The distributions of rates of return for Companies AA and BB are given below:
State of the Probability of
Economy This State Occurring AA BB
Boom 0.2 30% -10%
Normal 0.6 10% 5%
Recession 0.2 -5% 50%
We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

Question

Quizplus · Accepted Answer

A rational, risk-averse investor would consider both the expected return and the risk (volatility) of the securities. Security BB has a higher expected return due to the high return in recession, which might outweigh its higher risk for some investors.

The Distributions of Rates of Return for Companies AA and BB