Diversification and stock portfolios for risk-averse investors across economies

Investing in Economies: The Risk-Averse Investor

A risk-averse investor is looking for the least amount of volatility coupled with consistent gains. This means that this investor would prefer a very safe investment that returns a couple of percentage points per year over a very risky investment that could potentially return ten or twenty percent. Also, a risk-averse investor is looking to help balance any losses with gains in other sectors. This would help point to a preferred type of economy, out of the two listed that the investor has to choose from.

The second economy, where "stock returns are independent one stock increasing in price has no effect on the prices of other stocks" would be a better investment route for such an investor. This is not to say that the other option could not be lucrative, but in diversification, the portfolio is better balanced to absorb losses in one stock and gains in another. Also, as long as the economy is improving or staying relatively consistent, and stock gains average out at a few percentage points per year, a well diversified portfolio would be the better option (Gollier, 2004). In this independent stock market, gains and volatility would be dependent on other factors, which are a normal part of the economic landscape today. Since it is very unlikely that all companies will go bust at one time, a risk-averse investor needs to diversify.

For example, if one sector of stocks is not doing well, like agriculture, these losses could be balanced out with gains in another sector that the portfolio is invested in, perhaps in pharmaceuticals for example. In this way, gains and losses are balanced out. In the other economy, where all stocks increase and decrease with each other, the gains and losses would not balance each other out in a similar manner. That would mean that the portfolio, no matter where it is invested, would end up looking the same as it did if there was no diversification in it whatsoever. In fact, diversification in this economic climate would be impossible if all stocks moved in the same ways.

This type of investing would give a risk-averse investor the lowest ratio of risk to yield in any given economy where companies are independent of each other, stock performance wise (Gollier, 2004). Also, the risk attached to a combination of two or more assets will always be smaller than the sum of the individual risk if as long as the two assets have returns that are negatively correlated (Mankiw, 2007). Furthermore, riskier assets have that risk priced in, relative to their stock prices and yields in an independent economy (Mankiw, 2007). In these ways, an investor can make more money from these types of investments, but then again they also have a higher likelihood of losing their money. In most economies and stock markets, the higher yield investments are riskier plays.