Chapter 23
Stock Markets and
Personal Finance
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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Passive vs. Active Investing
Why Is It Hard to Beat the Market?
How to Really Pick Stocks, Seriously
Other Benefits and Costs of Stock Markets
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Introduction
“A blindfolded monkey
throwing darts at a
newspaper’s financial
pages could select a
portfolio that would do
just as well as one
carefully selected by
experts.”
COPYRIGHT © 2014, INDEX FUNDS ADVISORS, IFA.COM
Burton Malkiel, author
A Random Walk Down Wall Street
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Introduction
 In 1992, TV reporter John Stossel picked a
portfolio by throwing darts at the stock pages.
 After nearly a year, the portfolio beat 90% of
those picked by Wall Street experts.
 These results are backed up by economic
theory and many empirical studies.
 Economics provides important lessons for
investing wisely.
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Passive vs. Active Investing
 Mutual funds pool money from many customers
and invest it in many firms, in return for a fee.
 “Active funds” are run by managers who try to
pick stocks.
 These funds often charge higher fees.
 “Passive funds” simply attempt to mimic a broad
stock market index, such as the S&P 500.
 One study found that passive investing beat
97.6% of all mutual funds.
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Passive vs. Active Investing
Percent of Mutual Funds Outperformed by the S&P 500
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Passive vs. Active Investing
 Investor and business
magnate Warren Buffett
is often cited as an
example of someone who
systematically beats the
market.
 Others think Buffett just
got lucky.
CHIP SOMODEVILLA/GETTY IMAGES
Warren Buffett
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Passive vs. Active Investing
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Self-Check
Studies show that passive investing:
a. Underperforms most mutual funds.
b. Outperforms most mutual funds.
c. Provides the same returns as mutual funds.
Answer: b – outperforms most mutual funds.
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Beating the Market
 The efficient markets hypothesis states that
it is difficult to beat the stock market because
stock prices reflect all publicly available
information.
 Unless an investor is trading on inside
information, he or she will not systematically
outperform the market.
 Insider information quickly becomes public,
and opportunities for profit evaporate.
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Definition
Efficient markets hypothesis:
the prices of traded assets reflect all
publicly available information.
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Beating the Market
 Technical analysis is an approach that looks
for patterns in stock and asset prices.
 Proponents claim that stock prices exhibit
predictable mathematical patterns.
 One study examined 7,846 different strategies
of technical analysis.
 None of them systematically beat the market
over time.
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Self-Check
An approach that looks for patterns in stock and
asset prices is called:
a. Technical analysis.
b. Active investment.
c. Passive investment.
Answer: a – technical analysis looks for patterns
in prices.
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How to Pick Stocks
 Advice for investing:
 Diversify.
 Avoid high fees.
 Compound returns build wealth.
 No return without risk.
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Diversify
 Diversification lowers the risk of your portfolio.
 Picking a lot of stocks limits your exposure to
things going wrong in any particular company.
 You should diversify across different countries
and asset classes as well.
 The least risky assets for you are assets that
are negatively correlated with your portfolio.
 Your best strategy trading strategy is buy and
hold.
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Definition
Buy and hold:
to buy stocks and hold them for the long
run, regardless of what prices do in the
short run.
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Some Stock Indexes
 The Dow Jones Industrial Average (“the
Dow”) is composed of 30 leading American
stocks, each counted equally. It is not a very
diversified index.
 The Standard and Poor’s 500 (S&P 500) is a
broader index of 500 stocks.
 Larger companies receive greater weight than
smaller companies.
 The S&P 500 is a better indicator of the market
as a whole than the Dow.
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Some Stock Indexes
 The NASDAQ Composite Index averages the
prices of over 3,000 securities traded on the
National Association of Securities Dealers
Automated Quotations (NASDAQ).
 The NASDAQ index contains more small stocks
and high-tech stocks relative to the Dow or the
S&P 500.
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Avoid High Fees
 Mutual funds charge fees of between 0.09%
and 2.5% of your investment per year.
 Even small fees can add up to large differences
in returns over time.
• $10,000 invested for 30 years at 7%:
 $74,016 if fees are 0.1%.
 $57,434 if fees are 1%.
 Understand the incentives of the person you
are dealing with.
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Compound Returns
 A higher rate of return makes a big difference in
the long run.
 Rule of 70: If the rate of return of an investment
is x%, then the doubling time is 70/x years.
 With a return of 1%, an investment will double
approximately every 70 years ( 70/1 = 70).
 In the long run, stocks offer higher returns than
bonds.
 Stocks, however, have the potential for greater
losses than do bonds.
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Compound Returns
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Self-Check
The formula for calculating how long it will take a
sum of money to double is:
a. 70 x the rate of interest.
b. 70 / the rate of interest.
c. 70 + the rate of interest.
Answer: b – 70 / the rate of interest.
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Definition
Risk-return tradeoff:
higher returns come at the price of
higher risk.
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No Free Lunch
 There is a systematic trade-off between return
and risk.
 To get higher returns, you need to bear higher
risk.
 The expected returns on different assets,
adjusted for risk, should be equal.
 Assets that provide additional enjoyment (art,
real estate) generally underperform the stock
market.
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No Free Lunch
Higher returns come at the price of higher risk.
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Benefits of Stock Markets
 Stock markets have uses beyond investment.
 New stock and bond issues are an important
means of raising capital for capital investment.
 A well functioning stock market helps
companies get going or expand.
 Market prices give the public a daily report on
how well a company is run.
 Stock markets are a way of transferring
company control from less competent people to
more competent people.
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Self-Check
One benefit of stock markets is that they:
a. Redistribute money to poor people.
b. Are a source of capital for individuals.
c. Are a source of capital for businesses.
Answer: c – stock markets are a source of
capital for businesses.
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Costs of Stock Markets
 Stock markets (and other asset markets) can
encourage speculative bubbles.
 Stock prices rise far higher, and more rapidly,
than the fundamental prospects of the company.
 Capital is invested in areas where it is not very
valuable.
 When the bubble crashes, lower prices mean
people feel poorer and spend less.
 Workers must move from one sector to another,
creating labor adjustment costs.
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Costs of Stock Markets
The Boom and Bust in Tech Stocks: NASDAQ
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Takeaway
 It is difficult to consistently beat the market over
long periods.
 You should diversify your investments, avoid
fees and try to generate a high compound return
over time.
 Higher returns are accompanied by higher risk.
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Takeaway
 Active stock markets are an important part of a
healthy growing economy.
 They give investors a chance to earn money,
diversify their holdings, express opinions on the
market, and hedge risks.
 Stock markets also play a role in financing
innovative new firms.
 They are subject to speculative bubbles.
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