Consider The Following Two, Completely Separate, Economies. The Expected Return And Volatility Of All Stocks In Both Economies Is The Same. In The First Economy, All Stocks Move Together-- In Good Times All Prices Rise Together And In Bad Times They?


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Rosie Normanton answered
In bad times, it seems that the stocks in the first economy would fall together, based on the assumptions made in the question. When the economy is experiencing an upturn, stock prices will rise as investors increase their activity due to greater confidence levels. They see the potential in the economy and aim to gain from any increases in stock prices. As investment rises, so does aggregate demand (as investment is an important component of aggregate demand) so in a way it is the investment itself that leads to the economic upturn - although there are other factors at play as well. In an economic downturn, investors will buy out of stocks causing their prices to fall. This leads to the market suffering as investment decreases.
  • Which economy is most attractive to investors?
If in the first economy stock prices rise and fall together, we can assume that in the second economy stock prices rise and fall independent of one another. So which economy is the most attractive to investors? This may depend upon your point of view - or how risk aversive you are. In the first economy, there are bigger gains to be made if the economy is thriving. But if there is a sudden downturn, investors are set to lose out regardless of they have invested. In the second economy, an investor could invest in a varied range of stocks, meaning that prices rises in some stocks offset falls in other stocks. The overall gains or losses here are likely to be smaller, so it could be said there is less risk. The investor can also buy and sell different stocks to make a profit using their skill and experience.
  • What about the real world economy?
In the real world economy, stock prices do fall and rise independently of one another. However, there is still some element of connection. In a downturn, there will be a general fall in stock prices, and in an upturn many will rise. The real economy could be considered to be a mixture of the first and second economies above.

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