Risk Averse, I Would Select

¶ … risk averse, I would select the second economy. The reason for this is that the lack of correlation between firms in the economy is evidence of a lower degree of market risk. Risk aversion implies that I prefer the asset with the lowest total risk. There are two forms of risk -- market and firm-specific. In this situation, the short-term and long-term risk should also be considered.

The two economies have the same expected return and volatility. This would imply that the investor have no preference between the two, as the risk (volatility) is no different and the expected returns are the same. For a rational investor, the risk-adjusted return is not going to be different for either economy. However, the volatility is a measure of asset-specific risk. The two assets may have the same degree of volatility as one another, but within each asset are other assets. The risk associated with these assets is higher in the first economy.

This is because as one stock moves, so do the others. Any movement is going to be amplified. The economy will be subject to intense upward and downward movements during the time period. The expected return might be the same as in the second economy, but the path by which the economy will get there is going to be different. In the second economy, the assets move independently of one another. A shock to one part of that economy will not affect the portfolio as a whole. This reduced level of amplification in the returns is indicative of a lower degree of market risk.

As a risk averse investor, I am concerned that I might need my capital returned to me at an unexpected point in time. The first economy could conceivable be at a strong low point when I need my money -- it has a higher degree of market risk. It is less likely, based on the correlation of price movements within that economy, that the economy will be down significantly. There is also less risk that it will be up significantly, but as a risk averse investor I am only considering the downside risk. Therefore, I would choose the option that has the least amount of downside risk.

The question cuts to the difference between market risk and firm-specific risk, and short-term and long-term risk. In this situation, the two economies have equivalent market risk in the long-run. They do not have equivalent levels of market risk in the short-run, however. In addition, there is a higher degree of firm-specific risk in the first economy because the firms are impacted by each other. In the second economy, firm-specific risk is offset by the lack of correlated movement in other firms. This means that short-term risk of the economy in general is lower.