Chapter 9 Stock Markets and Personal Finance

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. Instructor Note: John Stossel is co-host of NBC’s 20-20.

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.

Passive vs. Active Investing

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?

Passive vs. Active Investing Notes: This slide builds so you can explain the process as it unfolds. You could try this experiment in a large class. The point of the exercise is to demonstrate that if enough people try, that even if stocks are picked by flipping a coin some people will be right every time over a fairly long period. In this example even after eight years 4 will have been correct every time. Given that so many people buy stocks it isn’t surprising that a few will have long winning streaks.

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.

Passive vs. Active Investing Why Is It Hard to Beat the Market? (cont.) Example: The number of senior citizens will double by 2020. 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. You might want to point out that since stock prices already reflect widely known information, they are traded based on other factors that are more likely to be judgment factors of individual investors. Insider trading is illegal. You can find out more about this on the U.S. Securities and Exchange Commission website at http://www.sec.gov/answers/insider.htm

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. You might want to point out that since stock prices already reflect widely known information, they are traded based on other factors that are more likely to be judgment factors of individual investors. Insider trading is illegal. You can find out more about this on the U.S. Securities and Exchange Commission website at http://www.sec.gov/answers/insider.htm. It might be important to point out that the issue is not whether one can make money in the stock market but whether one can systematically do better than the market overall (i.e. make rates of return higher than the average for the market).

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. You might want to point out that since stock prices already reflect widely known information, they are traded based on other factors that are more likely to be judgment factors of individual investors. Insider trading is illegal. You can find out more about this on the U.S. Securities and Exchange Commission website at http://www.sec.gov/answers/insider.htm. It might be important to point out that the issue is not whether one can make money in the stock market but whether one can systematically do better than the market overall (i.e. make rates of return higher than the average for the market).

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. Instructor Note: When we buy goods and services, we buy them for their intrinsic value. The only value a stock is its future value. Even dividends are dependent on how well the company is doing so falling stock prices probably signal low dividends. Both of which are unknown.

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.

How to Really Pick Stocks, Seriously 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. Instructor Note: One of the reasons why mutual funds are so popular is that it enables people to put relatively small amounts of money in a lot of different stocks.

How to Really Pick Stocks, Seriously 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.

How to Really Pick Stocks, Seriously 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. Instructor Note: The key to the “buy and hold” strategy is that if your are diversified your rate of return will be the market average. The efficient markets hypothesis says that you will have to be very lucky to beat this average by picking stocks.

How to Really Pick Stocks, Seriously 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.

How to Really Pick Stocks, Seriously 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.

How to Really Pick Stocks, Seriously 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.

How to Really Pick Stocks, Seriously 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.

How to Really Pick Stocks, Seriously

How to Really Pick Stocks, Seriously 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%. Instructor Note: These rates of returns are adjusted for inflation.

How to Really Pick Stocks, Seriously 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). Instructor Note: It might be wise to remind the students that this is an approximation and that risk in the real world can rarely be modeled with perfect mathematical accuracy. No mathematical sophistication can replace good judgment in guarding against fraud. Those who lost millions investing with con artist Bernie Madoff should have been suspicious when he was promising and delivering returns as high as 15% that something was wrong. It turned out he was running a classic Ponzi Scheme where he was paying off his older investors with the money he was bringing in from new investors. He wasn’t investing their money in the stock market at all! The whole scheme came crashing down when people started asking for their money after the stock market crash in September 2008.

How to Really Pick Stocks, Seriously Note: We measure risk using the standard deviation of the portfolio return. The standard deviation is a measure of how much the return tends to fluctuate from its average level. The larger the standard deviation the greater the risk.

How to Really Pick Stocks, Seriously 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. Instructor Note: You might emphasize that the total return to an investment in something like art is the sum of the financial return (a potential capital gain as the piece of art rises)and the nonmonetary returns that result from the enjoying the art. Part of the return of owning this Renoir is the enjoyment of looking at it.

How to Really Pick Stocks, Seriously 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. Instructor Note: You might explain that people buy mortgage insurance and home insurance because a home is a risky asset. The cost of this insurance reduces the financial return on their investment .

How to Really Pick Stocks, Seriously 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 2007-08. 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.

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?

Other Benefits and Costs of Stock Markets Stock markets have uses beyond investment 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. Stock prices give the public a daily report on how well a company is being run.

Other Benefits and Costs of Stock Markets Stock markets have uses beyond investment (cont.) 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.

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.

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.

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. Instructor Note: Bubbles are not new. A fun one to talk about is the tulip bulb bubble in mid 17th century Holland. See: “When the Tulip Bubble Burst, TULIPOMANIA:The Story of the World's Most Coveted Flower, Mike Dash, Crown Publishers. For a review of this book go to: http://www.businessweek.com/2000/00_17/b3678084.htm.

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.

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?

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

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.