Safe and Risky Investments

Safe and Risky Investments

Joe Conservative hates risk and is terrified of the prospects of losing money. He is strictly a bank CD man, being highly suspicious of the stock market. His girlfriend, Rita Riskaverse, doesn’t like risk either, but she studied investments in college and knows something about the relationship between risk and return.

Joe and Rita eventually get married but decide it makes sense for them to handle their investments individually. Joe puts $100,000 in a bank certificate of deposit earning 6% annually, while Rita spreads her $100,000 equally across five stocks, putting $20,000 in each one.

Twenty years later the two lovebirds decide to do some joint financial planning, which requires them to disclose the performance of their personal investment accounts.

Rita does some calculations on the performance of her five stocks. She tells Joe “I had one stock go bankrupt, two that earned less than your 6% from the bank, one that earned 8%, and one that earned 12%.”

Joe responds, “I told you the stock market was too risky. You should have listened to me.”

Suppressing a smirk, Rita shows Joe the data below.

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Joes’s Bank CD:
$100,000 x (1.06)^20 = $320,714

Rita’s Stocks:
Stock A: worthless $0
Stock B: $20,000 x (1.03)^20 = $36,122
Stock C: $20,000 x (1.05)^20 = $53,066
Stock D: $20,000 x (1.08)^20 = $93,219
Stock E: $20,000 x (1.12)^20 = $192,926
Total = $375,373
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Joe can’t believe it. Rita had one stock go under, two that were below-average performers, and two that did okay but certainly didn’t set the world on fire. It seems like luck to him that her portfolio is worth more than his – although he can’t put his finger on what was lucky. It just doesn’t seem fair.