Slide 2 of 36 Introduction How likely is it that an individual can learn to 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” and its implication for personal investing.
Slide 3 of 36 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.
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Slide 5 of 36 Passive vs. Active Investing 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 figure. Warren Buffett: Genius Investor or just lucky?
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Slide 7 of 36 Passive vs. Active Investing Why Is It Hard to Beat the Market? Tribute to the power of markets and the ability of market prices to reflect information. Let’s see what this means… 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.
Slide 8 of 36 Passive vs. Active Investing Why Is It Hard to Beat the Market? (cont.) Example: The number of senior citizens will double by Winning strategy: Buy stocks in companies producing goods that senior citizens want. Not so fast. If this is true why would anyone sell their stock in these companies? Answer: That the number of senior citizens is increasing is well known. The price of these stocks already reflects this information. Conclusion: Unless investor has insider information, he or she will not systematically outperform the market as a whole.
Slide 9 of 36 Passive vs. Active Investing Why Is It Hard to Beat the Market? (cont.) The Efficient Markets Hypothesis Prices of traded goods reflect all publicly available information. Implication of the hypothesis. Throwing darts at the stock pages will work as well as trying to figure out which stocks will beat the market. What if you have information that no one else has? You have to act very quickly. Let’s see why.
Slide 10 of 36 Passive vs. Active Investing Why Is It Hard to Beat the Market? (cont.) 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 also rose. Conclusion: Secrets do not last very long in the stock market and is another reason why it is hard to beat the market as a whole.
Slide 11 of 36 Passive vs. Active Investing Why Is It Hard to Beat the Market? (cont.) What about buying stocks when their price is low or after a big drop? Buying a stock is not like buying a banana. What’s the difference? 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.
Slide 12 of 36 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.
Slide 13 of 36 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. Sad example: 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.
Slide 14 of 36 How to Really Pick Stocks, Seriously 1.Diversify (cont.) Modern financial markets have made diversification easy. Buying 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.
Slide 15 of 36 How to Really Pick Stocks, Seriously 1.Diversify (cont.) Best trading strategy: Buy and Hold: based on two principles. Efficient markets hypothesis Diversification reduces risk. 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 so you couldn’t do better by trying to pick stocks. You are diversified so you are minimizing risk.
Slide 16 of 36 How to Really Pick Stocks, Seriously 1.Diversify (cont.) Simplest ways to implement this strategy. Replicate the well known stock indexes. Dow Jones Industrial Average (DJIA) Prices of 30 leading American stocks. Standard and Poor’s 500 (S&P 500) Prices of 500 different stocks. Larger companies receive a greater weight. NASDAQ Composite Index Prices of just over 3,000 stocks. Relatively higher weight to small companies and high-tech stocks.
Slide 17 of 36 How to Really Pick Stocks, Seriously 1.Diversify (cont.) 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 stock are risky because they tend to go up and down in harmony with the overall economy.
Slide 18 of 36 How to Really Pick Stocks, Seriously 1.Diversify (cont.) Examples of safer stocks. Walmart: does well in bad times because people switch to lower priced alternatives. Health care stocks: people need health care regardless of how the economy is doing. 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. If you are an aerospace engineer, don’t marry an aerospace engineer.
Slide 19 of 36 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.
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Slide 21 of 36 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%.
Slide 22 of 36 How to Really Pick Stocks, Seriously 4.No Free Lunch Principle 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).
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Slide 24 of 36 How to Really Pick Stocks, Seriously 4.No Free Lunch Principle (cont.) Applications of the no free lunch principle. Art: Underperforms the stock market by a few percentage points a year. Reason: People buy art because it is beautiful; the lower return is the price of possessing beautiful art. Part of the return of owning this Renoir is the enjoyment of looking at it.
Slide 25 of 36 How to Really Pick Stocks, Seriously 4.No Free Lunch Principle (cont.) 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. You get to live in the home—a significant part of the total return to owning a home. These nonmonetary returns tend to cancel each other out.
Slide 26 of 36 How to Really Pick Stocks, Seriously 4.No Free Lunch Principle (cont.) 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? 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.
Slide 27 of 36 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?
Slide 28 of 36 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. 2.Stock prices give the public a daily report on how well a company is being run.
Slide 29 of 36 Other Benefits and Costs of Stock Markets Stock markets have uses beyond investment (cont.) 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.
Slide 30 of 36 Other Benefits and Costs of Stock Markets Bubble, Bubble, Toil, and Trouble Stock markets (and other asset markets) have a downside in that 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.
Slide 31 of 36 Other Benefits and Costs of Stock Markets Bubble, Bubble, Toil, and Trouble Speculative bubbles (cont.) are difficult to spot in advance for durable assets like homes and stocks. 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.
Slide 32 of 36 Other Benefits and Costs of Stock Markets Bubble, Bubble, Toil, and Trouble (cont.) Example: 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. NASDAQ index tripled before falling back.
Slide 33 of 36 Other Benefits and Costs of Stock Markets Bubble, Bubble, Toil, and Trouble (cont.) 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.
Slide 34 of 36 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?
Slide 35 of 36 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
Slide 36 of 36 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.