Allen Young has always been proud of his personal investment strategies and has done very well over the past several years. He invests primarily in the stock market. Over the past several months, however, Allen has become very concerned about the stock market as a good investment. In some cases, it would have been better for Allen to have his money in a bank than in the market. During the next year, Allen must decide whether to invest $10,000 in the stock market or in a certificate of deposit (CD) at an interest rate of 8%. If the market is good, Allen believes that he could get a 15% return on his money. With a fair market, he expects to get an 6% return. If the market is bad, he will most likely get no return at all—in other words, the return would be 0%.
Allen estimates that the probability of a good market is 0.4, the probability of a fair market is 0.4, and the probability of a bad market is 0.2, and he wishes to maximize his long-run average return.
Mr. Young is thinking about paying for a stock market newsletter. A friend of his said that these types of letters could predict very accurately whether the market would be good, fair, or poor. Then, based on these predictions, Allen could make better investment decisions.
(a) Develop a decision table for this problem.
(b) What is the best decision?
(c) What is the most that Allen would be willing to pay for a newsletter?
(d) Mr. Young now believes that a good market will give a return of only 12% instead of 15%. Will this Information change the amount that Allen would be willing to pay for the newsletter? If your answer is yes, determine the most that Allen would be willing to pay, given this new information.