In structor s Ma nual Chapter 12 Page 144

Solutions to Problems at End of Chapter

1. Suppose that your 58-year-old father works for the Ruffy Stuffed Toy Company and has contributed regularly to his company-matched savings plan for the past 15 years. Ruffy contributes $0.50 for every $1.00 your father puts into the savings plan, up to the first 6% of his salary. Participants in the savings plan can allocate their contributions among four different investment choices: a fixed- income bond fund, a “ blend ”

option that invests in large companies, small companies, and the fixed-income bond fund, a growth-income mutual fund whose investments do not include other toy companies, and a fund whose sole investment is stock in the Ruffy Stuffed Toy Company. Over Thanksgiving vacation, Dad realizes that you have been majoring in finance and decides to reap some early returns on that tuition money he 's been investing in your education.

He shows you the most recent quarterly statement for his savings plan, and you see that 98% of its current value is in the fourth investment option, that of the Ruffy Company stock..

a. Assume that your Dad is a typical risk-averse person who is considering retirement in five years. When you ask him why he

has made the allocation in this way, he responds that the company stock has continually performed quite well, except for a few declines that were caused by problems in a division

that the company has long since sold off. In addition, he says, many of his friends at work have done the same. What advice would you give your dad about adjustments to his plan allocations? Why?

b. If you consider the fact that your dad works for Ruffy in addition to his 98% allocation to the Ruffy stock fund, does this make

his situation more risky, less risky, or does it make no difference? Why?

SOLUTION:

a. Dad has exposed himself to risk by concentrating almost all of his plan money in the Ruffy Stock fund. This is analogous to taking 100%

of the money a family has put aside for investment and investing it in a single stock.

First, Dad needs to be shown that just because the company stock has continually performed quite well is no guarantee that it will do so indefinitely. The company may have sold off the divisions which produced price declines in the past, but future problems are unpredictable, and so is the movement of the stock price. performance is no guarantee of future results ” is the lesson.

Second, Dad needs to hear about diversification. He needs to be counseled that he can reduce his risk by allocating his money among several of the options available to him. Indeed, he can reduce his risk considerably merely by moving all of his money into the

“ blend ” fund becaeudsbeyitdiessdigivne:rist ihfias a fixed- income component, a large companies component, and a small companies component. Diversification is achieved not only via the three differing objectives of these components, but also via the numerous stocks that comprise each of the three components.

Finally, Dad 's age and his retirement plans need to be considered. People nearing retirement age typically begin to shift the value of their portfolios into safer investments. “ Safer ” normally connotes less vari that the risk of a large decline in the value of a portfolio is reduced. This decline could come at any time, and it would be very

unfortunate if it were to happen the day before Dad retires. In this example, the safest option would be the fixed-income bond fund because of its diversified composition and interest-bearing design, but there is still risk exposure to inflation and the level of interest rates. Note that the tax-deferred nature of the savings plan encourages allocation to something that produces interest or dividends. As it stands now, Dad is very exposed to a large decline in the value of his savings plan because it is dependent on the value of one stock.

Individual equities over time have proven to produce the most variable of returns, so Dad should definitely move some, probably at least half, of his money out of the Ruffy stock fund. In fact, a good recommendation given his retirement horizon of five years would be to re-align the portfolio so that it has 50% in the fixed- income fund and the remaining 50% split between the Ruffy stock fund (since Dad insists) and the “ blend ”

Or, maybe 40% fixed-income, 25% Ruffy, 15% growth- income fund, and 20% “ blend ” fund. This latter

allocation has the advantage of introducing another income-producing component that can be shielded by the tax-deferred status of the plan.

b. The fact that Dad is employed by the Ruffy Company makes his situation more risky. Let 's say that the

hits a period of slowed business activities. If the stock price declines, so will th e value of Dad 's savings plan. If the company

encounters enough trouble, it may consider layoffs. Dad 's job may be in jeopardy. At the same time that his savings plan may be declining in value, Dad may also need to look for a job or go on unemployment. Thus, Dad is exposed on two fronts to the same risk. He has invested both his human capital and his wealth almost exclusively in one company.

2. Refer to Table 12.1.