CHAPTER • Uncertainty and Consumer Behavior 171 TABLE 5.5 INCOME FROM SALES OF APPLIANCES ($) HOT WEATHER COLD WEATHER Air conditioner sales 30,000 12,000 Heater sales 12,000 30,000 single product Suppose there is a 0.5 probability that it will be a relatively hot year, and a 0.5 probability that it will be cold Table 5.5 gives the earnings that you can make selling air conditioners and heaters If you sell only air conditioners or only heaters, your actual income will be either $12,000 or $30,000, but your expected income will be $21,000 (.5[$30,000] ϩ 5[$12,000]) But suppose you diversify by dividing your time evenly between the two products In that case, your income will certainly be $21,000, regardless of the weather If the weather is hot, you will earn $15,000 from air conditioner sales and $6000 from heater sales; if it is cold, you will earn $6000 from air conditioners and $15,000 from heaters In this instance, diversification eliminates all risk Of course, diversification is not always this easy In our example, heater and air conditioner sales are negatively correlated variables—they tend to move in opposite directions; whenever sales of one are strong, sales of the other are weak But the principle of diversification is a general one: As long as you can allocate your resources toward a variety of activities whose outcomes are not closely related, you can eliminate some risk THE STOCK MARKET Diversification is especially important for people who invest in the stock market On any given day, the price of an individual stock can go up or down by a large amount, but some stocks rise in price while others fall An individual who invests all her money in a single stock (i.e., puts all her eggs in one basket) is therefore taking much more risk than necessary Risk can be reduced—although not eliminated—by investing in a portfolio of ten or twenty different stocks Likewise, you can diversify by buying shares in mutual funds: organizations that pool funds of individual investors to buy a large number of different stocks There are thousands of mutual funds available today for both stocks and bonds These funds are popular because they reduce risk through diversification and because their fees are typically much lower than the cost of assembling one’s own portfolio of stocks In the case of the stock market, not all risk is diversifiable Although some stocks go up in price when others go down, stock prices are to some extent positively correlated variables: They tend to move in the same direction in response to changes in economic conditions For example, the onset of a severe recession, which is likely to reduce the profits of many companies, may be accompanied by a decline in the overall market Even with a diversified portfolio of stocks, therefore, you still face some risk Insurance We have seen that risk-averse people are willing to pay to avoid risk In fact, if the cost of insurance is equal to the expected loss (e.g., a policy with an expected loss of $1000 will cost $1000), risk-averse people will buy enough insurance to recover fully from any financial losses they might suffer • negatively correlated variables Variables having a tendency to move in opposite directions • mutual fund Organization that pools funds of individual investors to buy a large number of different stocks or other financial assets • positively correlated variables Variables having a tendency to move in the same direction