Mutual Funds and Company Stock
Response to peer:
• What advantages do mutual funds offer compared to the company stock?
1. Mutual funds often invest in a diverse range of stocks from various companies. This diversity spreads risk, lowering the impact of a single company’s bad performance. Investing in a single firm’s stock exposes you to greater risk because your rewards are related to the success or failure of that company.
2. Investing in individual company stocks can be dangerous, particularly if you are unfamiliar with stock analysis. Mutual funds provide access to a diverse selection of firms, industries, and sectors, limiting the impact of a bad stock on your overall portfolio.
3. Mutual funds are simple to buy and sell, giving investors a high level of liquidity. Selling individual stocks, on the other hand, may be susceptible to market conditions and may not be as quick or simple.
4. Individual stock purchases and sales may incur transaction costs, especially if you use a brokerage account. Mutual funds frequently have cheaper transaction fees, especially when considering the diversity they offer.
• Assume that you invest 5 percent of your salary and receive the full 5 percent match from your employer. What EAR do you earn from the match? What conclusions do you draw about matching plans?
Assuming your salary is $50,000.
1. You invest 5% of your salary: $50,000 * 0.05 = $2,500.
2. Your employer matches this with an additional 5%: $2,500 * 0.05 = $125.
So, with the match, your total investment for the year is $2,500 + $125 = $2,625.
Now, let’s assume the investments grow at a specific annual interest rate, compounded annually. For the sake of simplicity, let’s assume the interest rate is 6%.
Using the formula for compound interest:
A=P(1+r/n)^nt
Where:
• A = the future value of the investment/loan, including interest
• P = the principal investment amount (initial deposit)
• r = the annual interest rate (decimal)
• n = the number of times that interest is compounded per year
• t = the number of years the money is invested/borrowed for
In your case:
• P = $2,625 (initial investment after matching)
• r = 6% = 0.06 (as a decimal)
• n = 1 (since it’s compounded annually)
• t = 1 (1 year)
Plugging these values into the formula:
A=2778.75
So, after one year, your investment would grow to approximately $2778.75.
The EAR is essentially the equivalent annual interest rate that would yield the same final amount if compounded annually. In this scenario, the nominal interest rate and the EAR are the same because the investment is compounded annually. Therefore, the EAR would also be 6%.
The conclusion drawn about matching plans:
1. Employer matching plans, which provide additional contributions, can greatly increase your retirement savings. In this case, your contribution was essentially doubled by the employer’s match, resulting in higher returns.
2. It is generally recommended that you contribute enough to your retirement plan to receive the full employer match. If you do not do so, you will be leaving “free money” on the table, which can have a significant influence on your long-term financial well-being.
3. Many retirement plans, such as 401(k)s, provide tax breaks on contributions and growth, strengthening the benefits of employer-matching programs.
Reference:
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance (13th ed.). McGraw-Hill
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