ECON 1102 Lecture 10: macro chapter 10

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University of Minnesota Twin Cities
ECON 1102
Phelan Christopher

Macro Chapter 10 Page 1 of 4 Stock Markets and Personal Finance I. Passive Vs. Active Investing A. Intro 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 rms, 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 stocksthese 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 Poors 500 (SP 500), a basket of 500 large rms broadly representative of the U.S. economy. II. Why is it Hard to Beat the Market? A. The difculty of beating the stock market is a tribute to the power of markets and the ability of market prices to reect 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 cant work very well. B. Since for every buyer there is a seller, you cant get rich by buying and selling on public information 1. Efcient markets hypothesis: the claim that the prices of traded assets reect all publicly available information a) The prices of traded assets, such as stocks and bonds, reect 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 difcult for ordinary investors (that probably means you, too!) to systematically outperform the market, again, unless a trader has inside informationinformation that no one else has. Its restating our point that you might as well throw darts at the stock pages as try to gure out which companies will beat the market. The efcient 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 dont 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 whole. III. How to Really Pick Stocks, Seriously A. Diversify 1. The rst secret to picking stocks is to pick lots of them! Since picking stocks doesnt work well, the secret to wise investing is to invest in a large basket of stocksto diversify. Diversication lowers the risk of your portfolio, how much your portfolio uctuates 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 nancial markets have made diversication easy. Mutual funds let you invest in hundreds of stocks with just one purchase. And since stock picking doesnt work
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