Stock Markets and Personal Finance
I. Passive Vs. Active Investing
1. Many people invest in the stock market through a mutual fund.
a) A mutual fund pools money from many customers and invests the money in
many ﬁrms, in return, of course, for a management fee.
(1) Some of these mutual funds, called “active funds,” are run by managers who
try to pick stocks—these mutual funds often charge higher than average fees.
(2) Other mutual funds are called “passive funds” because they simply attempt
to mimic a broad stock market index such as Standard and Poor’s 500 (S&P
500), a basket of 500 large ﬁrms broadly representative of the U.S. economy.
II. Why is it Hard to Beat the Market?
A. The difﬁculty of beating the stock market is a tribute to the power of markets and the
ability of market prices to reﬂect information.
1. For every buyer of a stock, there is a seller. The buyer thinks the price is going up,
the seller thinks the price is going down. There is a disagreement. On average, who
do you think is more likely to be correct, the buyer or the seller? Of course, the
answer is neither. But if on average buyers and sellers have about the same amount
of information, stock picking can’t work very well.
B. Since for every buyer there is a seller, you can’t get rich by buying and selling on public
1. Efﬁcient markets hypothesis: the claim that the prices of traded assets reﬂect all
publicly available information
a) “The prices of traded assets, such as stocks and bonds, reﬂect all publicly
available information. Unless an investor is trading on inside information, he or
she will not systematically outperform the market as a whole over time.”
(1) It just means it is difﬁcult for ordinary investors (that probably means you,
too!) to systematically outperform the market, again, unless a trader has
inside information—information that no one else has. It’s restating our point
that you might as well throw darts at the stock pages as try to ﬁgure out which
companies will beat the market. The efﬁcient markets hypothesis is just
another way of saying there is no such thing as a free lunch.
C. The only way you can take advantage of information that other people don’t have is to
start buying or selling large numbers of shares. But once you start the buying or selling,
the rest of the market knows something is up. That is why secrets do not last very long in
the stock market and that is another reason why it is so hard to beat the market as a
III. How to Really Pick Stocks, Seriously
1. The ﬁrst secret to picking stocks is to pick lots of them! Since picking stocks doesn’t
work well, the “secret” to wise investing is to invest in a large basket of stocks—to
diversify. Diversiﬁcation lowers the risk of your portfolio, how much your portfolio
ﬂuctuates in value over time.
a) By picking a lot of stocks, you limit your overall exposure to things going wrong in
any particular company
2. Modern ﬁnancial markets have made diversiﬁcation easy. Mutual funds let you invest
in hundreds of stocks with just one purchase. And since stock picking doesn’t work