An individual with cash to invest has two investment choices:

Buy a stock fund that every year either earns 40% or -20% with a 50/50 probability.

Buy a bond fund that every year returns either 5% or 0% also with a 50/50 probability.

Assume that the returns on the two funds are independent, and that returns from year to year are also independent. Also assume an initial portfolio value of $1. (The answers, however, will be unaffected if you use a different initial portfolio value.)

In addition, suppose the value function is linear and is specified as:

v(z) = z for z > 0

v(z) = 3z for z < 0

a. Which fund does the investor prefer if he looks at his portfolio i) once a year; or ii) once every two years?

b. How does your answer to part a. help us understand the equity premium puzzle?