You have been employed by Telemetry Medical Instruments (TMI) for seven years an

Question

You have been employed by Telemetry Medical Instruments (TMI) for seven years and participate in their 401 (k) plan by having 5% of your paycheck invested in the plan. You have been so impressed with the performance of the company's stock that you currently have all of your 401 (k) money invested in TMI's common stock. What does prudent investment management suggest that you do about risk?

A) Close out your 401 (k) and put the money in the bank

. B) Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.

C) Close out your 401 (k) and invest in T-bills

. D) Take some of your investment out of TMI's common stock and invest it in the stocks and bonds of other firms.

Explanation / Answer

A prudent investment management suggest to spread the investments across a range of investments to minimize the risk. Putting all the money in one type of investments can have the highest risk of losing the money. We can evaluate the options below

A) Close Out 401 (k) and put the money in the Bank - A 401 (k) account offers an average annual return of 5 - 6% over a period of time whereas the average yield on balances in savings accounts is around 0.06% and could be even lower for bigger banks.

B) Increase the payroll deduction from 5% to 10% but keep all the funds invested in TMI - Though the stocks of TMI are currently giving good return, there is no guarantee that the performance can decline in future due to various factors internal and external to the firm resulting in decline in share price and consequently decline in returns. Increasing the deduction for investment in 401(K) is good but keeping all the money invested in stocks of TMI is not advisable for a long term.

C) Close out 401(K) and invest in T-Bills - T Bills which are issued by the Federal Government offers risk-free returns as the money is guaranteed by the Federal Government. However, the average yields are currently ranging between 0.05% for a 6 month T-Bill to 2.83% on of 30 year Treasury Bond. Investing at this rate will not result in higher accretions.

D) Take some of your investments in TMI's common stock and invest in stocks and bonds of other firms - By taking out some of the investments currently in TMI's stock and investing in stocks and bonds of other firms, the total risk of the portfolio will be minimised though there may be a decline in the rate of return currently earned by the investor. However this will ensure that the investor will not lose out the principal in case of any unexpected decline in stocks of TMI.

Based on the above D is the better choice.

(However a combination of B and D that is increase the contribution to 401(k) and spread the investment across stocks and bonds of other firms while reducing the concentration in stocks of TMI would be an even better choice.)

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