Jimmy has studied the bond market for the last century, and has determined that

Question

Jimmy has studied the bond market for the last century, and has determined that the real interest rate is 3.5%. He has also studied the stock market, and determined that the prevailing real growth rate of stocks is 7%. Jimmy is 25, and has just inherited $100,000 (let us ignore the sad circumstances surrounding the untimely death of his favorite aunt).

If Jimmy invests the inheritance in bonds, how much can he expect to have (in 2015 dollars) when he retires at 65?

How much will he have if he puts the $100,000 in stocks instead?

Explanation / Answer

This question has two parts:

1) We need to find the Future Value of Jimmy’s investment of $100,000 for 40 years (65 – 25) at 3.5% interest rate if he invests in bonds.

As we know, the formula to calculate the FV of an amount is: FV = PV * (1 + I/Y)N

Where PV is the present value of the investment, I/Y is the interest rate per period and N is the number of compounding periods.

So, we have: FV = $100,000 * (1.035)40

FV = $395,925.97 is the amount he would accumulate if he invests in bonds.

2) We need to find the Future Value of Jimmy’s investment of $100,000 for 40 years (65 – 25) at 7% interest rate if he invests in stocks.

As we know, the formula to calculate the FV of an amount is: FV = PV * (1 + I/Y)N

Where PV is the present value of the investment, I/Y is the interest rate per period and N is the number of compounding periods.

So, we have: FV = $100,000 * (1.07)40

FV = $1,497,445.78 is the amount he would accumulate if he invests in stocks.

I hope my solution solves your query.

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