3-22 Allen Young has always been proud of his personal investment strategies and
ID: 3199069 • Letter: 3
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 be- lieves 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 re- turn 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
Part (a)
Decision Table
Decision
State of Nature (SON) – Market Condition
Good
Fair
Bad
Invest in Stock Market
Return %
14
8
0
Probability
0.4
0.4
0.2
Invest in CD
Return %
9
Probability
1
Return from CD = 9% constant and fixed
Return from Stock – variable and hence expected return
= (14 x 0.4) + (8 x 0.4) + (0 x 0.2) = 8.8
DONE
Part (b)
Since the expected return from stock is less than the return fixed from CD,
optimum decision is to invest in CD ANSWER
Decision
State of Nature (SON) – Market Condition
Good
Fair
Bad
Invest in Stock Market
Return %
14
8
0
Probability
0.4
0.4
0.2
Invest in CD
Return %
9
Probability
1
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