Retirement Investment Products (RIP) offers a full complement of retirement planning services and a diverse line of retirement investments that have varying degrees of risk. With the investment products available at RIP, investors could form retirement funds with any level of risk preferred—from risk-free to extremely risky. RIP’s reputation in the investment community is impeccable because the service agents who advise clients are required to fully inform their clients of the risk possibilities that exist for any investment position, whether it is recommended by an agent or requested by a client. Since 1950, RIP has built its investment portfolio of retirement funds to $450 billion, which makes it one of the largest providers of retirement funds in the United States.

You work for RIP as an investment analyst. One of your responsibilities is to help form recommendations for the retirement fund managers to evaluate when making investment decisions. Recently, Howard, a close friend from your college days who now works for SunCoast Investments, a large brokerage firm, called to tell you about a new investment that is expected to earn very high returns during the next few years. The investment is called a “Piggy-back Asset Investment Device,” or PAID for short. Howard told you that he really does not know what this acronym means or how the investment is constructed, but all the reports he has read indicate that PAIDs should be a hot investment in the future, so the returns should be very handsome for those who get in now. The one piece of information he did offer what that a PAID is a rather complex investment that consists of a combination of securities whose values are based on numerous debt instruments issued by government agencies, including the Federal National Mortgage Association, the Federal Home Loan Bank, and so on.

Howard made it clear that he would like you to consider recommending to RIP that PAIDs be purchased through SunCoast Investments. The commissions from such a deal would bail him and his family out of a financial crisis that resulted from “bad luck” they experienced with their investments in the financial markets. Howard has indicated that somehow he would reward you if RIP invests in PAIDs through SunCoast because, in his words, “You would literally be saving my life.” You told Howard you would think about it and call him back.

Further investigation into PAIDs has yielded little additional information beyond what was previously provided by Howard. The new investment is intriguing because its expected return is extremely high compared with similar investments. Earlier this morning, you called Howard to quiz him a little more about the return expectations and to try to get an idea concerning the riskiness of PAIDs. Howard was unable to adequately explain the risk associated with the investment, although he reminded you that the debt of U.S. government agencies is involved. As he says, “How much risk is there with government agencies?”

The PAIDs are very enticing because RIP can attract more clients if it can increase the return offered on its investments. If you recommend the new investment and the higher returns pan out, you will earn a very sizable commission. In addition, you will be helping Howard out of his financial situation because his commissions will be substantial if the PAIDs are purchased through SunCoast Investments.

QUESTION: 

Should you recommend the PAIDs as an investment? Why?

Keep the following questions in mind as you answer:

• What it means to take risk when investing. How is risk related to 'expected returns?' What does it mean for an investor to be 'risk averse?'
• How would you determine the appropriate return for an investment you chose?

Answer rating: 100% (QA)

In finance we define risk as the chance that you will not receive the return that you expect regardless of whether the actual outcome is better than expected or worse than expected Riskier investments ... View the full answer