Consider The Following Two, Completely Separate Economies Analysis
Now if we take the second economy with the same stock and prices, but the stocks are not correlated with each other. We can find that, if an investors holds both of the stock and the price of A's Corporation stock falls by 10% the price of A's corporation stock will come down to $9 but it will have no impact on the price of B's corporation and hence the risk of the investor will minimize to just $1.
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.
Let’s consider an example. Suppose type S firms are affected only by strength of the economy, which has a 50-50 chance of being either strong or weak. If the economy is strong, type S stock will earn a return 40%; if the economy is weak, their return will be -20%. Because these firm face systemic risk (the strength of the economy), holding a large portfolio of type S firms will not diversify the risk. When the economy is strong, the portfolio will have the same return of 40% as each type S firm; when the economy is weak, the portfolio will also have a return of …show more content…
In this way, I can invest in different types of stocks and not have to worry that they will all act the same. If my stocks are independent of each other no matter the returns, then when one stock is not going well, another stock can be doing well. Therefore, they offset each other and I don’t lose all my investment money. For example, if you take the airline industry. When people are traveling and times are good, then investing in these companies are good but if all your investment is in this type of industry then when things are going good, you are happy and when things are going bad and people aren’t traveling, then your stocks are going to be bad and you won’t be happy. Since all of your money is tied to these investments, then you have to hope that people are traveling and that this industry is busy all year around. On the other side, if you have stocks independent of each other, then if one company or stock is going bad, you can put more money on another stock that is doing well since your money is not tied up in just one type of