Question

Your employer offers a number of benefits including retirement savings. Five percent of your annual salary will go towards your retirement fund and the employer will match that amount. Your retirement fund offers three different packages:

1. Invest in T-Bills

2. Invest in small cap stocks

3. Invest in the large cap stocks

Discuss the risk-return profile of each option. Which one would you choose?

Answer 1

I am prefering first option = invest in T bills due to reasons below :

Meaning of risk return profile

• risk profile is an evaluation of an individual's willingness and ability to take risks.
• It can also refer to the threats to which an organization is exposed.
• A risk profile is important for determining a proper investment asset allocation for a portfolio.
• Organizations use a risk profile as a way to mitigate potential risks and threats.
• risk profile identifies the acceptable level of risk an individual is prepared and able to accept.
• A corporation's risk profile attempts to determine how a willingness to take on risk (or an aversion to risk) will affect an overall decision-making strategy.
• The risk profile for an individual should determine that person's willingness and ability to take on risk. Risk in this sense refers to portfolio risk.
• Risk can be thought of as the trade-off between risk and return, which is to say the tradeoff between earning a higher return or having a lower chance of losing money in a portfolio.
• Willingness to take on risk refers to an individual's risk aversion.
• If an individual expresses a strong desire not to see the value of the account decline and is willing to forgo potential capital appreciation to achieve this, this person would have a low willingness to take on risk and is risk-averse.

1.Risk return profile in invest in T bills , are as follows :

• Meaning of T bills
• A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less.
• Treasury bills are usually sold in denominations of $1,000. However, some can reach a maximum denomination of $5 million in non-competitive bids.
• These securities are widely regarded as low-risk and secure investments.
• The longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.

• risks in invest in T bills

• the risks to investing in T-bonds are opportunity risks.
• That is, the investor might have gotten a better return elsewhere, and only time will tell.
• The dangers lie in three areas: inflation, interest rate risk, and opportunity costs.
• inflation ,
• Every economy experiences inflation from time to time, to one degree or another.
• T-bonds have a low yield, or return on investment. A little bit of inflation can erase that return, and a little more can effectively eat into your savings.
• That is, an investment of $1,000 in a T-bond for one year at 1% interest would get you $1,010. But if inflation was 2%, the initial investment when it is returned will have the buying power of a little under $990.
• This example uses round numbers for the sake of simplicity. The actual yield of a one-year T-bond as of March 6, 2020, was 1.41%. The annual inflation rate was 2.5%.
• interest rate risk
• When interest rates rise, the market value of debt securities tends to drop.
• This makes it difficult for the bond investor to sell a T-bond without losing on the investment.
• opportunity costs
• All financial decisions, even T-bond investments, carry opportunity costs.
• An investor who purchases a $1,000 T-bond loses the chance to invest or spend that $1,000 elsewhere. The investor might have been better off putting $1,000 into an exchange-traded fund (ETF) that offered a greater potential for return along with a greater risk of principal loss.
• For that matter, the investor might have bought a new laptop for $1,000. If inflation continues at its current pace, that model will cost $1,025 a year from now.

• Market Risk

  Investors' risk tolerance affects prices. T-Bill prices tend to drop when other investments such as equities appear less risky, and the U.S. economy is in an expansion. Conversely, during recessions, investors tend to invest in T-Bills as a safe place for their money spiking the demand for these safe products. Since T-bills are backed by the full faith and credit of the U.S. government, they're seen as the closest thing to a risk-free return in the market.

• balancing opportunity costs and risks are briefly says :

• Investors nearing or in retirement typically allocate a large portion of their portfolio to income-producing, conservative investments to protect their nest egg.

• Younger investors, on the other hand, are in the accumulation phase of saving for retirement and are able to take on more risk.

• Let's take a look at examples of balancing opportunity cost and risk as it relates to T-bills and younger and older investors.

• A 25-Year-Old Investor

  A 25-year-old worker who invests in T-bills for retirement is likely to earn only a fraction of what the average stock market returns would be over the next 40 working years. Since the worker is better able to absorb fluctuations in the market over the next several decades, there is very little reason to invest in T-bills for retirement.

• A 60-Year-Old Investor

  A 60-year-old worker, however, is a different story. With retirement much closer, Treasury bills offer very real security for any funds saved up to this point.

  Workers at this stage in life have less time to recover from losses incurred by an aggressive portfolio in a bad market. The difference in returns between T-bills and equities is also much smaller because there is much less time for the difference to compound. This is not to say that T-bills are necessarily the worker's best bet, especially since the maturities are less than a year, but they make more sense for older investors.

• return in invest in T bills ,

• Treasury Bills are one of the safest investments available to the investor.

• But this safety can come at a cost. T-bills pay a fixed rate of interest, which can provide a stable income.

• However, if interest rates are rising, existing T-bills fall out of favor since their rates are less attractive compared to the overall market.

• As a result, T-bills have interest rate risk meaning there is a risk that existing bondholders might lose out on higher rates in the future.

• Although T-bills have zero default risk, their returns are typically lower than corporate bonds and some certificates of deposit. Since Treasury bills don't pay periodic interest payments, they're sold at a discounted price to the face value of the bond. The gain is realized when the bond matures, which is the difference between the purchase price and the face value.

• However, if they're sold early, there could be a gain or loss depending on where bond prices are trading at the time of the sale. In other words, if sold early, the sale price of the T-bill could be lower than the original purchase price.
• pros and cons of T bill investment are as follows :
• Pros

• Zero default risk since T-bills have a U.S. government guarantee.

• T-bills offer a low minimum investment requirement of $100.

• Interest income is exempt from state and local income taxes but subject to federal income taxes.

• Investors can buy and sell T-bills with ease in the secondary bond market.

• Cons

• T-Bills offer low returns compared with other debt instruments as well as when compared to certificates of deposits (CDs).

• The T-Bill pays no coupon—interest payments—leading up to its maturity.

• T-bills can inhibit cash flow for investors who require steady income.

• T-bills have interest rate risk, so, their rate could become less attractive in a rising-rate environment.

2.Risk return profile in invest in small cap stocks , are as follows :

• meaning of small cap stocks

• Small-cap Equity Funds are those which invest in equity shares of companies which have smaller capitalization and listed under the 250th rank of the underlying benchmark.

• The “cap” in small-cap stocks refers to a company’s capitalization as determined by the total market value of its publicly traded shares.

• Small-cap stocks are generally defined as the stock of publicly traded companies that have a market capitalization ranging less than ₹500 crores.

• Technically speaking as underlying companies are young and seek to expand aggressively, they are more volatile and vulnerable to losses during downtime in the market.

• In a Small-Cap fund, the fund manager can have exposure to stocks of small companies in the range of 65%-90%.

• Small-cap stocks give individual investors an edge over institutional investors. This is because institutional investors prefer to purchases large-cap stocks due to its stability, while Investors hoping for aggressive returns will invest in these funds.

• Risk and return in investing in small cap stocks,

• a.Risk

  Small-cap funds suffer from market risk i.e. the Net Asset Value (NAV) of the fund fluctuates along with the movements of the underlying benchmark. Times when the market is not performing, small-cap funds suffer a lot as they are less-established and opt to move out of business. On the other hand, it’s a great investment avenue for those who can tolerate more risk and are looking for more aggressive growth.

  b. Returns

  In the last couple of years, the market has seen the small category perform exceptionally well and has also attracted a lot of investor interest and money in this category. Small-cap funds are presumed to have significant yet hidden potential to be a “multi-bagger” (Indian financial jargon for equity stock which gives a return of more than 100%) one day.

• Others

• c. Cost

  Small-cap equity Funds charge an annual fee to manage your money which is known as the expense ratio. SEBI has marked the upper limit for this at 2.50% of the average asset under management. A lower expense ratio translates into higher returns at the end of the day. So, while shortlisting a fund, look for one which has the lowest expense ratio.

  d. Investment Horizon

  Small cap fund faces substantial erosion of returns when the market starts going downwards. Hence, in order to allow the fund to generate returns according to your expectations, you need to stay invested for a long term. A long-term investment horizon is when you consider this option for a time horizon of 7-10 years.

  e. Financial Goals

  Small-cap Equity Funds can be ideal for investors who may have long-term goals like planning for your children’s education, saving for your retirement, taking an exotic vacation with your family, paying off your medium-term debt, and so on. Historically, these funds have delivered higher returns as compared to the benchmark. However, these can become highly risky bets. Thus, those who have a high-risk appetite may think of investing in these funds. These funds invest in companies which have a great potential to generate good returns.

• f.Tax on Gains

  When you redeem units of small-cap equity funds, you earn capital gains. These capital gains are taxable in your hands. The rate of taxation depends on how long you stayed invested in these funds; such a period is called the holding period.

  Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG are taxed at the rate of 15%. Conversely, capital gains made on holding period of more than 1 year are called long-term capital gains (LTCG). Owing to recent changes in budget 2018, LTCG in excess of Rs 1 lakh will be taxed at 10% without the benefit of indexation.

3.Risk return profile in invest in large cap stocks , are as follows

• meaning of large cap stocks ,
• Large-cap stocks are shares of a company with a market capitalization of more than $5 billion.
• These are the well-known companies you hear about in the news.
• A company's total capitalization is the company's stock price times the number of shares. You can invest in individual large-capcompanies by buying shares.
• Risk and return in large cap stocks

• large-cap investments are less risky than small-cap investments, you should still do thorough research before buying any stocks.

• Consider using mutual funds, which allow you to invest in many large-cap companies at once.

• You should always do some research, but the diversification that mutual funds provide reduces your risk and eliminates the task of having to research individual stocks to build a portfolio.

• Reasons to Invest in Large-Cap Stocks are , follows

• One of the main reasons to invest in large-cap stocks is their size makes them less likely to go out of business, so they are a safer investment than small-cap companies

• Investors usually flock to large-cap companies during a contraction in the business cycle. That doesn't mean they are immune to recessions; it just means they are more likely to withstand a slowdown without going out of business altogether.

• However, their stock prices may not grow as fast as smaller companies because it's hard to grow quickly when you already lead the market, and most of these companies are at the top of their industries.

• Large-cap stocks also create another source of income for conservative investors by paying out dividends. They pay dividends because their stock price probably won't appreciate as fast as a growth company, and they must compensate investors for the stagnant price and have the earnings to do it. These payments are an especially useful source of income when bond yields are low, which happens when the government is trying to stimulate the economy.

• Large-cap funds are the safest equity mutualfunds you can invest in. They have the least risk and offer the best returns for that level of risk. ... They usually invest in companies that have a market capitalization of 1–100. Hence, the risk factor becomes less, when compared to small and mid cap funds.

• Moderate-returns: Large-cap companies are well-established and have attained financial maturity. Therefore, their shares’ value cannot appreciate as much as the values of mid-cap and small-cap stocks. Returns on such stocks are mainly derived from the dividend component.
• Low-risk: Large-cap companies have a robust financial infrastructure, fortitude, and soundness. Ergo, large-cap shares react mildly to market volatility. It significantly lowers the risk on such investments, because, unlike mid-cap and small-cap companies, they do not run the risk of dissolution during market contraction, and can still afford to continue their business operations.
• Rich history: Companies in large-cap stocks list have been in business for a long period. They possess a rich operational history accessible to the general public through various means, thus reposing trust. It can be used by potential investors for analysis.
• Expensive: These stocks are, in most cases, more expensive than other investment options.
• Liquid: They are the most liquid investment options in the market because of their widespread popularity and readily available buyers.
• Stability: Large-cap shares offer stability to your investment portfolio. It is highly unlikely that a large-cap company will be rendered insolvent or inoperative by a bearish market or during a significant market crisis. Therefore, it can, to some degree, balance any losses suffered by you through other securities in your portfolio during a market slump.
• A regular flow of income: The primary source of income from large-cap stocks is through dividends and not capital appreciation. Therefore, although it might not yield substantial capital gains upon sale or transfer of the same, you are assured of regular dividends. This factor can compensate for the lack of periodical returns from other kinds of securities.
• Availability of information: Unlike mid-cap and small-cap companies, large-cap companies in India are obligated to provide access to their financial statements and other necessary documents to the general public. Their profitability and operations thus provide a comprehensive view of their performance in a large-cap stocks list. Such information is imperative for sound investment conduct. Therefore, you can assess this information against your portfolio to see what best complements it.

• Inclusion of these stocks allows you the much-needed balance in your investment portfolio. You can thus make the large-cap stock as the centre and form your investment portfolio around it. This method will ease the investment process.

• drawbacks of stocks in the large-cap are –

• Low capital appreciation: One of the major drawbacks of large-cap stocks is their limited potential for capital appreciation. Due to their mild response to market fluctuations, the stock values do not go up as much as mid-cap and small-cap stocks during the bullish market.
• Expensive: Investments in large-cap stocks in India require substantial capital; which is why individuals with low disposable income cannot afford to invest in these stocks.
• Rare: Presently, only a handful of large-cap companies exist in India after the recent SEBI categorisation.

• Therefore, if you are entering the market with low disposable income and an objective of high-return, then you should opt for other options to employ your capital.

From the above three packages , we can understand that no one is much good and no one is too bad .

That means all them have risks and also return in different ways .

You can choose any of them , only after studying its pros and cons .

In my opinion i will choose , Invest in T bills . Because it is very suit for a retiring person who likes to invest , due to reasons as i said above under the head " risk return profile in invest in T bills .

Choosing decision is different to all persons .i prefer t bills option due to above reason . That means , i don' t say that other 2 options are not good.it will be based on your wish.ok?

Hope you understand this ,

Comment me your feedback .