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Category: Business and Industry

Date Submitted: 08/25/2011 09:37 PM

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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 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.

As a risk-averse investor I would choose the second economy. The reason is that if I were to choose the first economy I would have to keep a substantial portion of my portfolio invested in risk-free investments. Therefore, because of the lack of correlation in the second economy means that I can more safely diversify my portfolio to avoid risk. If the economy were to turn bad my investments would do very poorly and my portfolio would not be diversified, unless as previously stated I had invested a large portion of my portfolio in risk-free investments. This would be necessary to counteract the greater risk I would be exposed to due to the nature of the first economy with stocks moving together.

The first economy would be classified under the Weak Market Theory because the prices all rise and fall together in good times and in bad. The second economy would fall into the category of an Efficient Market Hypothesis because prices rise and fall based on the independent financial position of the company. The efficient market hypothesis posits that it is not likely that one can 'beat the market' because all share prices already reflect all relevant information. It also states that stocks are all fairly priced because all relevant information has been considered and price has already risen or fallen based on that information.

A good example of an efficient market would be the S&P 500. All relative information has already been taken...