Question

You have saved $10,000 for a down payment on the purchase of a new car, however, since you plan to buy the car one year from today, you need to decide how to invest the money for one year. You are limited to one of two choices: 1. A Bond Fund with an expected return of 3%/year 2. A Stock Fund with an expected return of 7%/year. Which fund is best? Explain why!

Answer 1

$10,000 for a down payment on the purchase of a new car is saved today to make payment in one year.

Since our investment horizon is only one year, a bond fund with an expected return of 3% per year is best. Yes, the expected return on the stock fund is higher than that of a bond fund at 7%, but our goal is to preserve this capital, not to earn a higher return. Note that this is only expected return, not a guaranteed return.

One year is too short of a time to invest in stocks. The stock fund can easily lose value and result in negative returns, in which case we would not have enough money to make the downpayment for the car.

On the other hand, a bond fund is more likely to deliver expected return of 3% per year. So, it is the best fund to invest for the short-term.