Suppose that you are investing money in a portfolio of stocks and are choosing from among Badrisk Company, which returns 20% in good years and loses 40% in bad years; Worserisk Company, which returns 20% in good years and loses 70% in bad years; Norisk Company, which returns 7.5% all the time; and Lowrisk Company, which returns 15% in good years and loses 5% in bad years.
If you were completely risk-averse and your only goal was to minimize your risk, which stock(s) would you buy?
If you were risk-neutral, and good years and bad years each occurred half the time, which stock(s) would you buy? Why? (Show your work.
(Hint: Being risk-neutral means I only care about the expected rate of return.)
If you decided on a portfolio consisting of one third Badrisk, one-third Norisk, and one-third Lowrisk, what would be your rate of return in good years? In bad years? What would be your expected rate of return over all years if good years and bad years each occurred half the time? If Good years occurred 80% of the time and bad years 20% of the time?