Unit III Flashcards
How long would it take for the stock price to change?
It depends on the nature of the information, but typically, we find it to be a FEW SECONDS…
Take Turkey for example, which is home to a less developed stock market, but it’s estimated that it’ll be 4 seconds before the stock price goes up
Note: There may be people who already caught wind of the stock + There are computers that automatically purchase the stock
Efficient Market Hypothesis (EMH)
The price of any tradeable asset REFLECTS all publicly available information
- The Best Guess of Tomorrow is Today’s Price: Near-future changes in the market are nearly impossible to predict; in stocks, no price is obviously too high or too low. CURRENT price is the best estimation
- INCENTIVES MATTER: People act accordingly to data & information
- If the stock was high, it’d be likely to be sold tomorrow, so people will start SELLING IT NOW…the price would then go down
- If the stock price was too low, they’ll BUY IT NOW
The market ISN’T always right
The EMH doesn’t signify that the market is always right. It’s just that when it’s wrong, there’s NO public information to suggest it’s wrong!
“Beating the Market”
When you get a HIGHER THAN AVERAGE rate of return
(aka, you perform better than the overall market)
- Example: If 5% was the average made on the market, it’s difficult to reach 6% or higher
What 3 factors help people “beat” the market?
- LUCK
So many people gamble. It’s inevitable that, by chance, you’ll get a few people that have won many, many times over. - INSIDE TRADING
Trading before publicly-known information is released
Note: This is illegal because the information is not yet public, meaning the EMH can’t be applied
*PSYCHOLOGY
People succumb to panic, overconfidence, groupthink, bubbles, etc.
Example: If people are part of a group where others are also buying a company or take large buying risks, it’ll be easier to talk through mistakes when they arise
What are the 4 factors to consider when it comes to stock picking?
- Diversify
- Compound Return Builds Wealth
- Avoid High Fees
- No Return Without Risk
Diversify
(aka) “Hedging your Bet” - Buy lots of different kinds of stocks/invest in different places/assets
Tip: Diversify with both assets that are SAFE and assets that are HIGH-RISK
When diversifying, what do you need to avoid?
Correlated Risk: One kind of risk affects multiple assets
These are your bundles of investments that all have the same kind of risk.
*Example: You want to invest in Amazon, Twitter, Meta, Apple, & Alphabet. They seem diverse as they cover different sectors (consumer electronics, e-commerce/cloud, computing, social media).
In actuality, it’s not a diverse portfolio. Even if they’re in different industries, they’re ALL technology stocks. Thus, they’re at risk to new regulations that would disproportionally affect the tech sector or disturbances in the supply chain for semi-conductors.
(Consider a risk that would affect all investments - a computer bug, power outages, privacy/regulation, computer chip manufacturing…you’d expose yourself to these possibilities)
𓊝 Grain Ships & Stocks
Stocks are like grain ships.
If grain ships leave at the SAME time and get hit by a storm, all the assets they’re carrying will sink.
That’s why you:
1) Spread the ships out so they depart from different areas &
2) Vary what they’re made of
Compound Return Builds Wealth
Recall back to: The Rule of 70
70 divided by growth rate of return = estimation of the number of periods it takes to double
*Example: You invest 1,000 in 2024. Doing the Over the course of 10 years, you’ll have 2,000, twice as much and even more when you continue investing in the long run.
*A 4% annual rate of return means you will earn interest on the interest you earned in previous years. $100 becomes $104, then $108.16, then $112.49, then $116.99, etc. At 4% rate of return, you will double your money in 17.5 periods. Without compound interest, it would take 25 periods.
Buy & Hold Strategy
Buying & holding stocks for the long run, regardless of what their short-run fluctuations are
aka. Invest money, put it in the market, then don’t do anything with it; you’re in it for the long run
(even if the stock market takes a hit, still don’t sell it!)
*The buy & hold strategy is also supported by the idea of compound return building wealth & the rule of 70
Avoid High Fees
Picking stocks is a “fool’s game” - it’s hard.
1) It’s not worth the high fees charged
2) There’s no reason to pay a lot of people to do it
The best option then left? Use an index fund!
Index Funds
A collection of different stocks designed to follow a financial index (e.g. the S&P 500)
*Are very cheap, because they’re just following the market
*Follow the whole market and are a compilation of it, so it’s already quite diversified
International Index Funds
Most index funds follow U.S. stocks…
If you purchase an index fund, it’s only US stocks so, to DIVERSIFY it away from the U.S., consider an international index fund!
Or, instead, make 2/3 of your investments in US funds and the rest in a national fund, maybe even throw in some bonds
Stock Split
Stock gets value, price is high, company doubles the shares that are out there
No Return Without Risk
There’s profit opportunities that are sure things are quickly brought up, reducing the return.
Risk-Return Trade-Off
HIGHER returns come at the price of a HIGHER risk
*Differences in risk are offset by differences in return; very risky assets don’t get paid much
- RISKY: Junk Bond - Company won’t pay for money, may file for bankruptcy, won’t get your money back
*Example: A deal on a 100% return (doubled) in a year sounds too good to be true. Notice if no one else is investing + competition should be bringing the return down.
- SAFER: U.S. Government Bond - The most SAFEST asset to get because the government doesn’t get defaulted on loans. It’s why they get a terrible rate of return, but your money can be parked and not lost. LOW RISK & LOW RATE OF RETURN.
Investment & Age
Investment portfolios should differ with age
Young: Mostly stocks (equity)
Adult & Older: Shift more to bonds to have a reliable asset that holds its value
Conventional IRA (Individual Retirement Account)
Contributed with pre-tax money, best for those in the higher tax income
Deposits: You REDUCE YOUR TAXABLE INCOME FOR THE YEAR BY THAT AMOUNT
Withdrawals: That money taken out goes back to you as TAXABLE INCOME (with a cap on it)
aka. Get a tax deduction NOW, but pay income tax LATER in retirement
*Has penalty for early withdrawals if not aged at least 59 1/2
Roth IRA
Contributed with after-tax dollars; best for young investors who earn relatively little (lower tax bracket)
Deposits: Get no tax saving by inserting money
Withdrawals: Pay NO TAXES AT ALL, no matter how much the IRA has grown
aka. Get no tax deduction NOW, but owe no income tax LATER in retirement
What are the 2 major theories that may prove why college graduates make more money?
There’s ample evidence that having a college degree not only INCREASES your average salary, but also DECREASES the chance of long-term unemployment - you make more money and are likely to be employed!
Earning a college degree increases your attractiveness to employers through the 2 theories: HUMAN CAPITAL THEORY & SIGNALING THEORY
Human Capital Theory
Focuses on the stuff in people’s heads that makes them more productive
In college, you learn things that are practical in the real world. Armed with knowledge (and with the proof that you’ve learned it, i.e., a degree), more people want to hire you
It’s not merely learning the field, it’s about how learning about the field that gives you valuable skills that help you become more productive
Human capital are the “tools of the mind”
This includes reasoning, writing, technical, time management skills, experience, and intelligence.
Other examples:
* Meeting deadlines
* Independent work (you can manage yourself & learn things on your own)
* Excel (being familiar with the program)
* Groupwork
* Communication skills (academic writing)
* Critical thinking (researching)
* Comfortable with doing something momentarily uncomfortable (thinking on your feet)
The human capital theory suggests that your MAJOR MATTERS
How much money you make in the future should be influenced by your major
*It’s important to remember that the differences of salaries of bachelor degrees, for example, represent that compensating differentials play a part!
What does college “signal” about you that employees like?
*Dedication/attention to detail - it takes inherent focus & perseverance to get through 4 years of college
*Intelligence - signaling creates a sorting mechanism; if you’re smart, college is relatively manageable; if not, it’s difficult
*Willingness to conform + Dedication - have to be willing to be a team player, a personality that aligns with the expectations & job itself; demonstrate that you can mold to different rules
- Shows how people are willing to conform by doing the conventional thing; not working towards your major and being that job is not conforming
Signaling Theory
Signals represent an action or some observable trait used to show you have an unobservable trait
*Talk is CHEAP: Everyone can say they’re smart, so they have to SHOW they’re smart
There’s a distinction between the ACTION & LETTING PEOPLE KNOW THAT YOU DID IT
- Action & letting people know that you did it; is about fostering achievements vs.
- Selling yourself
If you have referenced a PAST leadership position you held during an interview, is that a signal?
In the interview, you are talking about the position, but you’re not actually it (anymore). But it IS a signal!
*If you’re lying about the position? That’s why the interviewer will ask you follow-up questions. If you’re nervous, inconsistent, or vague, they’ll assume you’re exaggerating your role.
They can also contact your references. If the claim is verifiable, it’s a signal. It’s less likely to be cheap talk.
When does signaling work? (2 things should hold)
When:
1) HARD to send the signal if you LACK the trait
2) EASY to send the signal when you HAVE the trait
Signaling Theory of Education
Argues that education signals competence, intelligence, diligence, and other traits employers find valuable
*If you’re smart and hard-working, getting a college degree is EASY
*If you’re stupid, lazy, sloppy, and not dedicated, hate being told what to do, not as intelligent, getting a college degree is HARD
Signaling & Philosophy/Graphic Design Major Paradox
Signaling solves this paradox:
*Philosophy requires a LOT of reading, thinking, & logic skills. It’s hard for most people.
Thus, it’s impractical but hard for everyone. The natural talent for philosophy is intelligence
*Graphic design is also difficult to learn, but not nearly as hard as philosophy. Some people have an intuitive grasp of it, some do it for fun.
Graphic design is useful, but much easier (especially for those with an inborn talent for it)
Signaling solves why your major matters
Some majors are harder to learn than others (e.g. philosophy)
Signals are RELATIVE
Value derives from standing out (depends on how common it is)
*You can get a degree to help demonstrate your skills. A degree used to be something special, but now more people get it. To stand out, people get a HIGHER degree
Applications of Signals in Life
*Peafowl: Peacocks have big feathers to attract peahens → The tail is a signal of a strong mate for peahens
*Interviews: Dressing nicely and being organized → You’re serious about the position, can act in a professional manner, have valuable skills like attention to detail
*Dating: Looking good & being funny → You take the date seriously, are genuinely interested, are worth being around
*Credit Score: Paying off your debt quickly & maintaining a low balance on your credit card → You are fiscally responsible and are worthy of a low interest rate if you need a loan
Arms Race in Human Capital Theory vs. Arms Race in Signaling Theory
Aggregate-Demand-Aggregate-Supply Model (AD-AS)
A model that illustrates national income determination & changes in the price level
What does the Aggregate Model look like?
(on the y-axis) Price Level: represents ALL prices
(on the x-axis) Real GDP: represents ALL quantities; the TOTAL OUTPUT OF THE ENTIRE ECONOMY
Aggregate Demand (AD)
Demand across the whole economy, not just a single sector
*Assumes ceteris paribus (the assumption that nothing else changes in a given situation)
Price level INCREASES, all other things being EQUAL, real output FALLS
Why does AD slope downwards?
The interest rate effect
Interest Rate Effect
As the price level goes UP, people want more money; they BORROW MORE…
but the amount of money in the system is the SAME (ceteris paribus)
*The demand for loanable funds goes up, because everything costs MORE
*If more people are borrowing money (but there is the same amount of money to borrow), the INTEREST RATE RISES
*HIGHER interest rates cut investment and consumption, REAL GDP FALLS
Interest Rate
The price of borrowing money
Mv = PL YR
*If price level (PL) INCREASES and money supply + velocity (Mv) REMAINS THE SAME, REAL GDP MUST FALL
*If the price level goes UP, the quantity goes UP because we keep the amount of money fixed
