Question

Suppose that two friends, Charles and Dina, are bullding portfolios. Charles decides to purchase shares in a mutual fund and pay fees to the fund's active portfolio manager. He argues that the manager will be able to find inexpensive stocks that will increase in value. Dina is more skeptical, and chooses to buy shares in an index fund, a type of mutual fund that buys each of the stocks in a given stock index as opposed to actively managing a portiolio. Dina bulids her portfolio based on the logic that:

A. The stock market exhibits informational efficlency.
B. All stocks are overvalued.
C. Stock analysts can use fundamental analysis to identify undervalued stocks.

Answer 1

Charles and Dina are making different investment choices, with Charles favoring an actively managed mutual fund and Dina selecting an index fund based on her belief in the informational efficiency of the market. While mutual funds allow professional management and diversification, an index fund typically comes with lower fees and tracks a stock index.

Step-by-step explanation:

The question relates to the investment strategies of two friends, Charles and Dina, who are building portfolios. Charles believes in the benefits of an actively managed mutual fund and hopes to gain from the portfolio manager's ability to select stocks that will rise in value. On the other hand, Dina chooses an index fund based on the concept of informational efficiency, which suggests that it is difficult to outperform the market by identifying undervalued stocks because all available information is already reflected in stock prices.

Mutual funds offer various benefits such as professional management, diversification, and liquidity. However, investing in a fund that tries to actively select stocks might incur higher fees. Dina's approach to invest in an index fund is cost-effective since it simply tracks a stock index and typically has lower management fees.

Dina operates on the assumption that the stock market exhibits informational efficiency, meaning that stock prices at any given time fully reflect all available information. Therefore, Dina likely believes that it is not possible to consistently outperform the market by analyzing individual stocks, and hence she opts for an index fund.