Last year Marcelino graduated from high school and received several thousand dollars from an uncle as a graduation gift. Marcelino, now in his first year of college, just heard of a guy in his dorm that invested in an oil exploration company and made a huge profit in a few months. Marcelino likes the idea of making some money fast and is considering investing his graduation gift money in a similar stock. Marcelino's roommate, Luc, just finished a personal finance course and is concerned that Marcelino may be getting himself into trouble. Luc knows that Marcelino likes to shop online, has run up a fairly large credit card bill, and has trouble balancing his budget on a monthly basis. In addition, Marcelino really doesn't

know much about investing or how people actually "make money investing." Luc has asked you to help him work through the following questions so that he can talk to Marcelino about his investment plans.

a. Before investing any money, what five things should Marcelino do first?

b. Is Marcelino's strategy of investing in an oil exploration stock to make quick profits investing or speculating? Support your answer.

c. Luc started talking to Marcelino about market efficiency and market timing. Based on what you now know, how likely is it that Marcelino can pick a stock that will "beat the market"?

d. Calculate the average annual rate of return if he purchases shares in an Internet stock at

$22

per share, holds the shares for

4

years, and sells them for

$61.

What is his after-tax rate of return if he is in the

25

percent marginal tax bracket?

e. What potentially significant disadvantage does Marcelino face if he sells his stock for

$61

per share after only 10 months and incurs a short-term capital gain?

f. What other risks does Marcelino face if he invests in an exploration stock?

g. By investing in two unrelated domestic stocks rather than in just one stock, would Marcelino increase or decrease his systematic risk exposure? What about his unsystematic risk exposure?

h. Luc has urged Marcelino to invest for the long term using a diversified approach. Marcelino is skeptical. Explain why Luc is probably correct.

Question content area bottom

Part 1

a. Before investing any money, Marcelino should:(Select all that apply.)

A.

make sure that he has adequate levels of homeowner's/renter's, auto, and health insurance to help cover unexpected property and liability, and medical expenses.

B.

establish and stick to a budget.

C.

have his financial affairs in order.

D.

find out the name of the oil exploration company.

E.

set goals.

F.

withdraw his money from the bank.

G.

establish and maintain an emergency fund equal to three to six months of his take home pay.

Part 2

b. Is Marcelino's strategy of investing in an oil exploration stock to make quick profits investing or speculating? Support your answer.(Select from the drop-down menus.)

Marcelino's plan to make a quick profit in an Internet stock is most closely aligned with the definition of

investment

speculation

.

Short-term strategies that depend almost solely on supply and demand to determine prices are representative of

speculation

investment

,

not

speculation

investment

.

Part 3

c. Luc started talking to Marcelino about market efficiency and market timing. Based on what you now know, how likely is it that Marcelino can pick a stock that will "beat the market"?(Select all the choices that apply.)

A.

The efficient market hypothesis states that all relevant information about a stock is reflected in the stock's current price. As such, it is extremely difficult to "beat the market" by picking one stock.

B.

It is extremely difficult to time the market, meaning that buying a stock at a low price and selling it at or near its high price is nearly impossible.

C.

Individuals, who say that they can beat the market or time the market accurately, tend to either underestimate their abilities or overestimate the probability of losing money in the stock market.

D.

Individuals, who say that they can beat the market or time the market accurately, tend to either overestimate their abilities or underestimate the probability of losing money in the stock market.

Part 4

d. Calculate the average annual rate of return Marcelino would receive if he purchases shares in an Internet stock at

$22

per share, holds the shares for

4

years, and sells them for

$61.

(Hint: Find the holding period return and divide by the number of years in the holding period.)

The annualized rate of return is

enter your response here%.

(Round to two decimal places.)

Part 5

What is his after-tax rate of return if he is in the

25

percent marginal tax bracket?

The tax due is

$enter your response here.

(Round to the nearest cent.)

Part 6

The after-tax rate of return is

enter your response here%.

(Round to two decimal places.)

Part 7

e. What potentially significant disadvantage does Marcelino face if he sells his stock after only 10 months, for

$61

per share, and incurs a short-term capital gain?

Unlike a long-term capital gain that could be taxed at a rate as low as 15% (for taxpayers in the 25% and higher tax brackets in 2012) or 0% (for taxpayers in the 10% and 15% tax brackets in 2012), short-term capital gains are subject to the full marginal tax rate. While this may not be a significant factor for Marcelino as a college student, the difference in capital gains tax rates can be dramatic for individuals in high marginal tax brackets.

Is the statement above true or false?

True

False

.

(Select from the drop-down menu.)

Part 8

f. What other risks does Marcelino face if he invests in an exploration stock?(Select the best choice below.)

A.

In addition to interest rate risk, Marcelino should ideally keep a watchful eye on all of the other risks. However given the uniqueness of an exploration stock the most important of the risks would be regulatory risk and exchange rate risk if the firm deals substantially in overseas markets.

B.

In addition to interest rate risk, Marcelino should ideally keep a watchful eye on all of the other risks. However given the uniqueness of an exploration stock the most important of the risks would be business risk, political and regulatory risk, and exchange rate risk if the firm deals substantially in overseas markets.

C.

In addition to interest rate risk, Marcelino should ideally keep a watchful eye on all of the other risks. However given the uniqueness of an exploration stock the most important of the risks would be political and exchange rate risk if the firm deals substantially in overseas markets.

D.

In addition to interest rate risk, Marcelino should ideally keep a watchful eye on all of the other risks. However given the uniqueness of an exploration stock the most important of the risks would be business risk and exchange rate risk if the firm deals substantially in overseas markets.

Part 9

g. By investing in two unrelated domestic stocks rather than in just one stock, would Marcelino increase or decrease his systematic risk exposure? What about his unsystematic risk exposure?(Select from the drop-down menus.)

Unsystematic

Systematic

risk cannot be eliminated through diversification. Holding one stock does not increase

unsystematic

systematic

risk; however, owning only one stock does increase

unsystematic

systematic

risk. In other words, if a company-unique problem occurs, there is insufficient diversification to reduce the risk of loss. By investing in two unrelated stocks, Marcelino should reduce the volatility of his portfolio due to

systematic

unsystematic

"business specific" risk.

Part 10

h. Luc has urged Marcelino to invest for the long term using a diversified approach. Marcelino is skeptical. Explain why Luc is probably correct.(Select all the choices that apply.)

A.

Luc is correct. Marcelino should avoid investing in only one stock. He should focus on accumulating a portfolio of stocks in different industries.

B.

By using a diversified approach, Marcelino will reduce systematic risk by allowing bad returns from a few stocks to be countered by higher returns in other stocks.

C.

By using a diversified approach, Marcelino will reduce unsystematic risk by allowing bad returns from a few stocks to be countered by higher returns in other stocks.

D.

Ultimately, this approach will reduce total portfolio variation (risk) without negatively affecting expected returns.