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Analysis of market efficiency and investment decision.

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You have been at your job for East Coat Yachts for a week now and have decided you need to sign up for the company’s 401(k) plan. Even after your decision with Sarah Brown, the Bledsoe Financial Services Representative, you are still unsure as to which investment option you should choose. Recall that the options available to you are stock in East Coast Yachts, the Bledsoe S&P 500 index fund, the Bledsoe Small-cap fund, the Bledsoe Large-Company Stock Fund, the Bledsoe Bond Fund, and the Bledsoe Money Market Fund. You have decided that you should invest in a diversified portfolio, with 70 percent of your investment in equity, 25 percent in bonds, and 5 percent in the money market. You have decided to focus your equity investment on large-cap stocks, but you are debating whether to select the S&P 500 Index fund or the Large-Company Stock Fund.

In thinking it over, you understand the basic difference in the two funds. One is a purely passive fund that replicates a widely followed large-cap index, the S&P 500, and has low fees. The other is actively managed with the intention that the skill of the portfolio manager will result in improved performance relative to an index. Fees are higher in the latter fund. You’re just not certain on which way to go, so you ask Dan Ervin, who works in the company’s finance area, for advice.

After discussing your concerns, Dan gives you some information comparing the performance of equity mutual funds and the Vanguard 500 index fund. The Vanguard 500 in the world’s largest equity index mutual fund. It replicates the S&P 500, and its return is only negligibly different from the S&P 500. Fees are very low. As a result, the Vanguard 500 is essentially identical to the Bledsoe S&P 500 index fund offered in the 401k plan, but it has been in existence for much longer, so you can study its track record for over two decades. The graph on the following page summarizes Dan’s comments by showing the percentages of equity mutual funds that outperformed the Vanguard 500 fund over the previous ten years. So for example, from January 1977 to December 1986, about 70 percent of equity mutual funds outperformed the Vanguard 500. Dan suggests that you study the graph and answer the following questions:

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1. What implications do you draw from the graph for mutual fund investors?

2. Is the graph consistent or inconsistent with market efficiency? Explain carefully.

3. What investment decision would you make for the equity portion of your 401k account? Why?

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