Sam,after taking a $200 loan from the bank to finance an investment that pays $1000 50% of the time and $0 50% of the time at a 100% interest,discovers another riskier investment that pays out $5,000 but only 10% of the time,while the other 90% of the time it pays zero.Would the he want to switch to the riskier investment?

Question

​Sam,after taking a $200 loan from the bank to finance an investment that pays $1000 50% of the time and $0 50% of the time at a 100% interest,discovers another riskier investment that pays out $5,000 but only 10% of the time,while the other 90% of the time it pays zero.Would the he want to switch to the riskier investment?

Quizplus · Accepted Answer

The expected return from the first investment is (0.5 * $1000) + (0.5 * $0) = $500. After paying back the $400 loan ($200 principal + $200 interest), Sam is left with $100. The expected return from the riskier investment is (0.1 * $5000) + (0.9 * $0) = $500. After paying back the loan, Sam is left with $100, which is the same as the first scenario. However, the potential payout of $5,000 (even at a 10% chance) represents an increase in potential return, making the riskier investment more attractive for higher potential earnings.

​Sam,after Taking a $200 Loan from the Bank to Finance

Sam,after Taking a $200 Loan from the Bank to Finance