Eva is risk-averse. Currently she has $50,000 to invest. She faces the following choice: she can invest in the stock of a start-up company, or she can invest in IBM stock. If she invests in the start-up company, then with probability 0.5 she will lose $30,000, but with probability 0.5 she will gain $50,000. If she invests in IBM. stock, then with probability 0.5 she will lose $10,000, but with probability 0.5 she will gain $30,000. Can you tell which investment she will prefer to make?

g. Suppose you have $1,000 that you can invest in Ted and Larry’s Ice Cream Parlor and/or Ethel’s House of Cocoa. The price of a share of stock in either company is $100. The fortunes of each company are closely linked to the weather. When it is warm, the value of Ted and Larry’s stock rises to $150 but the value of Ethel’s stock falls to $60. When it is cold, the value of Ethel’s stock rises to $150 but the value of Ted and Larry’s stock falls to $60. There is an equal chance of the weather being warm or cold.

a. If you invest all your money in Ted and Larry’s, what is your expected stock value? What if you invest all your money in Ethel’s?

b. Suppose you diversify and invest half of your $1,000 in each company. How much will your total stock be worth if the weather is warm? What if it is cold?

c. Suppose you are risk-averse. Would you prefer to put all your money in Ted and Larry’s, as in part a? Or would you prefer to diversify, as in part b? Explain your reasoning.