Question

Suppose that an investor is considering three alternative strategies: conservative, neutral, or aggressive. If economic conditions get better, then the strategies will return, respectively, 6%, 12%, and 20%. If economic conditions get worse, then the strategies will return, respectively, 4%, 2%, and -8%. If the probability of better economic conditions is 80%, then the conservative strategy would be evaluated based on its expected value of ...

Answer 1

The expected value of a conservative investment strategy, given an 80% chance that economic conditions will improve, is calculated to be 5.6% by combining the probabilities and respective returns for better and worse economic conditions.

Step-by-step explanation:

To calculate the expected value of the conservative investment strategy, one must take into account the probability of each economic condition (better or worse) and the corresponding returns. The expected value (EV) is the sum of each potential return multiplied by its probability. In this case:

• Return if economic conditions improve: 6% of investment.
• Return if economic conditions worsen: 4% of investment.

Given the probability of better economic conditions is 80% (0.8), we can calculate the expected value (EV) for the conservative strategy as follows:

EV = (Probability of better condition × Return if better) + (Probability of worse condition × Return if worse)

EV = (0.8 × 6%) + (0.2 × 4%)

EV = (0.8 × 0.06) + (0.2 × 0.04)

EV = 0.048 + 0.008

EV = 0.056 or 5.6%

Therefore, the expected value of the conservative strategy is 5.6%.