Economist: On average, returns are higher on stocks than on bonds, as

Question

Economist: On average, returns are higher on stocks than on bonds, as one would expect: higher average returns are a necessary incentive for investors to accept the greater risks of loss that come with stock investments. However, the average difference in returns between stocks and bonds is even greater than one would expect based on risk alone. Financial planners may be responsible. Their pay depends mainly on avoiding losses for their clients, which encourages them to recommend safe investments with low returns. This increased demand for bonds increases their price and hence decreases their potential return.

Which of the following is an assumption the economist’s argument requires?

A. At least some financial planners recommend that at least some of their clients invest only in bonds.
B. Investing in a specific stock rather than a specific bond is justified if the return will probably be much greater on the stock than on the bond.
C. On average, financial planners recommend less investment in stocks than the returns on such investments would justify for their clients.
D. The return on bonds is greater, on average, than the relative safety of bond investments would justify.
E. At least some financial planners try to increase their pay by recommending to their clients investments in safe stocks with low returns.

MartyMurray · Accepted Answer

Economist: On average, returns are higher on stocks than on bonds, as one would expect: higher average returns are a necessary incentive for investors to accept the greater risks of loss that come with stock investments. However, the average difference in returns between stocks and bonds is even greater than one would expect based on risk alone. Financial planners may be responsible. Their pay depends mainly on avoiding losses for their clients, which encourages them to recommend safe investments with low returns. This increased demand for bonds increases their price and hence decreases their potential return.

The economist concludes the following:

Financial planners may be responsible (for causing the phenomenon that the average difference in returns between stocks and bonds is even greater than one would expect based on risk alone).

The support for that conclusion is the following:

Their pay depends mainly on avoiding losses for their clients, which encourages them to recommend safe investments with low returns. This increased demand for bonds increases their price and hence decreases their potential return.

Which of the following is an assumption the economist’s argument requires?

The correct answer must be something the economist has assumed in going from the evidence about financial planners recommending safe investments to the conclusion about financial planners possibly being responsible for the larger than expected difference between the returns on stocks and bonds.

A. At least some financial planners recommend that at least some of their clients invest only in bonds.

The support for the conclusion does not depend on any financial planners recommending that their clients invest  only  in bonds. As long as they gravitate toward recommending bonds and recommend them more than they would if they were not emphasizing avoiding losses, the argument works.

Eliminate.

B. Investing in a specific stock rather than a specific bond is justified if the return will probably be much greater on the stock than on the bond.

The passage states as fact that the "average" difference between stock and bond returns is greater than would be expected.

This information about what is justified with regard to investing in "a specific stock" is not necessary for the argument to work since it is not necessary to support a fact with an assumption.

Also, the author's general statement about the overall "average" difference would not be supported by this statement about a specific stock in any case.

Eliminate.

C. On average, financial planners recommend less investment in stocks than the returns on such investments would justify for their clients.

Honestly, I don't consider this choice an assumption. The author states as fact that "This increased demand for bonds increases their price and hence decreases their potential return."

If financial planners are gravitating toward recommending bonds because they are risk averse and thus are causing the difference between stock and bond returns to be greater than expected, then we can infer that, as this choice says, "On average, financial planners recommend less investment in stocks than the returns on such investments would justify for their clients." After all, if they are unduly bidding up bonds, then they are also unduly staying away from stocks.

So, I think this choice is more of an inference based on what the passage says than an assumption.

Also, we don't need to assume this choice for the argument to work. After all, if financial planners are indeed playing it safe and recommending bonds to their clients and thus causing extra demand for bonds, then it follows that they are responsible for the greater than expected difference between the returns on bonds and the returns on stocks, regardless of whether anything is assumed about stocks.

In other words, we need only the statements about bonds for the argument to work. We don't need to assume anything about stocks. After all, the fact that there is extra demand for bonds could alone explain the greater than expected difference between bond returns and stock returns.

At the same time, none of the other choices work, and it's true that, for the statements in the passage to be true, this choice must be true as well. In other words, while this choice is not a necessary assumption, it does fit the scenario in such a way that if it's not true, then the conclusion cannot be correct. After all, if something that can be inferred from the statements in the passage is not true, then those statements cannot be true either.

So, we have to roll with this choice as the correct answer even though the argument works even if this choice is not assumed.

Keep

D. The return on bonds is greater, on average, than the relative safety of bond investments would justify.

This choice is contrary to what the passage says.

After all, the conclusion of the argument and the support for the conclusion are basically an explanation for why bond returns are even  lower  relative to stock returns than would be expected, not  greater  than is justified.

Eliminate.

E. At least some financial planners try to increase their pay by recommending to their clients investments in safe stocks with low returns.

The point of the argument is basically that financial planners make the difference between bond returns and stock returns greater than expected by avoiding losing money for clients by  recommending bonds .

We can see that, to argue that point, it is certainly not necessary to assume that financial planners  recommend stocks .

Eliminate.

Correct answer:  C

sachi-in · Answer

Premise: 
The premise is there is an unjustified level of low return in Bonds in comparison to Stocks.
This level of low return cannot be justified by the difference in Gain vs Risk analysis of these two instruments ( stocks / bonds )
The  Pay  of finalcial planners depends on avoiding risk so they may be avoiding the Stocks more than the Return vs Risk of the stocks can justify -> leading to higher Bonds being bought than expected -> Higher prices of Bond than expected -> Lower return than expected

Hypothesis / prethinking:  This low level of return is only becuase the fund managers / Financial planners have become ( abnormally ) less prone to avoid risks which leads to ( abnormally ) higher amounts of Bonds being bought leading to lower than expected return.

This will be valid only if fund managers are avoiding Stocks and buying Bonds at an higher rate than can be justified by their Gain vs Risk analysis.

A.  At least some financial planners recommend that at least some of their clients invest only in bonds. ( but doesn't necesscarily lead to unjustifiably larger amount of bonds being bought )

B.  Investing in a specific stock rather than a specific bond is justified if the return will probably be much greater on the stock than on the bond ( we are talking about the average Stock and Bond, some Bond may even give higher Return vs Risk than an individual Stock, but we are considering the market in general )

C. On average, financial planners  recommend  less investment in stocks than the returns on such investments would justify for their clients.  ( this comes very near to our hypothesis,
If we negate this -> Fund managers recomment less investment in stocks but not to an unjustifiable / excessive extent , then the argument falls apart since that would mean Financial planners are not responsible for the phenomenon.

D. The return on bonds is greater, on average, than the relative safety of bond investments would justify. ( If return is greater than the relative safety would justify then this itself could be a alternate reason why Bonds are being bought more than expected leading to lower return , this doesn't need to be assumed if we are considering the Financial planners to be our root cause )

E. At least some financial planners try to increase their pay by recommending to their clients investments in safe stocks with low returns. ( irrelevant )

sayan640 · Answer

MartyMurray  Can you please make me understand how C is the assumption ?  KarishmaB  , Can you please help me understand how C becomes the assumption ? Falsification / negation technique would help , surely.

Raman109 · Answer

Understanding the argument - 
Economist: On average, returns are higher on stocks than on bonds, as one would expect: higher average returns are a necessary incentive for investors to accept the greater risks of loss that come with stock investments. - Background info.

However, the average difference in returns between stocks and bonds is even greater than one would expect based on risk alone. - "however" introduces a contrast and contrary observation.

Financial planners may be responsible. - Conclusion.

Their pay depends mainly on avoiding losses for their clients, which encourages them to recommend safe investments with low returns. This increased demand for bonds increases their price and hence decreases their potential return. - So basically, to support the conclusion, the economist uses the premise that explains the relationship as to how the demand goes up, which pushes the prices up and lowers returns.

Which of the following is an assumption the economist’s argument requires?

A. At least some financial planners recommend that at least some of their clients invest only in bonds. - They may also recommend diversifying a portfolio as part of guidance and thus pushing up the demand. Some people recommend only bonds, which is not the minimum condition for the conclusion to be true.

B. Investing in a specific stock rather than a specific bond is justified if the return will probably be much greater on the stock than on the bond. - why it's justified is out of scope.

C. On average, financial planners recommend less investment in stocks than the returns on such investments would justify for their clients. - Yes. If, on average, they recommend less investment in stocks, it strengthens that they are pushing demand for the bonds.

D. The return on bonds is greater, on average, than the relative safety of bond investments would justify. - Out of scope.

E. At least some financial planners try to increase their pay by recommending to their clients investments in safe stocks with low returns. - Out of scope.

jain67 · Answer

Hi  MartyMurray  I selected choice E because after negating it broke down the argument.
Negation- "None of the financial planner........"
That means no financial planner recommended bond then our conclusion is broken.

Can you please let me know where I am going wrong?

TheVDR · Answer

C feels more like "stating the obvious" than an assumption.
Also, inverse proportionality between stock and bonds seems to be automatically assumed as if there are no other investment options, as per answer C.

pearrrrrrr · Answer

Hi  MartyMurray  @ sachi-in  
If choice  E. was   "At least some financial planners try to increase their pay by recommending to their clients investments in  bonds, rather than stocks .",   would this one be the assumption?

MBAApp27 · Answer

Could someone pls explain why A) is wrong?

DmitryFarberMPrep · Answer

Keep in mind that a correct assumption answer choice needs to be necessary to the argument. The argument says that bond values are driven down because financial planners feel the need to recommend bonds. So we already know that this is a common practice. It doesn't matter for our purposes whether, say, all planners recommend bonds 50% of the time, or half of planners recommend 100% bonds and the other half recommend 0%. We just need to know that recommending bonds is common, and we already know this from the premise. So A is not necessary, and doesn't really add anything to the argument.

stefan27

Could someone pls explain why A) is wrong?

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MBAToronto2024 · Answer

KarishmaB  can you please provide your analysis?

KarishmaB · Answer

Take an example to understand the argument: Say return on a company's stock is expected to be about 30% while the return on the company's bonds is only 10%. This makes sense because stocks are higher risk investments. But actually, the author says, the diff between stock and bond returns is even more than 20%. Why? Because planners suggest their clients to take more bonds (because of their ulterior motives) instead of stocks even when investing in stocks is justified as per risk-return. Say as per the risk profile of the customer, she should invest 60-40 in stocks and bonds respectively. But the planner suggests 50-50 to lower his own risk. Hence the demand for bonds is higher than what is justified as per the return they are offering. Since demand is higher, the companies' bonds get sold at higher prices so an investor pays more than the what is justified. So the actual return the investor gets on the bond could be just 8% say. Hence the difference between the returns becomes even higher i.e. 22%. To get the assumption, we need to know what the conclusion is. Conclusion: Financial planners are responsible for higher than expected difference between the returns of stocks and bonds. Now we look for an assumption. A. At least some financial planners recommend that at least some of their clients invest only in bonds. Incorrect. We do not need to assume that any planner tells their clients to invest ONLY in bonds. We are given that planners give preference to bonds even when stocks may be justified. B. Investing in a specific stock rather than a specific bond is justified if the return will probably be much greater on the stock than on the bond. There is a balance of risk and return. Whether investment in a stock for a return is justified depends on the risk appetite of the client. There is no blanket statement or assumption that greater return means investing is justified. C. On average, financial planners recommend less investment in stocks than the returns on such investments would justify for their clients. The first time I read this option, I wanted something better - something that said that planners recommend more bond investments than their return justifies. It is not necessary that they reduce the stock investments. But considering that investors have a fixed amount they invest, it would be a trade off. If the planners are recommending more investment in bond than is justified, then automatically, investment in stocks is less than justified. Negated C: On average, financial planners do not recommend less investment in stocks than the returns on such investments would justify for their clients. Now, if they do not recommend less investment in stocks, how do they increase investment in bonds? An investor does not have unlimited money to invest. An investor comes with a fixed amount say 100k that they need to invest. If more is invested in bonds, less is left for stocks. If less is not left for stocks, then more cannot be given to bonds and hence the conclusion breaks. D. The return on bonds is greater, on average, than the relative safety of bond investments would justify. We are given that return on bonds is lower. Incorrect. E. At least some financial planners try to increase their pay by recommending to their clients investments in safe stocks with low returns. "Safe stocks" is out of scope. Stocks are called risky and bonds are called safer. Answer (C) Some discussions on assumption questions: https://youtu.be/O0ROJfljRLU https://youtu.be/QoIAgREUfk0

shreyans4757583 · Answer

This is an AI generated post, but I think this might be helpful.

The Problem in Simple Terms 
Natural Gap: Stocks are risky, bonds are safe. To get people to buy risky stocks, they must offer a higher return.

Natural Stock Return: 10%

Natural Bond Return: 5%

The "Natural" or "Justified" Gap = 5% (This gap is normal and expected).

The Economist's Puzzle: The economist looks at the real world and sees:

Actual Stock Return: 10%

Actual Bond Return: 3%

The "Actual" Gap = 7% (This gap is too big).

The Economist's Question: Why are bond returns (3%) so much lower than they should be (5%)?

The Economist's Answer: Financial Planners (FPs) are distorting the market.

The Example: How the FPs Distort the Market 
Imagine the "justified" investment for a normal person is a 60/40 split: 60% in stocks and 40% in bonds. This is the "natural" demand based on risk and return.

Enter the Financial Planner (FP): You hire an FP. His pay contract says he gets a bonus for avoiding losses, but no extra bonus for high returns. He is terrified of losing your money.

The FP's "Distorted" Advice: He looks at your "justified" 60% stock plan and says, "That's way too risky! If the market crashes, I'll get in trouble. Let's play it safe." He recommends you put only 30% in stocks and 70% in bonds.

This is Option (C): The FP recommended "less investment in stocks" (30%) than the returns "would justify" (60%).

The "Flip Side": By recommending less stock, he is, by default, recommending more bonds (70%) than was justified (40%).

Multiply by Millions: Now, imagine all FPs are giving this same, extra-safe advice. Millions of investors are now trying to buy fewer stocks and way more bonds than is "natural."

The Market Effect:

A massive, artificial demand for bonds is created.

Basic economics: When demand for something skyrockets, its price goes up.

Basic finance: When the price of a bond goes up, its return (yield) goes down. (If you have to pay $1,200 for a bond that only pays $30 a year, your return is only 2.5%. If the "natural" price was $1,000, your return would have been 3%).

The Final Result: This flood of "distorted" money into bonds pushes their price up and crushes their return down to that low 3% level. This is what creates the extra-large 7% gap.

Why It's a Necessary Assumption 
The economist's entire explanation for the 7% gap depends on this chain of events. The chain must start with FPs pushing clients away from the "justified" amount of stocks and towards bonds.

Option (C) says this: FPs recommend less stock than is justified.

If (C) is FALSE: If FPs actually recommended the "justified" amount of stocks (60%), they wouldn't be distorting anything. There would be no artificial demand for bonds, the bond return would stay at the natural 5%, and the gap would just be the normal 5%. The economist's entire explanation for the extra 2% would be wrong.

Economist: On average, returns are higher on stocks than on bonds, as

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Economist: On average, returns are higher on stocks than on bonds, as

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