You have 1,000 that you can invest. If you buy Ford stock,...

You have $\$ 1,000$ that you can invest. If you buy Ford stock, you face the following returns and probabilities from holding the stock for one year: with a probability of 0.2 you will get $\$ 1,500$; with a probability of 0.4 you will get $\$ 1,100$; and with a probability of 0.4 you will get $\$ 900 .$ If you put the money into the bank, in one year's time you will get $\$ 1,100$ for certain. a. What is the expected value of your earnings from investing in Ford stock? b. Suppose you are risk-averse. Can we say for sure whether you will invest in Ford stock or put your money into the bank?

You have $\$ 1,000$ that you can invest. If you buy Ford stock, you face the following returns and probabilities from holding the stock for one year: with a probability of 0.2 you will get $\$ 1,500$; with a probability of 0.4 you will get $\$ 1,100$; and with a probability of 0.4 you will get $\$ 900 .$ If you put the money into the bank, in one year's time you will get $\$ 1,100$ for certain.
a. What is the expected value of your earnings from investing in Ford stock?
b. Suppose you are risk-averse. Can we say for sure whether you will invest in Ford stock or put your money into the bank?

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Key Concepts

Expected Value

Expected value is the weighted average of all possible outcomes in a probabilistic scenario, calculated by multiplying each outcome by its respective probability and then summing the results. In investment decisions, it provides an average return that one might expect if the experiment were repeated many times, but it does not account for the variation or risk among the outcomes.

Risk Aversion

Risk aversion refers to a preference for certainty over uncertainty, where individuals favor options that offer a guaranteed outcome over those with higher variability, even if the expected value of the uncertain option might be higher. This behavior is common in financial decisions, as risk-averse investors prioritize the reduction of potential losses over pursuing higher, but uncertain, gains.

Decision Making Under Uncertainty

Decision making under uncertainty involves evaluating choices where outcomes are probabilistic rather than certain. This concept includes considering both the expected value of outcomes and personal risk preferences, such as risk aversion, to decide on the best course of action when future returns are uncertain.

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