Question

Lucia Gomez, a flight attendant from Indiana, Pennsylvania, is thinking about jump-starting a retirement savings plan by investing the $50,000 gift that her elderly uncle gave her. She also wants to invest $1000 a month for the next 25 years for retirement. Lucia knows little about investments and does not seem to have a big desire to learn.

(b) Would you recommend active or passive investing for her, and why?
(c) Should Lucia be a lender or owner?

Answer 1

(b) Passive investing

As learnt from the case, Lucia has very limited knowledge about investments and is not eager to learn either. Her goals are rather long term (25 years horizon)

Active investing involves beating the stock market’s average returns and taking full advantage of short-term price fluctuations. Active investing also involves frequent trading and regular rebalancing. Additionally, continual monitoring is a part of the process of active investing. Thus, active investment strategies would not be ideally recommended for her, given her long time horizon and her apprehensions in learning about investing.

Another consideration over here will be that of the transaction costs. Transaction costs of buying and selling reduces the returns. For a retirement portfolio, she can invest passively in an index like the S&P 500 without worrying about the transaction costs/taxes and can easily track the investments.

c) As Lucia has a long term horizon, there is no need for conservative investments which are included in lending (fixed income investments/ investing in government bonds). In short term investment horizons, one needs to be careful to preserve the corpus for immediate liquidity needs.

When investing for long term goals, one can be aggressive and choose to be the owner by investing in the stock markets. Additionally, due to the long term horizon, the portfolio can also withstand the short term fluctuations and risks inherent in investing in equity. She can gain returns in the form of capital gains and can also defer any tax which can be incurred on her portfolio gains.

Thus, Lucia should be the owner.