You are a risk-averse investor who is considering investing in one of two economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move together in good times all prices rise together, and in bad times they all fall together. In the second economy, stock returns are independent one stock increasing in price has no effect on the prices of other stocks. Which economy would you choose to invest in? Explain.

1. A risk averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together.

2. A risk averse investor would choose the economy in which stocks move together because the uncertainty is much more predictable, and you have to predict only one thing.

3. A risk averse investor is indifferent in both cases because he or she faces unpredictable risk.

4. A risk averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio