Question

For each of the following pairs of investments, indicate which would always be preferred by a rational investor (assuming that these are the only investments available to the investor):

Portfolio A r = 19% σ = 21%
Portfolio B r = 15% σ = 21%
Preference
a)Portfolio A
b)Portfolio B
c)Indeterminate

Answer 1

Portfolio A has the highest expected return, making it the preferred choice despite the same level of risk as Portfolio B.

Step-by-step explanation:

When comparing two investments, a rational investor would examine both the expected return (r) and the volatility or risk (indicated by the standard deviation σ).

Given the choice between Portfolio A with an expected return (r) of 19% and a standard deviation (σ) of 21%, and Portfolio B with an expected return (r) of 15% and the same standard deviation (σ) of 21%, a rational investor would generally prefer the investment with the higher expected return if the risk level is the same.

Therefore, the preference would be:

• Portfolio A - Because it has a higher expected return of 19% compared to Portfolio B's 15%, while both portfolios have the same level of risk (σ = 21%).

In terms of safety, neither investment can be considered safer than the other since they both share the same level of risk (standard deviation).

However, in terms of return, Portfolio A is the preferred choice for having the highest expected return, which on average compensates for the identical level of risk between the two investments.