10 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL Stock Markets and Personal Finance

CHAPTER OUTLINE Passive vs. Active Investing How to Really Pick Stocks, Seriously Other Benefits and Costs of Stock Markets For applications, click herehere To Video To Video

Some good blogs and other sites to get the juices flowing: Food for Thought….

B ACK TO Passive vs. Active Investing How likely is it that an individual can learn to consistently perform better than the stock market? Burton Malkiel, author of A Random Walk Down Wall Street, says it is highly unlikely.

Take a look….. Burton Malkiel on his book A Random Walk Down Wall Street. (8:48 minutes) B ACK TO

Efficient Markets? John Stossel’s experiment: John picked his stocks by throwing darts. Over a year John beat 90% of the “market experts”. This chapter introduces the “ efficient markets hypothesis ” and its implication for personal investing.

B ACK TO Passive vs. Active Investing Active investing: Active investing: picking individual stocks. Passive investing: Passive investing: choosing a group of stocks that mimic a broad market index. Key U.S. indexes: DJIA : Dow-Jones Industrial Average (30 large, publicly-owned companies) S&P 500 : Standard and Poor’s 500 (500 large publicly held companies) NASDAQ : largest electronic screen-based equity securities trading market in the United States (3,700 companies)

B ACK TO Percent of Mutual Funds Outperformed by the S&P 500 Typical year: passive investing beats 60% 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.

B ACK TO Genius or Luck? Is it possible that a small number of experts can systematically beat the stock market? What about Warren Buffett? Often cited as an example of a person who sees farther than the rest of the 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 chart...

B ACK TO How to Become a Market Genius

B ACK TO Why Is It Hard to Beat the Market? Efficient Markets Hypothesis: Efficient Markets Hypothesis: the prices of traded assets reflect all publicly available information. The prices of traded assets, such as stocks and bonds, reflect all publicly available information. Unless an investor is trading on inside information, he or she will not systematically outperform the market as a whole over time. She had more information than you.

A mutual fund that mimics a broad stock market index is called a(n): a)active fund. b)passive fund. c)dependable fund. d)trends fund.

B ACK TO Why Is It Hard to Beat the Market? Markets are powerful and able to reflect much information. For every buyer there is a seller: so if you’re buying that high-tech stock because you think it’s about to explode, don’t forget someone is selling it to you because he thinks it won’t. Both buyers and sellers have access to the same information. Conclusion: If on average, buyers and sellers have access to the same information, stock picking can’t work very well.

B ACK TO Example of Efficient Markets? 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.  Potato prices rose. Conclusion: Secrets do not last very long in the stock market- another reason why it is hard to beat the market as a whole.

According to the efficient markets hypothesis, an investor who systematically outperforms the market is likely privy to: a)inside information. b)publicly available information. c)market statistics. d)None of these, as such an investor is merely lucky.

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.

B ACK TO 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, industry or country. Diversification has no downside—it reduces risk without reducing your expected return.

B ACK TO Diversify, continued Buy and Hold: Best trading strategy: Buy and Hold: buy stocks and then hold them for the long run, regardless of what prices do in the short run. Buy and hold is based on two principles. Efficient markets hypothesis Diversification reduces risk.

B ACK TO Diversify, continued Buy a large number of stocks (like a mutual fund) and hold them. Your rate of return will be the market average so you couldn’t do better by trying to pick stocks. You are diversified so you are minimizing risk.

B ACK TO 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.

B ACK TO There is a Wide Range of Loads

B ACK TO 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 (but are riskier). Since 1802, stocks have had an average rate of return of about 7% per year. Bonds? Averaged 2% per year over the same period.

B ACK TO The Rule of 70 The Rule of 70: The Rule of 70: if the rate of return on an investment is x percent, then the doubling time is 70/x years.

Suppose your rich aunt hands you a $3,000 check at the end of the school year. If you put it in a bank account earning a two percent real annual return on average, about how many years would it take until it was worth $6,000? a)2 years b)3 years c)35 years d)70 years

B ACK TO How to Really Pick Stocks, Seriously 4. No Free Lunch Principle (No Return Without Risk) The Risk-Return Tradeoff: The Risk-Return Tradeoff: higher returns come at the price of higher risk.

B ACK TO Measuring 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. Example: 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).

B ACK TO Real Estate is Not a High-Return Investment

Compared to bonds, stocks offer: a)lower risks and higher returns. b)higher risks and higher returns. c)higher risks and lower returns. d)lower risks and lower returns.

B ACK TO Other Benefits and Costs of Stock Markets 1.Important means of increasing the stock of capital. Rewards successful entrepreneurs and encourages people to start companies and look around for new ideas.

B ACK TO Other Benefits and Costs of Stock Markets 2. Stock prices give the public a daily report on how well a company is being run relative to other firms.

B ACK TO Other Benefits and Costs of Stock Markets 3.Are 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.

B ACK TO Bubble, Bubble, Toil, and Trouble Stock markets (and other asset markets) have a downside - they encourage speculative bubbles. Speculative bubbles  occur when stock 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.

B ACK TO The NASDAQ Index,

B ACK TO Bubble, Bubble, Toil, and Trouble When the bubble bursts: People feel poorer, and lower wealth leads to less spending… recession. People face unemployment.

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? a)Yes b)No B ACK TO