MODERN PRINCIPLES OF ECONOMICSThird Edition

Stock Markets and Personal Finance

Chapter 23

Outline

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.”

Burton Malkiel, authorA Random Walk Down Wall Street

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COPYRIGHT © 2014, INDEX FUNDS ADVISORS, IFA.COM

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

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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. Warren Buffett

CHIP SOMODEVILLA/GETTY IMAGES

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.

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.

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.

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

25 Higher returns come at the price of higher risk.

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.

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: NASDAQ29

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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.