The Facts 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 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 could chose one of the two economies in which to invest, which one would you chose.
What Does Risk Averse Mean?
There are numerous ways to describe what risk averse means; however, an accurate description of a risk averse investor is primarily an investor when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. So this person prefers low risk over higher risk and that preference drives their decision making. With this in mind, great care must be taken to examine the facts set, not through my own eyes (perspective), but through the perspective of a person who is indeed risk averse. A risk-averse investor dislikes risk, and therefore will stay away from adding high-risk stocks or investments to their portfolio and in turn will often lose out on higher rates of return. Investors looking for "safer" investments will generally stick to index funds and government bonds, which generally have lower returns. This leads me to hypothesize that to get the correct answer to the question is merely a matter of ascertaining which economy presents the highest level of risk and then concluding that is the economy that the risk averse individual would not be comfortable in.
An Examination of the Facts For the sake of our discussion we will label the first economy, Economy A and the second economy, Economy B. According to the problem, Economy A is subject to systematic risk. The problem states that in good times, all of the prices rise and in bad times, all the prices fall. Therefore we can deduce that the risk in Economy A is perfectly correlated common risk across all the stocks. We can therefore deduce that even if we hold a large portfolio of stocks in this type of economy, we cannot diversify the risk. Adding more stocks from various companies will not substantially reduce the level of risk that we are exposed to. When the economy is bad, it is bad for everyone and therefore everyone will have depressed earnings. Economy B has independently moving stocks which means that when some stocks are up, some stocks are down. Therefore the stocks in Economy B are said to be unique and exhibit diversifiable risk (Berk & DeMarzo, 2010). We can also deduce that the stocks are correlated meaning they do not move in unison. I could have some stocks in my portfolio moving in the positive direction, some moving in a negative direction, and still others not moving at all. This type of economy is conducive to diversifying the risk, meaning that as an investor, I can look at various categories or classifications of stock and offset the risky investments with more conservative investment. Therefore ideally, I can get to a point that I have neutralized the risk in my portfolio.
Conclusion
Based upon my risk aversion as an investor, I would chose to invest in Economy B which has independent stocks. The primary reason is that in Economy B, I could reduce the level of risk that I am exposed to through diversification of my portfolio. The ability to reduce my level of risk is not available in Economy A. Therefore, as an investor I would never feel comfortable investing in Economy A.
References
Berk, J., & DeMarzo, P. (2010). Corporate Finance: The Core. Boston: MA.