3-22 Allen Young has always been proud of his personal investment strategies and

Question

3-22 Allen Young has always been proud of his personal investment strategies and has done very well over the past several years. He invests primarily in the stock market. Over the past several months, how- ever, Allen has become very concerned about the stock market as a good investment. In some cases it would have been better for Allen to have his money in a bank than in the market. During the next year, Allen must decide whether to invest $10,000 in the stock market or in a certificate of deposit (CD) at an interest rate of 9%. If the market is good, Allen believes that he could get a 14% return on his money. With a fair market, he expects to get an 8% return. If the market is bad, he will most likely get no return at all-in other words, the return would be 0%. Allen estimates that the probability of a good market is 0.4, the probability of a fair market is 0.4 and the probability of a bad market is 0.2, and he wishes to maximize his long-run average return. (a) Develop a decision table for this problem. (b) What is the best decision?

Explanation / Answer

Solution :-(a)

Alternative Good Fair Poor Investment Amount 10000 10000 10000 Stock Market Probability 0.4 0.4 0.2 Return 10000*14% = 1400 10000*8% = 800 10000*0% = 0 purchase stock 1400*0.40 = 560 800*0.40 = 320 0 CD Return 10000*9% = 900 10000*9% = 900 10000*9% = 900 Return % 9% 9% 9% Probability 40% 40% 20% Solution (b) Expexted Return Stock (560+320)/10000 8.80% (14%*0.40 + 8%*0.40 + 0%*0.20) CD 9% The Best decision is to invest in Certificate of deposits (CD) The reason behind it is that the Expected return from CD is greater than Expected Return of Stock fell free to ask any query regarding it through comments.

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