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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?
| Text from Passage | Analysis |
| 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. |
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| However, the average difference in returns between stocks and bonds is even greater than one would expect based on risk alone. |
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| Financial planners may be responsible. |
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| Their pay depends mainly on avoiding losses for their clients, which encourages them to recommend safe investments with low returns. |
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| This increased demand for bonds increases their price and hence decreases their potential return. |
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The economist starts with what we'd normally expect (stocks outperform bonds by amount X due to risk), then points out reality is different (stocks outperform by amount \(\mathrm{Y}\), where \(\mathrm{Y} > \mathrm{X}\)). The economist then proposes financial planners cause this by recommending bonds, which drives up bond prices and lowers bond returns, making the stock-bond gap bigger than risk alone would justify.
Financial planners are responsible for the unexpectedly large gap between stock and bond returns because their incentive structure leads them to over-recommend bonds.
This is a causal explanation argument. The economist observes an effect (larger than expected return gap), proposes a cause (financial planner behavior), and explains the mechanism (planners recommend bonds → increased bond demand → higher bond prices → lower bond returns → bigger gap).
Assumption - We need to find what the economist must believe is true for their argument to work. We'll look for ways the conclusion could fall apart if certain things weren't true.
The economist makes specific claims about financial planner behavior (they recommend bonds because their pay depends on avoiding losses) and market effects (increased bond demand decreases bond returns, creating a larger-than-expected gap between stock and bond returns).
The economist's chain of reasoning goes: Financial planners avoid losses → they recommend bonds → bond demand increases → bond prices rise → bond returns decrease → this creates the unexpectedly large gap. We need to identify what could break this chain. We'll think about what must be true about financial planner influence, market responsiveness, and the connection between planner recommendations and actual market outcomes.