c21c-jn - Chapter 21.c. Investor Choice Investors do not...

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Chapter 21.c. Investor Choice Investors do not normally allocate their entire investment on assets with the highest rate of return because risk is involved with this kind of action. Higher rates of return are commonly associated with greater risk and investors who are risk averse would not put themselves in this kind of situation. Figure 5.5.5.1 shows an investor’s indifference curve. Since the indifference curves are examining the volatility or risk as a bad and expected returns as a good, the investor’s indifference curves are upward-sloping. Return-Risk Tradeoff Return Risk A B C U1 U2 U0 risk1 risk2 return1 return2 Figure 5.5.5.1 The Return-Risk Tradeoff. The indifference curves are upward-sloping if the expected return is a good and the risk or the volatility is seen as a bad. If the investor were to hold the expected return as return1 , there would be a rise in risk associated with the return and point A would move to point B, which places the investor at a lower indifference curve from U1 to U2 . Therefore, as the risk of the return rises from risk1 to risk2 , the expected return also rises from return1 to return2. This will move the point B to point C to compensate for the added risk and keep the investor’s utility at U2 . Investor Preferences toward Risk
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This note was uploaded on 09/25/2008 for the course ECON 160 taught by Professor Baim during the Summer '98 term at UCLA.

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c21c-jn - Chapter 21.c. Investor Choice Investors do not...

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