Stock Markets and Personal Finance Outline Passive vs Active Investing How to Really Pick stocks Seriously Other Benefits and Costs of Stock Markets Key Concept Efficient Markets Hypothesis Passive vs Active Investing Active investing picking individual stocks Done my money mutual funds Passive investing choosing a group of stocks that mimic a broad market index Money mutual fund Pool of funds from many investors which a money manager operates Are mutual funds any good No is the simple answer In a typical year passive investing in the S P 500 Index beats about 60 percent of all managed 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 Can a person systematically beat the stock market Warren Buffett Genius or Lucky Hard to Beat the Market The power of markets and the ability of market prices to reflect information 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 Example Example The number of senior citizens will double by 2020 Winning strategy Buy stocks in companies producing goods that senior citizens want Why would anyone sell their stock in these companies Answer Prices of these stocks already reflect this well known information Conclusion Conclusion Unless an investor has insider information he or she will not systematically outperform the market as a whole Systematically On purpose and consistently Efficient Markets Hypothesis The Efficient Markets Hypothesis prices of traded goods reflect all publicly available information Implication Throwing darts at the stock pages will work as well as trying to figure out which stocks will beat the market If you have information that no one else has you have to act very quickly Efficient Markets Hypothesis 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 Hard to Beat the Market What about buying stocks when their price is low or after a big drop Buying a stock is not like buying a banana 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 Hard to Beat the Market Technical analysis a field of study that looks for patterns in stock and asset prices The claim is that stock prices exhibit predictable mathematical patterns A team of economists studies 7 846 different strategies of technical analysis None of them systematically beat the market over time How to Pick Stocks 1 Diversify choose a large number of stocks Lowers risk by limiting exposure to things going wrong in any particular company All your eggs in one basket Diversification has no downside it reduces risk without reducing your expected return Diversification 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 Pick Stocks Buy and hold buy stocks and then hold them for the long run regardless of what prices do in the short run Best trading strategy based on two principles Efficient markets hypothesis Diversification How to Pick Stocks 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 You are diversified so you are minimizing risk Buy and Hold Simplest way to implement this strategy is to replicate the stock indexes Standard and Poor s 500 S P 500 includes prices of 500 different stocks Larger companies receive greater weight NASDAQ Composite Index includes prices of over 3 000 stocks Small companies and high tech stocks receive greater weights How to Pick Stocks 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 How to Pick Stocks Riskiest stocks are those that move up and down with the market For example Real Estate Safer stocks Wal Mart Health care How to Pick Stocks 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 Pick Stocks 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 The following table gives a representative range of fees Avoid High Fees How to Pick Stocks 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 How to Pick Stocks 3 Compound Returns Build Wealth 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 Compound Returns Build Wealth The rule of 70 If the annual rate of return is x then the doubling time is z years When compounded small differences in investment returns can have a large impact How to Pick Stocks 4 No Free Lunch Principle Higher returns come at the price of higher 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 No Free Lunch Other Costs Benefits of the Stock Market Stock markets have uses beyond investment 1 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
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