gmatbull wrote:
Historically speaking, successful long-term investors have preferred mixed investment portfolios with lower overall risk to less diversified portfolios containing more high-risk investments. But recent research shows that the most profitable investors carry a higher percentage of risk in their portfolios. This illustrates that choosing to develop a higher-risk investment portfolio is a better investment decision than is choosing to maintain a mixed portfolio with lower risk.
The conclusion drawn above relies upon which of the following assumptions?
A. Mixed portfolios with lower risk do not provide significant return on investment.
B. Investors may either develop more diversified lower-risk portfolios or less diversified higher-risk portfolios.
C. The returns on investment achieved by the most profitable investors can be achieved just as readily by less profitable investors.
D. The most profitable investors invest the majority of the portfolios in higher-risk positions.
E. The most profitable investors make better investment decisions than do those who receive a more modest return on investment.
There's a problem with the original argument, at least if we don't add an additional assumption, and I think it's just as important to spot the error here as it is to see why E is correct.
We are told that "the most profitable investors carry a higher percentage of risk", and that it is therefore true that "higher risk" is a "better investment decision". This might sound like a plausible argument on the surface, but it's actually borderline nonsense, as I can illustrate with an example scenario. Say you have 100 low-risk investors who all get a 10% return. Say you also have 100 high-risk investors, 3 of whom get a 20% return, and 97 of whom go completely bankrupt - they lose everything. Well, certainly our most profitable investors are the three who got the 20% return, and they are high-risk investors. But, overall, it doesn't seem that the high-risk group were making good decisions; almost all of them went bust.
Now we can see why we need to insert E into the argument. If the most profitable investors make the better decisions, and if the most profitable decided to take higher risk, then it naturally follows taking high risk is the better decision.
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07 Aug 2010, 06:14
43%
(02:19)
correct 
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