Here's Your Chance to Make Millions in the Stock Market (Part 2)

STUDENT'S VERSION

This lesson printed from:
http://www.econedlink.org/lessons/index.php?lid=865&type=student

INTRODUCTION

Part 1

Part 2

Part 3

PART 2 - An Historical Stock Jaunt: 1920's through WWII

 CAN YOU BE THE NEXT MARKET GURU?

In Part I of this three-lesson series, the theory of efficient markets was explained. The premise of this theory is that all asset prices reflect their true value based on all currently available information. If an asset or share of stock was truly undervalued, investors would step in, buy shares, and bid up the stock price until it was accurately valued. The converse is also true: if an asset was overvalued, investors would sell the asset and, in the process, force the price down until it also was accurately priced. In summary, you should have learned that there are no easy "twenty dollar bills" just lying around waiting for you to come by and pick them up.

The following lesson may give you an idea of how difficult it is to time the stock market. You will be given the chance to make decisions about investing in stocks at various times over the last 80 years. Even if you know some history of the U.S. stock market, you will likely still find it difficult to choose correctly every time.

TASK

In this lesson you willanalyze stock market returns within a historical context, explain the difference between a "buy and hold" versus a "market timing" strategy, explain why long-term investment horizons are important to investors, and explain how certain key statistics (P/E ratio, Dividend Yield, and Interest rates) are used in estimating stock values.

PROCESS

REVIEW OF KEY STATISTICS

Professional investment managers have a variety of statistics they examine in an effort to estimate the relative value of the stock market. To help you with your decision-making process, the main ones they use will be given during your trek through time. Read the following summaries of three key statistics to give you an idea of what information they contain. Keep in mind however, if markets are truly efficient, these ratios may be of little help. Perhaps you will find the relationship that others have not.

1. Price/Earnings (P/E) ratio: This ratio describes how much one is paying for every dollar a company earns. For example, if a company's stock price is $15 per share, and it earned $1 per share over the preceding year, its P/E ratio would be 15. To give you some historical perspective, the average P/E ratio over the last 80 years has been 15.7. As of 4/15/2002 the average P/E for the largest 500 stocks was 25. All else equal, the lower the P/E ratio, the less expensive stock prices are.

2. Dividend Yield: Many stocks pay dividends. Dividends are payments to shareholders from the company's earnings. The dividend yield is the dividend divided by the share price. As an example, suppose you buy stock at $10 a share and the company pays $1 per share in dividends. In this case, the dividend yield would be $1/$10 = 10 percent. For historical perspective, consider that the average dividend yield over the last 80 years has been 4.39 percent. At the end of the year 2001, it was 1.5 percent . All else equal, the higher the dividend yield, the more attractive stocks are.

3. Interest Rate: The one-year interest rate tells you how much you can expect to earn on bonds over the next year. Bonds are fixed-income instruments that guarantee a fixed return. Think of them as savings bonds that you may have. The higher the interest rate, the more bonds pay and the less attractive stocks will be. Thus, as interest rates rise, stock prices generally fall as investors move money out of stocks and into bonds. Conversely, as interest rates decline, investors move wealth from bonds and into stocks.

For the P/E ratio and dividend yield, the preceding five-year average will be given. This will give you a historical context in which to judge these two statistics so that you can at least make an educated guess as to whether the statistics are relatively high or low.

The question you have to answer is whether the statistical value will revert back to its average or keep on trending in one particular direction. For example, if the P/E ratio is above its five-year average, common wisdom would suggest stock prices are relatively high. This may portend that stock prices will soon fall. On the other hand, if P/E ratios have moved above their average, this may suggest P/E ratios are trending upwards and thus stock prices will rise. If all this sounds somewhat contradictory and confusing, it is. Forecasting stock prices is often considered more of an art than a science.

Are You Ready to Try to Make Your Millions?
In the following activity, you'll start with $100 and attempt to accumulate as much wealth as you can by either investing your money in the stock market or setting it aside safely in the bank. When investing in the stock market, your money will be spread among all the stocks in the market rather than placed in any single stock. This is much like investing in a diversified mutual fund. For those who aren't sure what a diversified mutual fund is, it is simply a fund that pools money from many different investors and invests in a basket of stocks. A single individual often does not have enough money to do this on his or her own. Now click below and begin your quest for guru status.

Interactive Activity

Part 1

Part 2

Part 3