Question

As you embark on your new career with “We Crunch the Numbers” you are confronted with a new problem, managing your own money. The firm has a 401(k) as well as money you want to invest outside your 401(k). You recently received a call from a former classmate who is a financial advisor. Your classmate guarantees to beat the S&P 500 for a fee of 1% of your total assets, annual. You took one financial class in your MBA and you are a strong believer in market efficiency. You also are aware that Vanguard has S&P 500 ETF that has an annual expense ratio of .03%. What is your decision?

Answer 1

Inorder to understand the decision we muat first know the following terms

Market Efficiency : This means the current prices of all the stocks are known to all and investors are well informed. This makes it very difficult for an investor to beat market return.

S&P 500 : This is a market index reflecting the stock performance of 500 top companies.

S&P 500 ETF : These are exchange traded funds that are issued by a Mutual fund or investing companies. Normal investors can invest in these ETF and expect to earn market rate of return

As we believe in market efficiency, we do not expect to beat the market. So we are not sure of the former classmate's guarantee to beat the market. Also it comes with a fee of 1% of total assets. Instead we can invest in Vanguard's S&P ETF (Vanguard is a well renowed investment company accross globe) and earn the market rate of return with very less cost (0.03% as expense).

Note : If you are risk averse, A part of the amount can be lodged in 401(k) which deposits the contribution in very less risk assets and earn some guarenteed returns and the excess of the mandatory contribution can be invested in S&P ETF