Modern Principles: Macroeconomics

Tyler Cowen and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Chapter 9

Stock Markets and

Personal Finance

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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.

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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.

•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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Passive vs. Active Investing

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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 ishe just lucky?

Before you answer, look at thenext figure. Warren Buffett: Genius

Investor or just lucky?

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Passive vs. Active Investing

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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.

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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.

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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.

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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.

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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.

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CHECK YOURSELF

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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously1.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.

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How to Really Pick Stocks, Seriously2. 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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How to Really Pick Stocks, Seriously

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How to Really Pick Stocks, Seriously3. 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%.

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How to Really Pick Stocks, Seriously4.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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How to Really Pick Stocks, Seriously

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How to Really Pick Stocks, Seriously4.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.

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How to Really Pick Stocks, Seriously4.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.

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How to Really Pick Stocks, Seriously4.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.

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CHECK YOURSELF

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?

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Other Benefits and Costs of Stock Markets

•Stock markets have uses beyond investment1. 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.

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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.

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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.

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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.

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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.

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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.

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CHECK YOURSELF

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?

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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

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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.