"Each of the following statements is dangerous or misleading. Explain why.
a. A long-term United States government bond is always absolutely safe.
b. All investors should prefer stocks to bonds because stocks offer higher long-run rates of return.
c. The best practical forecast of future rates of return on the stock market is a 5- or 10-year average of historical returns.
Answers:
a. A long-term bond of the government of the United States is always totally safe. Ths is in terms of dollars received. However, there seems to be a problem where the price of bond always fluctuates when there is change in the interest rates. Apart from the change in the interest rate, fluctuation also takes place when there is a change in the rate at which the payment of coupon received can easily be invested. Additiiionally, the payment are in the form of nominal dollars (Saez & Zucman, 2014). This calls for inflation risk to be considered.
b. The statement that stocks offer higher long-run rates of return compared to bonds is true. They have greater returns potential compared to bonds. But the volatility of stock is very high (This means that the measure of dispersion when it comes to the returns is high. Higher volatility makes the stock be riskier). Stocks have higher standard deviation of returns. The investment that is preferable to a person relies on the amount of risk that the person is in a position to tolerate. This matter is very complicated, and it relies on a number of factors. One factor that becomes very important is the investment time horizon (Eraker & Ready, 2015). For example, if an investor or investors have a short time horizon, then it means that stocks are generally not the prefered option. Stocks will be a prefered option if the investment time horizon is a bit long.
c. Forecasting of future rates of return on the stock market through the use of a 5- or 10-year average of historical returns is considered to be good. However, 10 years is not believed to be a sufficient amount of time when it comes to estimating average rate of return (Rapach & Zhou, 2013). The time not being well sifficient makes the 5- or 10-year average to be a bit misleading when forecasting average rate of return.