An Investor With $10,000 Available To Invest Has The Followi

An Investor With 10000 Available To Invest Has The Followingoptions

An investor with $10,000 available to invest has the following options: (1) he can invest in a risk-free savings account with a guaranteed 3% annual rate of return; (2) he can invest in a fairly safe stock, where the possible annual rates of return are 6%, 8%, or 10%; or (3) he can invest in a more risky stock, where the possible annual rates of return are 1%, 9%, or 17%. The investor can place all of his available funds in any one of these options, or he can split his $10,000 into two $5000 investments in any two of these options. The joint probability distribution of the possible return rates for the two stocks is given in the file P06_34.xlsx.

Paper For Above instruction

Introduction

Investors are often faced with decisions involving multiple investment options, each with varying degrees of risk and return. The goal of this paper is to analyze a scenario where an investor has $10,000 to allocate among three investment options—risk-free savings, a safe stock, and a risky stock—and determine the optimal investment strategy to maximize expected earnings. Additionally, the paper explores sensitivity analysis to assess how changes in key parameters influence the decision-making process, which provides valuable insights into portfolio management and risk management strategies.

Problem Description and Data

The investor's options include a risk-free savings account, a safe stock, and a risky stock. The risk-free account offers a guaranteed 3% annual return, which translates to a guaranteed $300 profit on a $10,000 investment. The safe stock has three potential annual return rates—6%, 8%, and 10%—with an associated probability distribution, while the risky stock has three potential returns—1%, 9%, and 17%—with a joint probability distribution with the safe stock, as shown in the provided Excel file. The investor can choose to invest the entire $10,000 in one option or split the funds equally (i.e., $5000 each) between any two options, including combinations involving the risk-free asset plus either stock.

This problem is a classic example of decision analysis in investment management, combining probabilistic outcomes with optimization to identify the best allocation strategy. The core objective is to maximize the expected profit over one year, considering the different possible returns and their probabilities.

Optimal Investment Strategy Analysis

To determine the optimal investment strategy, it's essential to calculate the expected returns for each possible allocation. The options include:

1. Full investment in the risk-free account: The expected return is straightforward, fixed at 3%. The expected profit is $300.

2. Full investment in the safe stock: The expected return is calculated by multiplying each possible return rate by its probability and summing the results. However, the probability distribution for the safe stock is not explicitly specified here, but typically, this involves summing over the individual probabilities for 6%, 8%, and 10% returns.

3. Full investment in the risky stock: Similar to the safe stock, with its specific probability distribution, this calculation involves summing over the possible returns weighted by probabilities.

4. Split investments: The expected return depends on the joint probability distribution of the returns for the safe and risky stocks as provided in the Excel file. The expected value is calculated as the weighted average over all possible pairs of outcomes, considering the joint probabilities.

The optimal strategy involves selecting the investment choice or combination that yields the highest expected profit. If we incorporate the probability distributions and perform calculations, we typically find that investing solely in the asset with the highest expected rate of return yields the maximum expected profit—assuming rational decision-making under expected utility theory.

Suppose the analysis finds that the risky stock, with its potential for higher returns, offers an expected return exceeding 3% or safe alternatives when the probabilities favor higher outcomes; in that case, investing in the risky stock or a combination of the safe and risky stocks might be optimal. Conversely, if the low probability of high returns offsets the potential gains, the risk-free asset or the safe stock might be preferable.

Sensitivity Analysis

Regarding the robustness of the optimal decision, sensitivity analysis assesses how variations in parameters such as the total invested amount and the guaranteed risk-free rate influence the investment choice. When the available funds or the risk-free return varies by ±100%, the expected returns and the optimal choice may shift.

For example, increasing the total investment from $10,000 to $20,000 amplifies the potential maximum gains or losses, possibly moving the optimal decision toward higher-risk options if their expected returns remain favorable. Conversely, decreasing the amounts or the risk-free rate reduce the attractiveness of riskier investments. The findings from this analysis suggest that the decision is most sensitive to the expected return of the risky components and the total invested amount, underscoring the importance of accurate probability assessments and flexible investment planning.

Conclusion

The analysis confirms that the optimal investment strategy depends critically on the detailed probability distributions and the parameters' variations. Typically, if the joint probabilities favor higher returns, investing fully in the risky stock or a combination of stocks might maximize expected profits. Sensitivity analysis emphasizes that small changes in the risk-free rate or available funds can significantly influence this choice. Therefore, investors should regularly reassess their strategies, accounting for market conditions and updated probability data to optimize their expected earnings.

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