Unit III

Question 1

How long would it take for the stock price to change?

Answer 1

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

Question 2

Efficient Market Hypothesis (EMH)

Answer 2

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

Question 3

The market ISN’T always right

Answer 3

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!

Question 4

“Beating the Market”

Answer 4

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

Question 5

What 3 factors help people “beat” the market?

Answer 5

• 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

Question 6

What are the 4 factors to consider when it comes to stock picking?

Answer 6

1. Diversify
2. Compound Return Builds Wealth
3. Avoid High Fees
4. No Return Without Risk

Question 7

Diversify

Answer 7

(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

Question 8

When diversifying, what do you need to avoid?

Answer 8

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)

Question 9

𓊝 Grain Ships & Stocks

Answer 9

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

Question 10

Compound Return Builds Wealth

Answer 10

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.

Question 11

Buy & Hold Strategy

Answer 11

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

Question 12

Avoid High Fees

Answer 12

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!

Question 13

Index Funds

Answer 13

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

Question 14

International Index Funds

Answer 14

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

Question 15

Stock Split

Answer 15

Stock gets value, price is high, company doubles the shares that are out there

Question 16

No Return Without Risk

Answer 16

There’s profit opportunities that are sure things are quickly brought up, reducing the return.

Question 17

Risk-Return Trade-Off

Answer 17

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.

Question 18

Investment & Age

Answer 18

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

Question 19

Conventional IRA (Individual Retirement Account)

Answer 19

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

Question 20

Roth IRA

Answer 20

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

Question 21

What are the 2 major theories that may prove why college graduates make more money?

Answer 21

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

Question 22

Human Capital Theory

Answer 22

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

Question 23

Human capital are the “tools of the mind”

Answer 23

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)

Question 24

The human capital theory suggests that your MAJOR MATTERS

Answer 24

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!

Question 25

What does college “signal” about you that employees like?

Answer 25

*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

Question 26

Signaling Theory

Answer 26

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

Question 27

If you have referenced a PAST leadership position you held during an interview, is that a signal?

Answer 27

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.

Question 28

When does signaling work? (2 things should hold)

Answer 28

When:
1) HARD to send the signal if you LACK the trait
2) EASY to send the signal when you HAVE the trait

Question 29

Signaling Theory of Education

Answer 29

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

Question 30

Signaling & Philosophy/Graphic Design Major Paradox

Answer 30

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)

Question 31

Signaling solves why your major matters

Answer 31

Some majors are harder to learn than others (e.g. philosophy)

Question 32

Signals are RELATIVE

Answer 32

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

Question 33

Applications of Signals in Life

Answer 33

*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

Question 34

Arms Race in Human Capital Theory vs. Arms Race in Signaling Theory

Question 35

Aggregate-Demand-Aggregate-Supply Model (AD-AS)

Answer 35

A model that illustrates national income determination & changes in the price level

Question 36

What does the Aggregate Model look like?

Answer 36

(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

Question 37

Aggregate Demand (AD)

Answer 37

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

Question 38

Why does AD slope downwards?

Answer 38

The interest rate effect

Question 39

Interest Rate Effect

Answer 39

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

Question 40

Interest Rate

Answer 40

The price of borrowing money

Question 41

Mv = PL YR

Answer 41

*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