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Comparing the Potential Returns of Investing in Stock

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The Jacksons have recently started saving about $300 per month ($3600 per year) for their children's education. They are currently investing this amount in bank CDs each month, but they are now considering investing in stock instead. The Jacksons have never owned stock before.
The Jacksons are currently earning an interest rate of 5% on their CDs. If they invest in a specific stock from this point on, they will achieve an annual return ranging from 2 to 9%. The stock will generate an annual return of only 2% if stock market conditions are weak in the future, but it could generate an annual return of 9% if the stock market conditions are strong. The Jacksons want to compare the potential returns of investing in stock to the CDs.

1.Compare the returns from investing in the bank CDs to the possible returns from the stock over the next 12 years by filling in the following table:

CD: Annual Return=5% Weak stock market conditions Strong stock market conditions
Amount invested per year $3600 $3600 $3600
Annual return 5% 2% 9%
Value of investment in 12 years

a) Explain to the Jacksons why there is a tradeoff when investing in bank CDs versus stock to support their children's future college education.

b) Advise the Jacksons on whether they should invest their money each month in bank CDs, in stocks, or in some combination of the two, to save for their children's college education.

c) The Jacksons are considering investing in an initial public offering (IPO) of a high-tech firm, since they have heard that the return on IPOs can be very high. Advise the Jacksons on this course of action. Refer to the following links on information about IPOs and provide citations for any other sources that you use to answer this question.

http://www.investopedia.com/terms/i/ipo.asp#axzz1pIJjpFAk
http://www.renaissancecapital.com/IPOHome/Press/IPOReturns.aspx
http://wrhambrecht.com/pdf/what_history_tells_us.pdf
http://bear.warrington.ufl.edu/ritter/IPOs2011Underpricing1912.pdf
http://bear.warrington.ufl.edu/ritter/IPOs2011Longrun020112.pdf

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Solution Summary

This is an analysis of the effects of saving and investing to insure that a child will have enough money for a college education. It examines the factors to consider as well as the risk components to be considered.

Solution Preview

First let's determine the potential future value of the $3600 in the three differing scenarios:

Amount Invested CD - 5% Weak market - 2% Strong market - 9%

3600 x FV factor (1.796) 64,656

3600 x FV factor (1.268) 45,648

3600 x FV factor (2.813) 101,268

Now we can see the differences in the forecast amount ...

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