Fin200 Financial Management: Efficient Market Assessment Answers

1. What are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan? What issues relating to the concept of the time value of money may beimportant in this decision-making process? Explain.

1. “If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin.” Explain why this is not the case.

1.

In the present era, knowledge is termed to be power especially in the context of retirement planning because it is the procedure to determine goals for retirement and actions to be conducted in the present to achieve them. For tertiary sector employees, retirement planning is significant because they have shorter employment period in comparison to other sector employees (Bodie, 2013). It is because; they work on the basis of their technical knowledge which gets quickly obsolete with the introduction of new technology. Consequently, they are required to do effective retirement planning for their secure financial future.

Generally, they have two major options for investment that is enumerated as below:

Defined-benefit plan

Defined benefit plan is a plan in which sponsorship is provided by the employer for an employee promising a pension payment at the time of retirement. In this investment option, benefits for the tertiary sector employees are computed by using in formulas which consider factors like a term of employment and salary history of the concerned individual (Gino and Mogilner, 2014). This portfolio is managed by the company by bearing the entire risk, and at the end, they provide promised a return to their employees. This investment option also comprises restrictions regarding withdrawal of funds without attracting any penalty. This is the safest option for investment as risk is not to be borne by employees and as a consequence, they earn a comparatively lower return in this option.

Investment choice plan

Investment choice plan provides the benefit of selection to the employee regarding the option of investment of amount accumulated in a superannuation fund.  In this option, tertiary sector employee is allowed select multiple investment options for the purpose of diversification in order to mitigate the risk and to earn optimised returns (Merton, 2014). However, this is a risky option for retirement planning as it fluctuates as per trend in the market due to which there are adverse as well as favourable possibilities for a net worth of investment. Due to the involvement of higher risk, tertiary sector employees tend to earn a higher return in this option.

For the selection of one of the above-described options that are required to considered following factors in their retirement planning:

Personal financial roadmap

Initially, roadmap is required to be determined by tertiary sector employees by defining their goals and amount that can be invested for the achievement of goals. If employees do not have any specific needs and their requirements are satisfied by the default retirement plans, then they should go for defined benefit plans (Clark, Lusardi and Mitchell, 2015). On the other hand, if they have customised plans then they can develop their own portfolio by defining their risk-bearing capacity.

Risk bearing capacity

Each investment option comprises some degree of risk thus it is important for tertiary sector employees so understand the impact of risk on the worth of investment (Bodie, 2013). By considering the nature of both the investment options, it can be said that employees having less tendency to bear risk should go with defined benefit plan and if they can bear higher risk, then investment choice plan should be preferred. It is because; in defined plan returns are fixed, but in investment choice plan higher returns can be earning by taking high-risk portfolio.

Inflation factor

Employees must be aware of the fact that their savings can be eroded by inflation. Due to this aspect, they make sure that selected retirement vehicle provide them with the best opportunity for outpacing the factor of inflation (Howard and Yazdipour, 2015). In this aspect, in defined benefit plan they must assure that provide return is capable of mitigating future inflation factor and in investment choice plan portfolio is designed by considering by risk as well as inflation factor. Thus, tertiary sector employees should go with the option providing better outpacing of inflation factor through return on investment.

Current financial position

The current financial position of employees defines their risk-bearing capacity for making an investment in retirement planning (Thakur, Jain and Soni, 2017). For example, if employees have other secure investment then they should consider investment choice plan to earn a higher return, but if do not have future security then they must go with defined benefit plan. With this approach, employees will be able to gain financial stability for their future.

Age factor

Age plays a crucial role in determining investment option plan because it will affect the period of investment. Return on investment can be maximised by enhancing the term of investment with taking the minimum risk (Gino and Mogilner, 2014). By considering this fact, young employees should go for investment choice plan as they can later invest for secure retirement. On the other hand, middle age employee should go for defined benefit plan to ensure guaranteed returns at the time of investment.

Issues associated with the time value of money to considered by tertiary sector employees for making decisions for retirement planning

Time value of money is important for investment decisions as it is bothered in converting capitals into long-term investment projects. Cash flow from long-term investment appears at the various point of time in outlook; it cannot be compared to each other as well as to the outlay of project spent at present.  Thus to make it similar, the discount is done of upcoming cash flows in investment proposal (Keynes, 2016). The theory of TVM is very helpful to retirement planning. Estimate models are used while making an investment in stock and bonds in which time value is considered for analysis. Territory sectors have to set up their financial needs and goals. After identifying the goals, setting up of targets is must so, as to, convert needs into financial terms. To achieve these targets they must be aware of the concept of Time Value of Money (TVM).

For an example, if territory sectors are providing their employees two retirement options first $100000 at the time of retirement and in second option providing $100000 after 10 years. While selecting any of the options following reasons must be kept in mind by them:

• Purchasing power: Due to inflation, $100,000 can be utilised for investing at present rather than investing it after 10 years.  Further assuming it in a different way, that how 100000 could buy 10 years ago. This can be understood by an example before 10 years one litre of milk cost dollar 1, and at present, it is dollar 3, and later than 10 years, it would be dollar 5.
• Opportunity cost: A dollar received at present can be invested at the particular point of time to earn interest (Brigham and Ehrhardt, 2013). Thus it will result in higher worth in future. Thus, investment having higher present value will be preferable for investment.
• Risk-return: suppose an individual is giving his money to be utilised by another it will generate risk which is termed as default risk. However, returns and interests are expected to balance risks by considering the time value of money.  

The present analysis shows that there is no perfection option as a decision for investment in retirement planning mainly depends on risk bearing capacity and investment goals of employees. Thus, they are required to consider above-described aspects in planning for the investment.

2.

Efficient market hypothesis (EMH) is a fundamental theory which states that it is impossible to beat the market as the efficiency of the stock market includes prices which already integrate and reveals all pertinent information related to it (Erdem, 2017). A market is assumed to be efficient regarding the stock prices as it regulates rapidly on the basis of standard average. The basic reason for the existence of the efficient market is the strong competition among investors to gain returns from latest information (Suliman, 2017). EMH includes different degrees which are weak, semi-strong and strong which mark the adding up of non-public information in stock prices. The fundamental theory of modern portfolio states that the source that underpins monetary decision-making is efficient markets. Further, the opportunity for higher returns can only be availed by taking higher risk in the portfolio.

By considering the above description, it can be said that considered statement is not true because efficient market hypothesis does not imply portfolio selection with a pin will result in higher profits. The investor must first ensure that the portfolio is well diversified or not. Well, diversification of the portfolio is very important to be maintained so as to achieve an optimized return from the portfolio (Graziani, 2015). The necessity of a large number of investment options is must because it will make a reduction in risk.  However, it doesn’t imply that higher diversification in investment leads to higher returns. It is because if diversification if not strategic, then entire portfolio will have similar trend due to which risk will not be mitigated (Burton and Shah, 2017). Secondly, the portfolio manager must assure that the risks incurred by the investments are appropriate for the manager as well as for clients. An investor should choose risk-free investment in this situation. After ensuring these factors investor must modify his portfolio to take benefit of special law for tax advantages given by the government. Expected returns can be achieved through these taxes reduction as an investor will be able to optimise their return on investment.

References

Bodie, Z., 2013. Investments. McGraw-Hill.

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.

Burton, F.E.T. and Shah, S.N., 2017. Efficient Market Hypothesis. CMT Level I 2017: An Introduction to Technical Analysis.

Clark, R., Lusardi, A. and Mitchell, O.S., 2015. Financial knowledge and 401 (k) investment performance: a case study. Journal of Pension Economics & Finance, pp.1-24.

Erdem, O., 2017. Efficient market hypothesis.

Gino, F. and Mogilner, C., 2014. Time, money, and morality. Psychological Science, 25(2), pp.414-421.

Graziani, G., 2015. The efficient market hypothesis: a case study concerning the US stock market.

Howard, J.A. and Yazdipour, R., 2015. Retirement Planning: Contributions from the Field of Behavioral Finance and Economics.

Keynes, J.M., 2016. General theory of employment, interest and money. Atlantic Publishers & Dist.

Merton, R.C., 2014. The crisis in retirement planning. Harvard Business Review, 92(7/8), pp.43-50.

Suliman, O., 2017. EFFICIENT MARKET HYPOTHESIS. The American Middle Class: An Economic Encyclopedia of Progress and Poverty [2 volumes], 70, p.126.

Thakur, S.S., Jain, S.C. and Soni, R., 2017. A study on perception of individuals towards retirement planning. IJAR, 3(2), pp.154-157.