Here's Your Chance to Make Millions in the Stock Market (Part 1)
This lesson printed from:
Posted November 8, 2002
Author: William Trainor
Posted: November 8, 2002
Updated: June 10, 2009
In this lesson students will learn about the impact that efficient markets have on attempting to correctly time the stock market, as well as how investing in stocks should have long-term investment goals. Part I begins by having students read and discuss a story. A small exercise is included which demonstrates that predicting what a stock does next is not so easy. Parts II and III takes the student through an interactive historical simulation giving the student a chance to make decisions about investing in the U.S. stock market.
- Explain the concept of market efficiency.
- Identify what is needed for market efficiency to hold.
- Explain the difference between a "buy and hold" versus a "market timing" investment strategy.
- Use the concept of market efficiency to explain why investors find it difficult to time the markets.
- Explain the importance of long-term investment horizons for investors.
PART 1: Why Making Millions Is Not So Easy
In this lesson students learn how efficient markets affect investor's efforts to time the stock market; they also learn why people who invest in stocks should have long-term investment goals. Part I begins by having students read and discuss a story. A small exercise is included which demonstrates that predicting what a stock might do next is not so easy. Parts II and III take the students through an interactive historical simulation and give the students a chance to make investment decisions.
A MARKET EFFICIENCY STORY
An elderly economics professor was walking down a busy street with one of his energetic students to the local café for lunch. Along the way, as he was explaining the concept of market efficiency to his student, the professor stepped right on a wadded up $20 bill and continued to stroll on. The student, who was looking down in studious thought at the time, was amazed at his good fortune and stooped down to pick it up. As the student rushed to catch up with the professor, he asked the professor whether he had seen the $20 bill. The professor quipped "My dear lad, haven't you been listening to anything I have been saying about efficient markets? Although I saw the $20, I knew my eyes must have been deceiving me. Efficient markets theory dictates that it couldn't possibly be there because if it had been, someone else would have already picked it up."
The story above is an old joke among economists. It highlights both the conclusions and possible folly of assuming the extreme case of efficient market theory. Most scholars believe (in one form or another) in efficient markets. Although there are several forms of what is referred to as the "market efficiency hypothesis," its basic premise is that all stock prices accurately reflect all historical and current information. This means that whenever you purchase a stock, you are getting the best price based on available information. If the stock you chose was truly undervalued, investors would have already been buying the stock and thus pushing the stock price up until it was considered accurately valued. The opposite occurs for overpriced stocks. In essence, the theory states that there are no $20 bills, or even $1 bills just lying around for you to pick up. When was the last time you found a $1 bill lying around? This is market efficiency at work.
In support of this theory, many studies have shown that picking stocks by throwing darts at the stock table is just as likely to earn you profits as listening to the "market experts." In fact, the Wall Street Journal publishes an ongoing feature that pits investment professionals’ stock picks against stocks picked at random by throwing darts at a stock quotations page. Read the following article "Stock Pros Easily Beat Darts; Margin Is Among the Widest " for an example. As might be expected, the market professionals win about half the time while dart throwers win the other half. One could conclude from this exercise that even the market professionals cannot find $20 bills lying around.
Furthermore, correctly determining whether the entire market is going to rise or fall is also not possible, according to market efficiency theory. Why not? Consider what might happen if everyone thought the market was going to decline over the next day or throughout the next month. In that case, investors would sell their stocks and push the market lower immediately until everyone thought that stocks were accurately priced. Conversely, if everyone thought the stock market was going to rise over the next day or month, investors would buy up stocks, pushing market prices higher immediately, until once again everyone thought stocks were accurately priced--or at least until half the investors thought prices were going up and the other half thought they were going down. Consider this simple truism: for every share of stock sold, someone must have bought it; and for every share of stock purchased, someone must have sold it. Prices fluctuate when there are no buyers and sellers at the current price quotes.
So why are there still those who believe they can pick undervalued stocks or time the market accurately? As you may have gleaned from the story at the beginning, someone must reach down to pick up the $20. Many people think they are the ones who see the $20 first, so to speak. Depending on how you view that possibility, you can be a proponent of market efficiency theory or a detractor of it. If you are a proponent, you will probably favor a "buy and hold" investment strategy--acquiring a diversified stock portfolio and holding it long enough to benefit from its growth in value over time, regardless of short-term price fluctuations. Detractors, on the other hand, believe they can identify individual stocks that are undervalued, or identify times when the market in general is under- or overvalued. Although most investors and professionals believe in market efficiency, the economic incentive for correctly timing the market can be gargantuan--making market timing a tempting proposition.
Consider the following. By using a simple buy and hold strategy, if you had invested $100 in a diversified portfolio or mutual fund in 1960, by December of 2000 it would have been worth $8,477--for an average annual return of 11.17 percent per year. However, if you could have had the foresight needed to pull your money out of the stock market during the months when it would lose value, and to put it back in when the market was set to rise, your $100 would now be worth $1,126,878--for an average annual return of 26.26 percent! Now you can see part of the reason why market timers still try to time the market. On the other hand, if you had missed only the top 10 percent of monthly returns--i.e., only four years worth of monthly returns out of 40 years over this time period--your $100 would be worth only $215--an average annual return of 1.9 percent. Now you see why the buy and hold proponents assert that more fortunes have been lost than gained by investors trying to correctly predict the market.
In the interactive activity below there are three graphs showing actual price movements for several different stocks over a multi-year period. Efficient markets theory states that one cannot look at charts and have any reliable insight as to what these stocks would do in the future. Examining charts to determine what a stock will do next is called "technical analysis." There are many theories on how to examine charts for predicting stock returns. Click on the following link for further details on chart pattern theories. Unfortunately, these theories have not proved to be reliable over time.
How well can you do? For each stock graphed in the interactive activity below, decide what you would like to do.
1. Suppose you are watching the news one evening and the reporter states that Microsoft had reported earnings better than expected earlier that day. If the stock market is indeed efficient, would it be possible to buy Microsoft stock the next day and profit from this new information?
[No. Although the price of Microsoft stock most likely did rise after the positive announcement, it is too late for you to profit from this information. As soon as new information is reported, investors react immediately. Unless you were one of the first investors to hear the information, you will be too late. Think of it this way: if someone tells you there is a $20 bill lying in an aisle at Wal-Mart, this does not mean that you can go grab it an hour later. Someone else is likely to have already picked it up.]
2. Suppose your next-door neighbor tells you that a new stock called XYZ issued shares on the New York Stock Exchange last week. He tells you most authoritatively that this stock is definitely going to skyrocket. Should you go out and buy this stock based on your neighbor's advice?
[No. There is no reason to think your neighbor is any more adept at picking winning stocks than you are. Keep in mind that even the professionals who analyze corporations for a living often cannot choose undervalued stocks with any more accuracy than you might attain by throwing darts at a stock page.]
3. Examining the information from question 2: Suppose you also know that your next-door neighbor is a high- ranking manager for XYZ and he tells you that--based on the latest sales figures for his company (which have not been released to financial news outlets yet)--buying this stock is a can't lose proposition. Assuming markets are efficient, could you profit from this information?
[In this case you probably could profit from your neighbor's advice since he has information the rest of the market does not have. However, it is illegal for him to trade on that information, and it is highly unethical and illegal for him to relay that information to you as well. This is what is referred to as insider trading. Company managers cannot buy or sell on any information that is deemed important before it is publicly announced. However, even with this rule, quite a bit of research does suggest that it's a good idea to buy when insiders buy and sell when insiders sell. This is not to suggest that anybody is trading on insider information, but it does suggest that insiders have a better idea of the fair value of their company's shares. Many sites detail the purchases and selling of shares by corporate insiders. See the following article on insider trading for more information.]
4. What factors can you think of that might explain why U.S. stock markets are more efficient (i.e., that prices reflect all available information) than stock markets in less developed countries?
[The U.S. stock market is likely to be more efficient than most financial markets for the following reasons:
a) More professional analysts following stocks.
b) Better information about the companies that are analyzed.
c) Better technology to analyze companies' information, better software, computational power, etc.
d) Faster dissemination of information via the Internet, television, etc.
e) Better regulatory authorities to make sure the information being disseminated by corporations is accurate, Enron notwithstanding.
f) Better markets in terms of being able to process orders, quote prices, etc.]
5. If markets are indeed efficient, why do all these investment managers, financial analysts, mutual fund managers, etc., get paid for trying to find undervalued stocks?
[Keep in mind that somebody has to do the research to keep stock prices accurate--i.e., somebody is always looking for $20 bills lying around. Even if these managers do manage to find "$20 bills lying around," after accounting for the time and effort it took to find them, they only earn enough to compensate them for their time and effort. Because all these analysts are constantly researching companies, we can be fairly confident, when buying or selling a stock, that we are getting the best price for it.]
1. Click on the following link for further details about the theory of market efficiency
2. Read the article "The Cocktail Party Fallacy " written by Eugene Fama who really focused attention on the concept of efficient markets back in 1970.