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Chapter 5 Understanding Risk

Multiple Choice Questions

2. All other factors held constant: A) An investment with more risk should offer a lower return and sell for a higher price. B) An investment with less risk should sell for a lower price and offer a higher return. C) An investment with more risk should sell for a lower price and offer a higher return. D) An investment with less risk should sell for a lower price and offer a lower return. Answer: C LOD: 2 Page: 91 A-Head: Defining Risk. A-Head: Defining Risk. 4. Inflation presents risk because: A) Inflation is always present. B) Inflation cannot be measured. C) There are different ways to measure it. D) There is no certainty regarding what inflation will be in the future. Answer: D LOD: 2 Page: 91 A-Head: Defining Risk.

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8. The expected value of an investment: A) Is what the owner will receive when the investment is sold. B) Is the sum of the probabilities of a payoff times the payoff. C) Is the probability weighted sum of the possible outcomes. D) Cannot be determined in advance. E) b and c Answer: E LOD: 1 Page: 94 A-Head: Measuring Risk.

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9. If an investment will return $1500 half of the time and $700 half of the time, the expected value of the investment is: A) $1,250 B) $1,050 C) $1,100 D) None of the above. Answer: C LOD: 2 Page: 94 A-Head: Measuring Risk. 11. If an investment has a 20% (0.20) probability of returning $1,000; a 30% (0.30) probability of returning $1,500; and a 50% (0.50) probability of returning $1,800; the expected value is: A) $1,433.33 B) $1,550.00 C) The average of the three possible payoffs. D) a and c E) b and c Answer: B LOD: 3 Page: 95 A-Head: Measuring Risk.

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14. An investor puts $2000 into an investment that will pay $2,500 one-fourth of the time; $2000 one-half of the time, and $1,750 the rest of the time. What is the investor's expected return? A) 12.5% B) $250.00 C) 6.25% D) 3.13% Answer: D LOD: 3 Page: 95 A-Head: Measuring Risk. 15. If an individual voluntarily purchases insurance on their home to protect them from a loss due to fire, the individual: A) Is convinced they are going to have a fire. B) Believes the premium for the policy is less than the expected loss from a fire. C) Has calculated the probability of a fire to be high. D) None of the above. Answer: B LOD: 2 Page: 96 A-Head: Measuring Risk. 16. An investment pays $1,500 half of the time and $500 half of the time. Its expected value and variance respectively are: A) $1,000; 500,000 dollars B) $2,000; 250,000 dollars2 C) $1,000; 250,000 dollars D) $1,000; 250,000 dollars2 Answer: D LOD: 3 Page: 97 A-Head: Measuring Risk.

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18. An investment pays $1000 three quarters of the time, and $0 the remaining time. Its expected value and variance respectively are: A) $1,000: 62,500 dollars2 B) $750; 46,875 dollars C) $750; 62,500 dollars D) $750; 46,875 dollars2 Answer: D LOD: 3 Page: 97 A-Head: Measuring Risk. 19. The standard deviation is generally more useful than the variance because: A) It is easier to calculate. B) Variance is a measure of risk, where standard deviation is a measure of return. C) Standard deviation is calculated in the same units as payoffs and variance isn't. D) None of the above. Answer: C LOD: 2 Page: 98 A-Head: Measuring Risk.

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22. An investment will pay $2000 a quarter of the time; $1,600 half of the time and $1,400 a quarter of the time. The standard deviation of this asset is: A) 217.94 B) $1,650 C) 47,500dollars2 D) $217.94 Answer: D LOD: 3 Page: 99 A-Head: Measuring Risk. Use the following to answer questions 23-24: Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. 23. Which of the following statements is correct? A) Investment A and B have the same expected value, but A has greater risk. B) Investment B has a higher expected value than A, but also greater risk. C) Investment A and B have the same expected value, but A has lower risk than B. D) Investment A has a greater expected value than B, but B has less risk. Answer: C LOD: 3 Page: 99 A-Head: Measuring Risk.

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26. The difference between standard deviation and value at risk is: A) Nothing, they are two names for the same thing. B) Value at risk is a more common measure in financial circles than is standard deviation. C) Standard deviation reflects the spread of possible outcomes where value at risk focuses on the value of the worst outcome. D) Value at risk is expected value times the standard deviation. Answer: C LOD: 2 Page: 100 A-Head: Measuring Risk. 27. A $600 investment has the following payoff frequency; a quarter of the time it will be $0; three quarters of the time it will payoff $1000. Its standard deviation and value at risk respectively are: A) $750; $600 B) $433; $600 C) $0; $1000 D) $433; $1000 Answer: B LOD: 3 Page: 100 A-Head: Measuring Risk.

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29. Comparing a lottery where a $1 ticket purchases a chance to win $1 million to one where a $5,000 ticket purchases a chance to win $5 billion, we notice many people would participate in the first but not the second, even though the odds or winning are the same. We can perhaps best explain this outcome by: A) Higher expected value for the lottery paying $1 million. B) Higher expected value for the lottery paying $5 billion. C) Lower value at risk for the lottery paying $1 million. D) a and c Answer: C LOD: 2 Page: 101 A-Head: Measuring Risk. 30. Which of the following statements is true? A) Leverage increases expected return while lowering risk. B) Leverage increases risk. C) Leverage lowers the expected return and lowers risk. D) Leverage lowers the expected return and increases risk. E) b and d Answer: B LOD: 2 Page: 98 A-Head: Measuring Risk.

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32. A risk-averse investor versus a risk-neutral investor: A) Will never take a risk, while the risk neutral investor will. B) Needs greater compensation for the same risk versus the risk neutral investor. C) Will take the same risks as the risk neutral investor if the expected returns are equal. D) None of the above. Answer: B LOD: 1 Page: 102 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff. 33. A risk-averse investor will: A) Always accept a greater risk with a greater expected return. B) Only invest in assets providing certain returns. C) Never accept lower risk if it means accepting a lower expected return. D) Sometimes accept a lower expected return if it means less risk. Answer: D LOD: 2 Page: 102 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff. 34. A risk-averse investor will: A) Never prefer an investment with a lower expected return. B) Always prefer an investment with a certain return to one with the same expected return but any amount of uncertainty. C) Always require a certain return. D) Always focus exclusively on the expected return. Answer: B LOD: 2 Page: 103 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff. 35. Up to what amount would a risk-neutral gambler pay to enter a game where on the flip of a fair coin, if you call the correct outcome the payoff is $2000? A) More than $1000 but less than $2000 B) Up to $2000. C) Up to $1000 D) None of the above. Answer: C LOD: 2 Page: 102 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff.

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37. The most a risk-averse individual would pay to participate in a flip of a fair coin with a payoff of $500 if the correct outcome is called is: A) $500 B) An amount less than $250. C) $250 D) An amount not to exceed $500 E) None of the above Answer: B LOD: 2 Page: 102 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff. 39. A risk-averse investor compared to a risk neutral investor would: A) Offer the same price for an investment as the risk neutral investor. B) Require a higher risk premium for the same investment as a risk neutral investor. C) Place more focus on expected return and less on return than the risk neutral investor. D) None of the above. Answer: B LOD: 2 Page: 103 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff.

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46. High oil prices tend to harm the auto industry and benefit oil companies. A) High oil prices are an example of systematic risk. B) High oil prices are an example of idiosyncratic risk. C) Neither systematic or idiosyncratic. D) None of the above. Answer: B LOD: 1 Page: 104 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 47. Changes in general economic conditions usually produce: A) Systematic risk. B) Idiosyncratic risk. C) Risk reduction. D) Lower risk premiums. Answer: A LOD: 1 Page: 105 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk.

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48. Unexpected inflation can benefit some people/firms and harm others. This is an example of: A) Systematic risk. B) Unmeasured risk. C) Idiosyncratic risk. D) Zero risk since the effects balance. Answer: C LOD: 1 Page: 104 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 49. Diversification is the principle of: A) Eliminating risk. B) Reducing the risk we carry to just two. C) Holding more than one risk at a time. D) Eliminating investments from our portfolio that have idiosyncratic risk. Answer: C LOD: 1 Page: 105 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 50. Diversification can: A) Eliminate all risk in a portfolio. B) Eliminate risk only if the investor is risk averse. C) Eliminate the systematic risk in a portfolio. D) Eliminate the idiosyncratic risk in a portfolio. Answer: D LOD: 2 Page: 105 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk.

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53. An investor who diversifies into two stocks that are not perfectly positively correlated will find that the standard deviation of the portfolio is: A) The sum of the standard deviations of the two individual stocks. B) Greater than the sum of the standard deviations of the individual stocks. C) Less than the sum of the standard deviation of the tow stocks. D) Less than the average of the two individual standard deviations. Answer: D LOD: 2 Page: 107 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 55. Systematic risk: A) Is the risk eliminated through diversification. B) Represents the risk affecting a specific company. C) Cannot be eliminated through diversification. D) Is another name for unique risk. Answer: C LOD: 2 Page: 109 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 57. If the returns of two assets are perfectly positively correlated, an investor who puts half of their savings into each will: A) Reduce risk. B) Have a higher expected return. C) Not gain from diversification. D) Reduce risk but lower their expected return. Answer: C LOD: 2 Page: 108 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 58. In order to benefit from diversification, the returns on assets in a portfolio must be: A) Perfectly positively correlated. B) Perfectly negatively correlated. C) Just not be perfectly positively correlated. D) The ones that have the same idiosyncratic risks. Answer: C LOD: 2 Page: 108 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk.

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61. If an investment offered an expected payoff of $100 with $0 variance, you would know that: A) Half of the time the payoff is $100 and the other half it is $0. B) The payoff is always $100. C) Half of the time the payoff is $200 and the other half it is $0. D) None of the above. Answer: B LOD: 3 Page: 107 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 62. The fact that not everyone places all of their savings in U.S. Treasury bonds says: A) Most investors are not risk averse. B) Many investors are actually risk seekers. C) Even risk averse people will take risk if they are compensated for it. D) None of the above. Answer: C LOD: 2 Page: 109 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 64. Sometimes spreading has an advantage over hedging to lower risk because: A) It can be difficult to find assets that move predictably in opposite directions. B) It is cheaper to spread than hedge. C) Spreading increases expected returns, hedging does not. D) a and c Answer: A LOD: 2 Page: 108 A-Head: Reducing Risk Through Diversification. 65. Spreading involves: A) Finding assets whose returns are perfectly negatively correlated. B) Adding assets to a portfolio that move independently. C) Investing in bonds and avoiding stocks during bad times. D) Building a portfolio of assets whose returns move together. Answer: B LOD: 1 Page: 108 A-Head: Reducing Risk Through Diversification. 66. Investing in a mutual fund made up of hundreds of stocks of different companies is an example of: A) Spreading.
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B) C) D) E) Diversifying Risk reduction. Lowering variance of a portfolio. All of the above.

Answer: E LOD: 2 Page: 109 A-Head: Reducing Risk Through Diversification. 67. An individual purchasing auto insurance is an example of: A) Hedging. B) Passing risk to someone else. C) Risk premium. D) Systematic risk. E) a and d Answer: B LOD: 1 Page: 106 A-Head: Reducing Risk Through Diversification. 68. An automobile insurance company that writes millions of policies is practicing a form of: A) Mutual fund. B) Hedging. C) Spreading D) Diversification. E) c and d Answer: E LOD: 2 Page: 106 A-Head: Reducing Risk Through Diversification. 71. The variance of a portfolio containing n assets: A) Approaches 1 as n increases. B) Approaches 0 as n increases. C) Is constant for any n greater than two. D) Fluctuates up or down as n increases, depending on the idiosyncratic risk of the assets being added. Answer: B LOD: 2 Page: 109 A-Head: Reducing Risk Through Diversification. 73. A life insurance company can make profits because: A) Individuals have life spans that are very similar.
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B) Individual life spans are independent. C) Individual life spans are perfectly positively correlated. D) None of the above. Answer: B LOD: 2 Page: 106 A-Head: Reducing Risk Through Diversification. 75. A portfolio of assets has lower risk than holding one asset, but the same expected return and higher transaction costs. Which of the following statements is most correct? A) The portfolio is attractive to people who are risk averse and risk neutral, but not to risk seekers. B) The portfolio is attractive to investors who are risk neutral. C) The portfolio is not attractive to investors who are risk neutral. D) None of the above. Answer: C LOD: 2 Page: 102 A-Head: Reducing Risk Through Diversification.

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Short Answer Questions 76. An individual faces two alternatives for an investment: Asset A has the following probability return schedule: Probability of return .25 .20 .20 .15 .10 .10 Return (yield) % 11.0 10.5 9.5 9.0 6.5 -1.0

Asset B has a certain return of 8.0%. If the individual selects asset A does she violate the principle of risk aversion? Explain. Answer: Asset A provides an expected return of 8.65%. For the investor the 0.65% premium may be a large enough differential to compensate for the additional risk, so she may still be risk averse. LOD: 3 Page: 93 A-Head: Measuring Risk. 77. An individual faces two alternatives for an investment. Asset 'A" has the following probability of return schedule: Probability of return .25 .20 20 15 .10 10 Return (yield)% 15.0 12.0 10.0 9.0 7.5 0.0

Asset 'B' has a certain return of 10.25%. If this individual selects asset 'A' does it imply she is risk averse? Explain. Answer: Since both assets provide the same expected return, they would be equally attractive to an investor who is risk neutral. An investor who is risk averse would prefer Asset B, which provides the same expected return but with less risk than asset A. LOD: 3 Page: 102 A-Head: Measuring Risk.
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78. Please explain why returns on assets compensate for systematic risk but not for idiosyncratic risk. Answer: Idiosyncratic risk can be reduced through diversification. Systematic risk cannot since it affects all assets. LOD: 2 Page: 106 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk, Reducing Risk Through Diversification. 79. Consider the following two assets with probability of return = Pi and return = Ri. Calculate the expected return for each and the standard deviation. Which one carries the greatest risk? Why? Asset A Pi Ri 0.40 12.0% 0.50 8.5% 0.10 -2.0% Asset B Pi Ri 0.20 11.5% 0.50 10.0% 0.30 0.0%

Answer: For asset A, the expected return = 0.4(12) + 0.5 (8.5) + 0.1(-2.0) = 8.85% For asset B, the expected return = 0.2(11.5) +0.5(10.0) + 0.3(0) = 7.30% For asset A, the standard deviation is 3.98 =
0.4(12 8.85)2 + 0.5(8.5 8.85) 2 + 0.1( 2 8.85)2

For asset B, the standard deviation is 4.81 = 0.2(11 5 7.3) + 0.5(10 7.3) + 0.3(0 7.3) Since asset B has a higher standard deviation than asset A, its return has higher risk. LOD: 3 Page: 99 A-Head: Measuring Risk.
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80. Explain why an asset that carries more risk should sell for a lower price but offer a higher expected return. Answer: An asset that carries more risk will sell for a lower price because the asset should have less demand which would cause the price to be lower. At the same time, due to the higher risk, savers will require a risk premium be added to the risk free return to hold this asset. LOD: 2 Page: 103 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff.

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81. Explain why casinos will find professional gamblers participating in the various games of chance even though these professionals know the odds are in favor of the house and against them. Answer: Most professional gamblers are aware the odds are against them but continue to participate. They do this because part of their compensation may come in the form of the thrill of gambling, which to some degree reflects that, at least in terms of playing games of chance, they are risk seekers. LOD: 2 Page: 102 A-Head: Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff. 82. What is the expected value of a $100 bet on a flip of a fair coin, where heads pays double? Answer: The expected value of this event is calculated as E.V. = PH (H) + PT (T); where H is the payoff from the coin turning up heads and T is the payoff if the coin turns up tails. PH and PT are the probabilities of the coin turning up heads or tails respectively. Substituting actual values in out formula reveals: E.V. = 0.5 ($200) + 0.5($0) = $100 LOD: 2 Page: 94 A-Head: Measuring Risk. 83. An individual owns a $100,000 home. She determine that her chances of suffering a fire in any given year to be 1/1000 (0.001). She correctly calculates her expected loss in any year to be $100. Explain why this really isn't a good way to measure her potential for loss. Answer: While all of her calculations may be accurate this individual may be better off considering value at risk, which is the worst outcome. The value at risk from a fire for her in this case is $100,000 which, if suffered, could prove devastating. LOD: 2 Page: 94 A-Head: Measuring Risk.

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84. Identify at least three possible sources for a risk an individual may face in planning for retirement. Answer: In planning for retirement an individual faces at least the following uncertainties: Life span, there is uncertainty regarding how long an individual's life will be. Unexpected inflation, no one knows what the inflation rate will be in the future. This makes earning a targeted real return difficult. Health problems or other unforeseen contingencies can use up funds that were being set aside for retirement. LOD: 2 Page: 104 A-Head: Sources of Risk: Idiosyncratic and Systematic Risk. 85. What is the probability of tossing a pair of dice once and getting a 1? How about a 7? Answer: It is impossible to toss two dice and get a 1, since the smallest number you can roll is a 2. So the probability of getting a 1 is 0. On the other hand a seven can be obtained a 6 different ways, and since there are 36 possible outcomes from a single roll of a pair of dice, the answer is 6/36 or 1/6 or 16.7% LOD: 3 Page: 93 A-Head: Measuring Risk.90. You do some research and find for a driver of your age and gender the probability of having an accident that results in damage to your automobile exceeding $100 is 1/10 per year. Your auto insurance company will reduce your annual premium by $40 if you will increase your collision deductible from $100 to $250. Should you? Explain. Answer: An increase of a deductible from $100 to $250 exposes you to an out-ofpocket possible loss of $150 when you have an accident. But the chances of incurring this out-of-pocket loss is 1/10 (0.10) each year, so we can calculate the expected loss as E.L. = 0.1($150) + 0.9($0) = $15.00. Since this expected loss is less than the $40 in premium savings it makes good sense to increase the deductible LOD: 3 Page: 96 A-Head: Measuring Risk. 92. You buy an asset for $2500. The asset will return $3300 half of the time and $2700, the other half. The expected return is 20% (a gain of $500) and the standard deviation is 12% ($300). How would using $1,250 of borrowed funds change the expected return and standard deviation specifically? Answer: Borrowing 50% of the funds needed to purchase the asset is using leverage. It will double the expected return as well as the standard deviation. For example, if the asset returns the $3,300, the lender will have to be repaid $1,250, but this leaves $2,050 for you. If the asset returns $2,700 the lender still needs to be repaid, leaving
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$1,450 for you. Since each of these outcomes is equally likely, we can calculate the expected return and standard deviation of leverage. Expected value = ($2,050) + ($1,450) = $1,750. The $1,750 expected value on a $1,250 investment is an expected return of 40%. So the expected return doubled using leverage. The standard deviation can also be calculated: = 0.5($2,050 $1,750) + 0.5($1,450 $1,750) = $300 or 24% of the actual amount invested. So while the expected return doubled, so did the standard deviation. LOD: 3 Page: 98 A-Head: Measuring Risk.
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93. What would be the impact of leverage on the expected return and standard deviation of purchasing an asset with 10% of the owner's funds and 90% borrowed funds? Answer: We can use the general formula: Leverage factor = Cost of Investment/ Owner's Contribution to the Purchase In this case the leverage factor would be 10; so the expected return and the standard deviation would both increase by a factor of 10. LOD: 2 Page: 98 A-Head: Measuring Risk. 96. Explain why a company offering homeowners insurance policies would want to insure homes across a wide geographic area. Answer: One of the lessons from this chapter is the ability to reduce risk through diversification, and one way to effectively diversify is through spreading of risk. Since the homes can be exposed to losses which can hit specific areas, like hurricanes, tornadoes, wild fires, floods, etc. (a form of idiosyncratic risk). An insurance company would not be spreading risk effectively if all or most of the homes they insured were located in one specific area. By insuring homes across a wide geographic area the insurance company can effectively spread risk. LOD: 2 Page: 108 A-Head: Reducing Risk Through Diversification. 97. Explain the rapid rise in popularity of mutual funds. Answer: The chapter covered the topic of spreading risk and one of the ways for an individual investor to spread risk is to purchase many different financial assets. The problem for any one individual is it could be expensive, both in terms of absolute dollars but also in transaction costs to purchase many different assets. Mutual funds allow individuals to pool their funds and purchase many different assets, thereby achieving most of the benefits of diversification without requiring a lot of funds to invest or high transaction costs. LOD: 2 Page: 108 A-Head: Reducing Risk Through Diversification. 98. Considering leverage, can you explain why a mortgage lender would want borrowers to have larger down payments, and when the borrower doesn't the mortgage lender may require mortgage insurance? Answer: We saw that leverage can do two things for the borrower, one it will increase
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the expected return but it also increases risk. As an example, a homebuyer putting 10% down rather than 20% increases the leverage factor from 5 to 10, this will double the expected return for the borrower but also double the risk. The mortgage lender (the counterparty) is certainly concerned with the risk since the doubling of the risk also works against them. As a result, they would want a larger down payment or insurance protection in the event that the borrower does not meet their obligations. LOD: 2 Page: 98 A-Head: Measuring Risk.

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100. You read about the employees and others who invested their retirement funds in Enron stock. What lesson(s) should be learned from this? Answer: Actually there are a few; one is that employees need to pay more attention to the decisions being made regarding retirement funds. Another lesson is that a high return in the past does not guarantee a high return in the future and attention should always be paid to the probabilities of certain returns. Perhaps the most valuable lesson is that diversification works. Many of the employees had large percents of their retirement funds in Enron stock, so that when the company went bankrupt much of their retirement fund was lost. Had the employees better diversified Enron's bankruptcy would not have been so catastrophic for them. LOD: 2 Page: 110 A-Head: Reducing Risk Through Diversification.

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