Suppose that the percentage annual return you obtain when you invest a dollar in

Question

Suppose that the percentage annual return you obtain when you invest a dollar in gold or the stock market is dependent on the general state of the national economy as indicated below. For example, the probability that the economy will be in "boom" state is 0.15. In this case, if you invest in the stock market your return is assumed to be 25%; on the other hand if you invest in gold when the economy is in a "boom" state your return will be minus 30%. Likewise for the other possible states of the economy. Note that the sum of the probabilities has to be 1--and is.

Based on the expected return, would you rather invest your money in the stock market or in gold? Why? (Need to show and explain work).

State of economy Probability Market Return Gold Return Boom 0.15 25% (-30%) Moderate Growth 0.35 20% (-9%) Week Growth 0.25 5% 35% No Growth 0.25 (-14%) 50%

Explanation / Answer

The concept of expected values to decide on the investment strategy.
For example, the expected value of the percentage returns on stocks is
E(stocks) = 0.15 * 25 + 0.35 * 20 + 0.25 * 5 + 0.25 * (-14) = 8.5%
Likewise, we can calculate the expected value corresponding to gold and obtain E(gold) = 13.6%
Since investing in gold yields higher expected returns than stocks, it is better to invest in gold.

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