1. Before we plunge into the world of finance, let’s review the rule of 70. Suppose your rich aunt hands you a $3,000 check at the end of the school year. She tells you it’s for your education. But what should you really do with that extra money? Let’s see how much it would be worth if you saved it for a while.
If you put it in a bank account earning 2% real annual return on average, how many years would it take before it was worth $6,000? Until it was worth $12,000?
If you put it in a Standard and Poor’s 500 (S&P 500) mutual fund earning an average 7% real return every year, how many years would it take before it was worth $6,000? Until it was worth $12,000?
Suppose you invest a little less than half your money in the bank and a little more than half in a mutual fund, just to play it somewhat safe, so that you can expect a 5% real return on average. How many years now until you reach $6,000 and $12,000?
2. Let’s do something boring just to drive home a point: Count up the number of years in Figure 10.1 in which more than half of the mutual funds managed to beat the S&P 500 index. (Recall that the Standard and Poor’s 500 is just a list of 500 large U.S. corporations—it’s a list that overlaps a lot with the Fortune 500.) What percentage of the time did the experts actually beat the S&P 500?
3. Consider the supply and demand for oranges. Orange crops can be destroyed by below-freezing temperatures.
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If a weather report states that oranges are likely to freeze in a storm later this week, what probably happens to the demand for oranges today, before the storm comes?
According to a simple supply and demand model, what happens to the price of oranges today given your answer to part a.
How does this illustrate the idea that stock prices today “bake in” information about future events? In other words, how is a share of Microsoft like an orange? (Note: Wall Street people often use the expression, “That news is already baked into the price,” when they talk about the efficient markets hypothesis.)
4. In the United States, high-level corporate officials have to publicly state when they buy or sell a large number of shares in their own company. They have to make these statements a few days after their purchase or sale. What do you think probably happens (choose a, b, c or d) when newspapers report these true “insider trades”? (Note: The right answer according to theory is actually true in practice.)
When insiders sell, prices rise, since investors increase their demand for the company’s shares.
When insiders sell, prices fall, since investors increase their demand for the company’s shares.
When insiders sell, prices fall, since investors decrease their demand for the company’s shares.
When insiders sell, prices rise, since investors decrease their demand for the company’s shares.
5. Let’s see how fees can hurt your investment strategy. Let’s assume that your mutual fund grows at an average rate of 7% per year—before subtracting the fees. Using the rule of 70:
How many years will it take for your money to double if fees are 0.5% per year?
How many years will it take for your money to double if fees are 1.5% per year (not uncommon in the mutual fund industry)?
How many years to double if fees are 2.5% per year?
6.
If you talk to a broker selling the high-fee mutual fund, what will he or she probably tell you when you ask them, “Am I getting my money’s worth when I pay your high fees?”
According to Figure 10.1, is your broker’s answer likely to be right most of the time?
1. Your brother calls you on the phone telling you that Google’s share price has fallen by about 25% over the past few days. Now you can own one small slice of Google for only $540 a share (the price on the day this question was written). Your brother says he is pretty sure the stock is going to head back up to $700 very soon and you should buy.
Should you believe your brother? (Hint: Remember someone is selling shares whenever someone else is buying.)
2. In most of your financial decisions early in life, you’ll be a buyer, but let’s think about the incentives of people who sell stocks, bonds, bank accounts, and other financial products.
Walking in the shopping mall one day, you see a new store: the Dollar Store. Of course, you’ve seen plenty of dollar stores before, but none like this one: The sign in the window says, “Dollars for sale: Fifty cents each.” Why will this store be out of business soon?
If business owners are self-interested and fairly rational people, will they ever open up this dollar store in the first place? Why or why not?
This dollar store is similar to stories people tell about “cheap stocks” that you might hear of on the news. Fill in the blank with any prices that make sense: “If the shares of this company were really worth ____, no one would really sell it for ______.”
3. How is “stock market diversification” like putting money in a bank account?
4. Warren Buffett often says that he doesn’t want a lot of diversification in his portfolio. He says that diversification means buying stocks that go up along with stocks that go down; but he only wants to buy the stocks that go up! From the point of view of the typical investor, what is wrong with this reasoning?
5. You own shares in a pharmaceutical company, PillCo. Reading the Yahoo! Finance Web site, you see that PillCo was sued this morning by users of PillCo’s new heart drug, Amphlistatin. PillCo’s stock has already been trading for a few hours today.
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When the bad news about the lawsuits came out, what probably happened to the price of PillCo shares within just a few minutes?
According to the efficient markets hypothesis, should you sell your shares in PillCo now, a few hours after the bad news came out?
In many statistical studies of the stock market, the best strategy turns out to be “buy and hold.” This means just what it sounds like: You buy a bunch of shares in different companies and hold them through good times and bad. People often have a tough time with the “bad” part of “holding through good times and bad.” What does your answer to part b tell you about this idea?
6. There are three stocks available: a solar energy firm, an oil firm, and an airline. You can invest in two. Which two?
1. What is so bad about bubbles? If the price of Internet stocks or housing rises and then falls, is that such a big problem? After all, some people say, most of the gains going up are “paper gains” and most of the losses going down are “paper losses.” Comment on this view.
2. Mr. Wolf calls you with what he says is a tremendous opportunity in the stock market. He has inside knowledge about a pharmaceutical company and he says that the price will go up tomorrow. Of course, you are skeptical and decline his offer. The next day the price does go up. Mr. Wolf calls again and says not to worry, tomorrow the price will go down and that will be a good time to buy. Again, you decline. The next day the price does go down. Mr. Wolf calls you over the next several weeks and every time his predictions about the stock price prove to be amazingly accurate. Finally, he calls to tell you that tomorrow is the big one, the day the price will skyrocket. Mr. Wolf has been accurate many times in a row so you empty your bank account to buy as much stock as possible. The next day the price of the stock goes nowhere. What happened?
Let’s see how fees can hurt your investment strategy. Let’s assume that your mutual fund grows at an average rate of 5% per year—before subtracting the fees. Using the rule of 70:
How many years will it take for your money to double if fees are 0.5% per year?
How many years will it take for your money to double if fees are 1.5% per year (not uncommon in the mutual fund industry)?
How many years to double if fees are 2.5% per year?
* We measure risk using the standard deviation of the portfolio return. The standard deviation is a measure of how much the return tends to fluctuate from its average level: thus, the larger the standard deviation, the greater the risk. A rule of thumb is that there is a 68% probability of being within ±1 standard deviation of the mean return. For the S&P 500, for example, the mean return is about 12% and the standard deviation is about 20% so in any given year, there is a 68% probability that the return will be between –8% and 32%. Of course, there is a 32% probability that something else could happen! But beware! The rule of thumb is only an approximation. Risk in the real world can rarely be modeled with perfect mathematical accuracy.