Question

You are a risk-averse investor who is considering investing considering in two 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 price has no effect on the prices of other stocks. Which stock would you choose to invest in?

Answer 1

I will be trying to invest into the other economy in which the stock are not related to each other movement, because in that economy the correlation coefficient between different stock would be lower and that will help me to achieve higher diversification benefits, and I would be not taking much risk because my portfolio would be highly diversified because stock returns are different and one stock increasing in price has no effect on the prices of the other stock, so that will help me in gaining through advantages of correlation coefficient in management of the portfolio diversification

in the first economy there is a very high correlation between movement of the shares so there would not be diversification benefits because of similar movements in various stocks and hence I would be preferring to invest into the economy where is stock has independent returns and their movement is not correlated with each other because that will offer me with diversification benefits.