You have been at your job with East Coast Yachts for a week now and have decided you need to sign up for the company’s 401(k) plan. Even after your discussion with Sarah Brown, the Bledsoe Financial Services representative, you are still unsure as to which investment option you should choose. Recall that the options available to you are stock in East Coast Yachts, the Bledsoe S&P 500 Index Fund, the Bledsoe Small-Cap Fund, the Bledsoe Large-Company Stock Fund, the Bledsoe Bond Fund, and the Bledsoe Money Market Fund.
You have decided that you should invest in a diversified portfolio, with 70 percent of your investment in equity, 25 percent in bonds, and 5 percent in the money market fund. You have also decided to focus your equity investment on large-cap stocks, but you are debating whether to select the S&P 500 Index Fund or the Large-Company Stock Fund. In thinking it over, you understand the basic difference in the two funds. One is a purely passive fund that replicates a widely followed large-cap index, the S&P 500, and has low fees.
The other is actively managed with the intention that the skill of the portfolio manager will result in improved performance relative to an index. Fees are higher in the latter fund. You’re just not certain on which way to go, so you ask Dan Ervin, who works in the company’s finance area, for advice. After discussing your concerns, Dan gives you some information comparing the performance of equity mutual funds and the Vanguard 500 Index Fund. The Vanguard 500 is the world’s largest equity index mutual fund. It replicates the S&P 500, and its return is only negligibly different from the S&P 500.
Fees are very low. As a result, the Vanguard 500 is essentially identical to the Bledsoe S&P 500 Index Fund offered in the 401(k) plan, but it has been in existence for much longer, so you can study its track record for over two decades. The graph below summarizes Dan’s comments by showing the percentage of equity mutual funds that outperformed the Vanguard 500 Fund over the previous ten years. So for example, from January 1977 to December 1986, almost 70 percent of equity mutual funds outperformed the Vanguard 500.
Dan suggests that you study the graph and answer the following questions:
1. What implications do you draw from the graph for mutual fund investors? If I was to draw any implications from the graph for mutual fund investors it would be an expectation that the investors will outperform the market. As with any business the high performers will continue performing and the low performers will be let go. If we were looking at the level of market efficiency it would be expected that mutual funds would outperform the market. It is expected that half of all investors will outperform the market.
2. Is the graph consistent or inconsistent with market efficiency? Explain carefully. I believe that the graph shows consistency with market efficiency, but even the most efficient of markets must be willing to spend on research to outperform the market and even then many investors do not outperform the market. The graph is consistent with market efficiency because if even the highest performers are not outperforming the market, even with high financing, then as would be expected average investors will not be outperforming the market.
3. What investment decision would you make for the equity portion of your 401(k) account? Why? If I was to make an investment decision based on the equity portion of this 401K plan I would choose to invest in the S&P 500 index. There should also be investments made in small cap funds as this will help diversify the portfolio. Small cap funds however are not available as an option so the S&P 500 would be the best choice as an investment decision.