Problem 3-20: Investment Strategy for Mickey Lawson

1
Problem 3-20 Investment Strategy for Mickey
Lawson

• November 2006

2
The Problem

• Based on information from Problem 3-19, develop
  an opportunity loss table for the investments
  Mickey is considering Stock Market, Bonds, or
  Certificates of Deposit (CDs).
• What decision would minimize the expected
  opportunity loss?
• What is the minimum Expected Opportunity Loss
  (EOL)?

3
Decision Model

• Decision is being made under risk.
• Probabilities are known.
• The Decision Model will be the minimization
  (Minimax) of expected opportunity loss.

4
Data Used for the Decision
State of Nature State of Nature
Decision Alternative Good Economy Poor Economy
Stock Market 80,000 -20,000
Bonds 30,000 20,000
CDs 23,000 23,000
Probability 0.5 0.5
5
Calculations for Each Option under two States of
Nature
State of Nature State of Nature
Decision Alternative Good Economy Poor Economy
Stock Market 80,000-80,000 23,000(-20000)
Bonds 80,000-30,000 23,000-20,000
CDs 80,000-23,000 23,000-23,000

6
Total Expected Opportunity Loss
State of Nature State of Nature
Decision Alternative Good Economy Poor Economy Maximum in a Row
Stock Market 0 43,000 43,000
Bonds 50,000 3,000 50,000
CDs 57,000 0 57,000
Probability 0.5 0.5
7
Smallest Expected Opportunity Loss Based on
Probability for Each State of Nature

• Stock Market 43,000 x 0.5 21,500
• Bonds 50,000 x 0.5 25,000
• CDs 57,000 x 0.5 28,500
• Given the information above, Mickeys best
  decision would be to invest his funds in the
  stock market.