Question

1. You have collected and partially analyzed the following data about three different stocks in MSM

Stock 1                         Standard Deviation of returns =12%
Probability	Return
50% Chance	20%
50% Chance	-4%

Stock 2                         Standard Deviation of returns =19.5%
Probability	Return
30% Chance	30%
40% Chance	10%
30% Chance	-20%

Stock 3                        Standard Deviation of returns =12%
Probability	Return
10% Chance	30%
40% Chance	15%
40% Chance	10%
10% Chance	-21%

Instructions: Assuming you are a rational investor and you plan to invest all your funds in one of the above stocks, which one would achieve your goal to balance risk with expected return.     

Answer 1

since we need to balance the risk and the expected return :

we need to select the stocks which provides us with the best trade-off between the return and risk.

STOCK 1:there is a 50% chance to get a return of 20% with a standard devitation of 12%,so we get a reward to risk ratio of 1.67. yet again we have a 50% chance of incurring a loss as well.

in stock 2,

the highest probability is a 40% chance of a 10% return witha 19.5% standard deviatio. here again, the reward to risk ratio is 0.512, next is the 30% cahnce of 30% return with a standard deviation of 19.5, the reward to risk ratio is 1.54

in stock 3:

the highest probability is 40% chance of getting 15% returns with a standard deviation of 12% ,therefore, we get a reward to risk ratio of 1.25. rest of all the probabilities are too low to consider, in comparison to the other stock we have .

therefore, as rational investor i will choose STOCK A . it best balances the risk and return, hence the investor should invest all its fund in this stock.