Here's Your Chance to Make Millions in the Stock Market (Part 3)
This lesson printed from:
Posted November 8, 2002
Author: William Trainor
Posted: November 8, 2002
Updated: June 10, 2009
In Part III of this lesson, students will have the opportunity to complete an interactive exercise that will take them on a historical tour of the stock market from Post WWII through the year 2001. Students will learn the difference between a buy and hold vs market timing strategy as it relates to investing. Part III of this exercise is a continuation of Part II which took the student through the major market events from 1920 through WWII.
- Analyze 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 for investors.
- Explain the use of certain key statistics (P/E ratio, Dividend Yield, and Interest rates) for estimating stock values.
PART 3: A Jaunt through the History of Stocks, from the Post-War Years through 2001
Can You Be the Next Market Guru?
Part I of this three-part series of lessons explained the theory of efficient markets. Part II explained some of the key statistics that some investors use in making investment decisions. It then took you on through an interactive exercise in which you were given the option of investing in stocks or placing your money in the bank. The time period covered in that exercise went from 1920 thorough the end of World War II. Now you will be given another chance to make millions. If you are able to time the market correctly in this next exercise, you could end up with over $2 million dollars.
REVIEW OF KEY STATISTICS
These statistics were reviewed in more detail in Part II. Abbreviated definitions are given to refresh your memory.
1. Price/Earnings (P/E)ratio: This ratio describes how much one is paying for every dollar a company earns. All else equal, the lower the P/E ratio, the less expensive stock prices are.
2. Dividend Yield: The dividend yield is the dividend divided by the share price. 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. All else equal, 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 into stocks.
Are You Ready to Try to Make Millions (Again)?
This time you'll start with $1,000, and your goal will be to see how much money you can make by saving or investing in the stock market.
As in Part II, the preceding five-year average will be given for the P/E ratio and the dividend yield. This will give you a historical context in which to judge these two statistics and make at least an educated guess as to whether the statistics are relatively high or low.
COUNTING OUR MONEY
In Part I of this exercise, the concept of market efficiency was explained. You then had a chance to see if you could predict which way prices were going for individual stocks based on historical charts. Choosing stocks in this way is called technical analysis, and it is generally considered to be unreliable at best. How well did you do?
In Parts II and III you could choose when to invest in stocks and when to place your money in the bank. It is likely that you missed a few predictions--maybe more than a few--and your predictions here were based on records from the past. Predicting the future is even more difficult.
If you did manage to guess right more often than not, try the following exercise. Each evening, write down a prediction telling whether the Dow Jones Industrial Average is going to increase or decrease the next day. (The Dow Jones Industrial Average is an index of 30 stocks which gives an indication of how the overall stock market performed. Information on this index will be given on the front page of any business section in any newspaper.) Given my confidence in market efficiency, I am willing to predict that you will guess correctly no more than 7 out of the 10 days. A few of you may be able to guess correctly more often than that, but in these cases the good guessers might simply be lucky.
The market efficiency theory does not mean that investing in the stock market is futile It does mean that outperforming the stock market is extremely difficult. Market efficiency is an economic good. It is extremely beneficial to investors, businesses, and to our economic growth. Businesses are assured of raising capital for building plants, expanding output, hiring workers, etc., at minimal cost. Stock investors are assured of a fair stock price and return on their investments. And economic growth is enhanced as capital flows freely from those who have excess capital to those who need it most.
Finally, I hope you have seen that although timing the stock market correctly is difficult, making money is not. If the historical returns in the stock market are any indicator of future returns, investing in the stock market over the long haul will eventually earn you your millions.
Have students answer the following questions:
1. If a company reported $2 in earnings last year and its’ PE ratio is 15, what is its stock price?
[PE = Price/earnings, thus Price = PE * earnings or $2 * 15 = $30.]
2 . Assume the average PE ratio for the stock market is 28 and dividend yields are less than 2%. In the recent past, the PE ratio has averaged around 18 and the dividend yield was 4%. The Federal Reserve begins to raise interest rates. Based on these facts, do you think stock prices will rise, stay the same or fall? Why?
[This was actually the situation in 2000. Stock prices were valued at very high levels relative to historical averages and when interest rates began to rise, stocks began to tumble. The bursting of the technology bubble led fuel to the fire but fundamental analysis based on PE ratios, dividend yields, and interest rates should did portend some decline in the future. Unfortunately, most people ignored these factors and thought earnings and PE ratios would continue to rise. When reported earnings begin to not meet expectations, stock prices began to fall.]
3 . Recently, the validity of many financial numbers used to value stocks has come under question. Companies such as Enron which fraudently inflated earnings cost investors billions of dollars. Steven Pearlstein wrote an article in the June 28th edition of the Washington Post "In Blossoming Scandal, Culprits Are Countless" that describes the path that may have led to the increasing fraud that seems to permeate some companies. If investors increasingly distrust the numbers that corporations report, what do you think will happen to stock prices? Explain.
[The effects of investors fearing widespread fraud within the corporate world was evident during the middle of 2002 . Whether the misreporting of numbers is widespread or not, just the fact investors think it is widespread will lead to falling stock prices. This occurs because investors will move their money out of stocks and into financial instruments they consider safe such as Treasury bonds. This has indeed already occurred as reflected in rising bond prices and falling stock prices. If the confidence in the market cannot be restored, stock prices will continue to fall. Efficient markets are based on the premise that everyone has all available information. When this information becomes suspect, efficient markets are undermined.]
1. Not yet satisfied with picking stocks based on the past. See how well you can do in the future by playing one of the many stock market games run on the Internet. A good place to start by trying The Stock Market Game . This is an excellent Web site to learn the fundamentals of trading stocks. Participants start out with 100,000 virtual dollars in a cash account. Game players can take the Stock Market Basics course offered and learn the techniques to research companies in order to decide which stocks to buy or sell. Sign up for the game more than once with different login names and trade different stocks in each account to test various investing strategies. Each day, the site generates a list of the players' rankings so you can see who builds the stock portfolio with the greatest value. There is also National SMS . SMS stands for Stock Market Simulation. The word simulation means that the SMS is more than just a game. It is a tool that teachers can use to help instruct their students in the world of economics, finance, current events, math, social studies, and technology.