Second Edition Stock Markets and Personal Finance Chapter 10

Chapter Outline  Passive vs. Active Investing  How to Really Pick stocks, Seriously  Other Benefits and Costs of Stock Markets 2

Introduction  How likely is it that an individual can consistently do better than the stock market?  Burton Malkiel, author of A Random Walk Down Wall Street says it is highly unlikely.  John Stossel’s experiment: John picked his stocks by throwing darts. After nearly a year, John beat 90% of the “market experts.”  This chapter introduces the “efficient markets hypothesis”. 3

Passive vs. Active Investing  Active investing – picking individual stocks.  Passive investing – choosing a group of stocks that mimic a broad market index.  In a typical year passive investing in the S&P 500 Index beats about 60 percent of all mutual funds. One 10 year study found passive investing beat 97.6 percent of all mutual funds. Conclusion: Very few mutual fund managers beat the market. 4

Passive vs. Active Investing 5

 What about Warren Buffett? Often cited as an example of a person who sees farther than the rest of the market. 6  Can an expert systematically beat the stock market? Started as a paperboy and worked his way up to $52 billion by purchasing undervalued stocks. Is he a genius investor or is he just lucky? Before you answer, look at the next figure.

Passive vs. Active Investing 7

Why Is It Hard to Beat the Market?  The power of markets and the ability of market prices to reflect information. For every buyer there is a seller. Both buyers and sellers have access to the same information. No reason to believe that either the buyers or the sellers will be correct most of the time. Conclusion: If on average, buyers and sellers have access to the same information, stock picking can’t work very well. 8

Why Is It Hard to Beat the Market?  Example: The number of senior citizens will double by Winning strategy? – Buy stocks in companies producing goods that senior citizens want. Why would anyone sell their stock in these companies? Answer: Prices of these stocks already reflect this well known information.  Conclusion: Unless an investor has insider information, he or she will not systematically outperform the market as a whole. 9

Why Is It Hard to Beat the Market?  The Efficient Markets Hypothesis – prices of traded goods reflect all publicly available information.  Implication Throwing darts at the stock pages will work as well as trying to figure out which stocks will beat the market. If you have information that no one else has, you have to act very quickly. 10 Let’s see why.

Why Is It Hard to Beat the Market?  Within minutes of the news that the Russian power plant at Chernobyl had melted down: Shares of U.S. nuclear power plant companies tumbled. Price of oil jumped. P otato prices also rose.  Conclusion: Secrets do not last very long in the stock market. 11

Why Is It Hard to Beat the Market?  What about buying stocks when their price is low or after a big drop? Buying a stock is not like buying a banana. The value of the banana is the benefit of eating it now. You know what that is. The value of the stock is its future price. You don’t know that for certain.  Conclusion: After adjusting for broker commissions, this strategy has not systematically beat the market overall. 12

Why It is Hard to Beat the Market?  Technical analysis – a field of study that looks for patterns in stock and asset prices. The claim is that stock prices exhibit predictable mathematical patterns  A team of economists studies 7,846 different strategies of technical analysis. None of them systematically beat the market over time. 13

Check Yourself  Is it better to invest in a mutual fund that has performed well for five years in a row or one that has performed poorly for five years in a row? Use the Efficient Markets Hypothesis to justify your answer. 14

How to Really Pick Stocks, Seriously 1.Diversify – choose a large number of stocks. Lowers risk by limiting exposure to things going wrong in any particular company. If you put all of your wealth in one “basket” you are risking disaster.  Many employees of Enron put their life’s savings in Enron stock.  When Enron went bankrupt in 2001 they lost everything! Diversification has no downside – it reduces risk without reducing your expected return. 15

Diversify  Modern financial markets have made diversification easy. B uying shares of mutual funds makes it possible to buy hundreds of different stocks. Including international firms in your portfolio reduces risk because not all nation’s economies move together. 16

How to Really Pick Stocks, Seriously  Buy and hold – buy stocks and then hold them for the long run, regardless of what prices do in the short run. Best trading strategy based on two principles:  Efficient markets hypothesis  Diversification Buy a large number of stocks and hold them. You don’t have to do anything more. Your rate of return will be the market average. You are diversified so you are minimizing risk. 17

Buy and Hold  Simplest way to implement this strategy is to r eplicate the stock indexes. Dow Jones Industrial Average (DJIA) – includes prices of 30 leading U.S. stocks Standard and Poor’s 500 (S&P 500) – includes prices of 500 different stocks.  Larger companies receive greater weight NASDAQ Composite Index – includes prices of over 3,000 stocks.  Small companies and high-tech stocks receive greater weights. 18

How to Really Pick Stocks, Seriously  The riskiest stock is not necessarily the one that moves up and down a lot.  In a diversified portfolio: Individual stocks may go up and down. They won’t likely all move together.  Riskiest stocks are those that move up and down with the market. For example: Many real estate stocks are risky because they tend to go up and down with the overall economy.  Safer stocks: Wal-Mart, Health-care. Why? 19

How to Really Pick Stocks, Seriously  Lesson: The least risky assets for you are assets that are negatively correlated with your portfolio: If part of your salary or bonus is in company stock, don’t invest more of your money in that stock. I f you are an aerospace engineer, don’t marry an aerospace engineer.

How to Really Pick Stocks, Seriously 2.Avoid High Fees Avoid investments and mutual funds that have high fees or “loads”.  Small fees can add up to large differences over time. Make sure you know what you are paying before you buy.  Some funds charge fees of 0.19% per year while others charge as much as 2.5% per year for the same service.  The following table gives a representative range of fees. 21

Avoid High Fees 22

How to Really Pick Stocks, Seriously 3. Compound Returns Build Wealth If you have a long time horizon, you probably should invest in (diversified) stocks rather than bonds. In the long run, stocks offer higher returns than bonds.  Since 1802, stocks have had an average rate of return of about 7% per year.  Bonds over the same period averaged 2%. $10,000 invested now will return:  $76,112 in 30 years at 7%.  $18,113 in 30 years at 2%. 23

Compound Returns Build Wealth  The rule of 70 – If the annual rate of return is x%, then the doubling time is years.  When compounded, small differences in investment returns can have a large impact 24

How to Really Pick Stocks, Seriously 4.No Free Lunch Principle: Higher returns come at the price of higher risk. How is risk measured?  Standard deviation of the portfolio return  Rule of thumb: There is a 68% probability of being within ±1 standard deviation of the average return. E xample: Mean return for S&P 500 ≈ 12%, standard deviation ≈ 20%. Result: 68% probability that the return will be between -8% (12-20) and 32% (12+20). 25

No Free Lunch Principle 26  Higher returns come at the price of higher risk.

How to Really Pick Stocks, Seriously  Application of the no free lunch principle Art: Underperforms the stock market by a few percentage points a year. 27 Reason: People buy art because it is beautiful; the lower return is the price of possessing beautiful art. Part of the return to this Renoir is the joy of owning it.

How to Really Pick Stocks, Seriously  Application of the no free lunch principle Real estate: Over long periods of time, the rate of return on real estate is about zero! Why? A home tends to be a risky asset:  For most homeowners, most of their wealth is in their home.  Insuring against this risk lowers the financial rate of return on the home.  Living in the home is a significant part of the total return to owning a home.  Nonmonetary returns tend to cancel each other out. 28

No Free Lunch Principle  From 1950 to 1997 housing prices hardly changed at all.  The housing bubble began in the late 90s and broke in  Will the price of housing return to its long term range? The “bubble” burst  Two lessons: Most of the time a house is a good place to live but not to Invest. Investments with nonmonetary benefits yield lower financial returns. 29

Check Yourself  How does investing in stocks of other countries help to diversify your investments?  Many people dream of owning a football or baseball team. Would you expect the return on these assets to be relatively high or low? 30

Other Benefits and Costs of Stock Markets  Stock markets have uses beyond investment 1.Important means of increasing the stock of capital.  New stock issues are an important means of raising money for investment in new capital.  Reward successful entrepreneurs, and thus encourage people to start companies and look around for fresh ideas. 31

Other Benefits and Costs of Stock Markets 2.Stock prices give the public a daily report on how well a company is being run. 3.A way of transferring company control from less competent people to more competent people.  Poorly run companies have low stock prices.  People who think they can do better can buy enough of the company’s stock to gain control. 32

Bubble, Bubble, Toil, and Trouble  Stock markets (and other asset markets) have a downside in that they encourage speculative bubbles. Speculative bubbles:  Occur when asset prices rise far higher and more rapidly than can be accounted for by the fundamental prospects of the company.  Are based in human psychology that can be hard to understand. 33

Bubble, Bubble, Toil, and Trouble  Speculative bubbles are difficult to spot in advance. Is the big run-up in the price of homes or stocks:  A result of discounting the future at a lower rate so that assets that pay off in the future are worth more?  Or, does it result from a bubble?  It is not always easy to tell. 34

 The dot-com bubble of the 90s. Many of these companies had never earned a profit or even any revenue. Many were listed on the NASDAQ exchange. Bubble, Bubble, Toil, and Trouble 35 NASDAQ index tripled before falling back.

Bubble, Bubble, Toil, and Trouble  Boom and Bust in Tech Stocks: NASDAQ 36

Bubble, Bubble, Toil, and Trouble  Speculative bubbles can hurt the economy. Capital is invested in areas where it is not really valuable. Dot-com bubble: capital was invested in many firms that eventually failed. Real estate bubble: capital was allocated to risky loans and securities based on these loans. When the bubble bursts:  ↓Wealth leads to ↓ spending.  Labor is dislocated. 37

Check Yourself  The Federal Reserve has been criticized for not stepping in and bursting the housing bubble, which would have prevented the housing collapse. Do you think this criticism is valid, based on what you have read in this section? 38

Takeaway  It is difficult for a single investor to consistently beat the market average.  Investors are well advised to: Diversify Avoid brokerage fees Understand that the promise of higher returns are often accompanied by higher risk 39

Takeaway  Stock markets and other trading markets give investors a chance to… Earn money Diversify their holdings Express opinions on the course of the market Hedge risks  Stock markets are subject to bubbles, but… Are an important part of a healthy, growing economy. 40

Second Edition End Of Chapter 10