Suppose that the percentage annual return... Suppose that the percentage annual

Question

Suppose that the percentage annual return...

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 s in a boom state our return will be minus 309 Likewise or the other possible states of the economy. Note that the sum of the probabilities has to be 1--and is tate of economy Gld Return (-30%) (-996) 35% Probability Market Return Boom 0.15 Moderate Growth 0.35 20% Week Growth 0.25 o Growth 0.25 1496) 50% Based on the expected return, would you rather invest your money in the stock market or in gold? Why?

Explanation / Answer

Expected return from investing in stock is computed as:

= 0.15*25 + 0.35*20 + 0.25*5 + 0.25*(-14)

= 8.5%

Similarly, the expected returns from investing in gold is computed as:

= 0.15*(-30) + 0.35*(-9) + 0.25*35 + 0.25*50

= 13.6%

Therefore based on expected return, we should invest our money in gold rather than in stock market as gold gives a higher expected return.

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