portfolio in this economy means greater chances of returns. Even if a stock in the mining industry falls drastically, the other stocks in the telecoms industry will remain unaffected and others may even go up. I would
