The distributions of rates of return for Companies AA and BB are given below: $\begin{array}{llrr}\text { State of the } & \text { Probability of } \
\text { Economy } & \text { This State Occurring }&AA&BB\
\text { Boom } & 0.2 & 30 \% & -10 \% \
\text { Normal } & 0.6 & 10 \% & 5 \% \
\text { Recession } & 0.2 & -5 \% & 50 \%
\end{array}$ 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

The decision for a risk-averse investor to add Security AA or BB to a well-diversified portfolio depends on the expected return and risk (volatility) of each security, not just the returns in different states. Without calculating the expected returns and the overall risk (standard deviation) of each security, we cannot conclusively determine which security is better for a risk-averse investor. Additionally, the presence of a negative return in a boom economy for BB and a positive return in a recession for BB suggests that BB could offer diversification benefits that are not immediately apparent from the given information.

The Distributions of Rates of Return for Companies AA and BB