Consider the following two, completely separate, economies. Te 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.
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A risk adverse investor would choose the economy in which stock-returns are independent because the risk can be diversified away in a large portfolio.
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