10
CHAPTER
DYNAMIC P OWERP 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
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questions
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Video
Food for Thought….
Some good blogs and other sites to get the juices flowing:
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.
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Take a look…..
Burton Malkiel on his book A Random Walk Down
Wall Street. (8:48 minutes)
http://www.youtube.com/watch?v=Ff3P-9g-1oY
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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.
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Passive vs. Active Investing
Active investing: picking individual stocks.
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)
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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 A C K
T O
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...
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How to Become a
Market Genius
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Why Is It Hard to Beat the Market?
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.
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Try it!
A mutual fund that mimics a broad
stock market index is called a(n):
a)
b)
c)
d)
active fund.
passive fund.
dependable fund.
trends fund.
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Try it!
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.
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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.
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Try it!
According to the efficient markets
hypothesis, an investor who
systematically outperforms the market is
likely privy to:
a)
b)
c)
d)
inside information.
publicly available information.
market statistics.
None of these, as such an investor is
merely lucky.
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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
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.
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Diversify, continued
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.
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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.
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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.
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There is a Wide Range of Loads
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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.
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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.
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Try it!
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)
b)
c)
d)
2 years
3 years
35 years
70 years
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How to Really Pick Stocks, Seriously
4. No Free Lunch Principle (No Return
Without Risk)
The Risk-Return Tradeoff: higher returns
come at the price of higher risk.
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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).
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Real Estate is Not a
High-Return Investment
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Try it!
Compared to bonds, stocks offer:
a)
b)
c)
d)
lower risks and higher returns.
higher risks and higher returns.
higher risks and lower returns.
lower risks and lower returns.
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.
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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.
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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.
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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.
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The NASDAQ Index, 1997-2002
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Bubble, Bubble, Toil, and Trouble
When the bubble bursts:
People feel poorer, and lower wealth leads to
less spending… recession.
People face unemployment.
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Try it!
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
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