Economics for Life Real World Financial Literacy Chapter 13 Investing Fundamentals

13 . Investing Fundamentals The Nature of Investing Generally speaking , an investment is something you put time or money into and get a return from . For example , we talk about investing in a personal relationship . We also talk about investing in the stock market . For this chapter , we will use the financial definition of investing a financial asset you contribute money to and from which you receive an interest payment , a dividend , or an increase in the market value over time ( or all three ) You use money from your savings to invest Income ( paycheck ) Taxes Disposable Income ( take home pay ) With your Disposable Income , you can either spend it or save it Disposable Income Consumption Savings Unless you hide your cash in the ground , you will take your savings and invest it somewhere you will get a return . 205

Savings Investment Keeping these equations in mind , it is hopefully apparent that the more disposable income you save , the more you are able to invest . But where to invest ?

Risk and Reward On Wall Street , the standard saying is risk follows returns . By choosing a lower risk investment ( such as US . Treasury Bonds ) you will receive a lower return . Treasury Bonds are considered the safest investment possible because the has always paid those bonds back ( except for debts from the Revolutionary and Civil Wars , but that another story ) Almost all interest rates are influenced by the rate on the Treasury Bonds , which are considered a return . In terms of risk , the three traditional investment instruments are stocks , bonds , and cash . We can analyze each in terms of risks and rewards . On Wall Street , risk is measured by beta ( the Greek letter ( which measures the volatility or deviation from the average historical return of an investment . Stock prices are negatively correlated with . Below , you can see a chart showing the prices and volatility of the general stock market . The grey bars are , so it is easy to see their impact on the stock market . The 500 is a general index of the overall stock market . It was created and is maintained by the financial company Standard and Doors , which is a major credit rating company . The index consists of the prices of 500 stocks out of the public companies listed on American stock exchanges , and the composition of these 500 selected companies reflects the composition of the entire market . 206 i

500 4000 3500 3000 2500 2000 1500 1000 500 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Figure . 500 Daily Closes and by Fred Rowland is used under a License . Source Yahoo Finance data ( Adding bonds tends to lower both risk and potential return . The following chart shows the maximum gains and losses on various portfolios consisting of all stocks ( on the left ) through a series of mixed stocks and bonds to a portfolio consisting of all bonds ( on the right ) As you can see the maximum gains and losses are greatest with an all stock portfolio .

Best Annual Gain and Worst Annual Loss Portfolio Mix ( Bonds ) 60005 . I I I I ac I mum moor Annual Gain Annual Loss Figure . Best Annual Gain and Worst Annual Lost by Fred is used under a License . Source Vanguard data . Finally , some investment advisors suggest you should hold up to 10 cash in your portfolio , either for emergencies or to take advantage of bargains that may arise in the market . This should not be kept in a checking account but in a money market fund . The current annual return on money market funds is ( Vanguard Prime Money Market Fund ) How Return on Investment is Calculated Inflation can have a large impact on your investment , so it is important to understand how that works . Let say you have cash and save it by hiding it in your mattress . Your money gets less valuable every day by exactly the rate of inflation because money is something we need to buy goods and services . If 208

you hide your savings in a mattress and the rate of inflation is , your money is depreciating in value by per year . The same thing happens to money you keep in a checking account that pays no interest . Your money is depreciating at a rate of per year . Even further , the money you receive as a dividend or interest on your investment is also depreciating at the annual rate of inflation . The real quest , then , is to find an investment that gives a return greater than the rate of inflation . In order to be able to compare the return on all sorts investments , like buying stocks or buying a Picasso , we use the same measure to calculate returns . The return on an investment comes from two areas dividends or interest paid and the price appreciation . For example , you may put your savings in stocks and get a dividend of per year plus the stock price may have increased by over the course of a year . Thus , your total return for that year would be 10 . Alternatively , those investors who buy gold or a Picasso do not get any interest or dividends but receive returns from the price appreciation of their asset over time . If you bought gold today at per ounce and after a year its price was per ounce , your annual return would be , The general calculation of a return on investment ( ROI ) is the appreciation in the price ( value ) of the investment ( asset ) over a year plus any dividends or interest earned during that year , compared to the original cost of the investment ( asset ) The calculation is thus Price end of year Price beginning of year Price beginning of year 209

This calculation will yield a decimal which is then expressed as a percent annual return . The general formula is expressed as a bacl calculation ROI ( ROI Now , here an example . Let say you purchase 100 shares of Apple stock at per share . At the end of one year , it is now selling on the stock market for per share . In addition , you receive a dividend of from Apple during the year . Your return could be expressed like this ( ROI or 40 ROI If your investment is held for multiple years , you would use the total price appreciation of the asset plus add up all the dividends and calculate your total return . You would then divide the total return by the number of years you held 210

the asset to get the average annual return . This annual return allows investors to compare the annual returns for all sorts of investments that are dissimilar , such as paintings , antique automobiles , collectibles , and stocks and bonds . However , there is one more complication to consider taxes on your profits from investments . The profits you make from the price appreciation ofan asset is called a capital gain , and it is taxed when you sell the asset to realize the gain . Taxation of the capital gain is different if you own the asset for less than one year ( a capital gain ) or own it for more than one year ( a capital gain ) A capital gain isjust added to your regular income on your tax return and taxed at your regular income tax rate . On the other hand , if you sell the asset after owning it for more than one year , you will be taxed at the capital gains rate . If your total taxable income is or below , a single person will pay capital gains tax . income is to , they will pay a 15 capital gains tax . Above that level , the to 20 . The tax rates ( or brackets ) are somewhat different for married people . Tax laws give an incentive to hold investments over one year . Historical Returns on Various Investments Vanguard Mutual Funds , a , has created historical returns of various portfolios that are made up mixes and bonds going all the way back to 1926 . Below are the returns of those different allocations . Income An investor seeks current income with minimal risk to principal and is comfortable with only modest growth of principal . They have a investment time horizon .

Av Annual Return 1926 to 2018 , Web . 96 66 13 , as , A , A 99 08 . ca . A ?

Figure . Return 7926 to 2018 by Fred Rowland is used under License . Balanced A investor seeks to reduce potential volatility by including investments in their portfolio and accepting moderate growth of principal and is willing to tolerate price fluctuations . They have a to investment time horizon . 40 stocks 60 bonds 212

Growth A investor seeks to maximize the potential for growth of principal and is willing to tolerate potentially large price . They have a investment time horizon . Generating current income is not a primary goal . 80 stocks 20 bonds We can actually trace the historical returns on stocks and bonds going all the way back to 1870 . The historical returns do not , of course , guarantee that the same returns will happen in the future , but most ofthe stock market investors are wise , and wise investors demand certain minimum returns in order to take the risk on investments . In their 2019 study of investment returns , The Rate of Return on Everything Oscar , Knoll , Dmitry , and Alan Taylor calculated returns on stocks , bonds , and housing in 16 developed nations going all the way back to 1870 . As Thomas notes in his book Capital in the Century , housing is important in all developed nations , since it represents approximately of the wealth in a typical economy ( 2021 ) Here is a graph ofthe real rates of return in the world 213

Rates of Return on Assets I I I I Since 1870 Since 1950 I Figure . Rate of Returns on Assets . Source data ( 2079 ) The Portfolio Theory of Investing Asset allocation is spreading out your investment in various financial assets to maximize your profit while minimizing your risk . However , as I stated before , in order to achieve a higher return , you must take a higher risk . A low risk portfolio would be invested in all bonds , and from to 2018 achieved an average annual return of with low volatility . A moderately high risk portfolio would be invested in all stocks , and from to 2018 achieved an average annual return of . with much higher volatility . Professional stock pickers are merely making educated guesses as to which stocks will appreciate the most over the next year . This is because no one can accurately predict the future . Wall Street is myopic in their focus on returns . In contrast , Warren Buffet , Chair of , has always focused on profits . Even with all their computer models and data dumps , not a single active 214

stock picker has consistently beaten the overall rise or fall of the market , as measured by the stock market indexes of the Dow Jones Industrial Average , the 500 , or the . Therefore , the only way to achieve consistent average returns is to invest in a broadly diversified portfolio of investments . As mentioned before , a portfolio stocks has achieved a average return over the years from 1926 to 2018 . As a small investor , you will not have enough money to diversify by buying stocks yourself . Experts say you should have a minimum of 20 diverse stocks in a portfolio . Instead , you should invest in a mutual fund that contains all 500 stocks . Almost every mutual fund company has a fund that is exactly that . Currently , you do not need to invest in bonds due to their lower returns . However , when you get within five years of retirement , you will need to rethink that strategy . Finally , in your portfolio allocation , you do not need to invest in a global stock portfolio . This strategy was popular over fifteen years ago because when the was in a recession , Europe was not in a recession . This is no longer true . Globalization has connected world economies , and now European and . Economies are . Another reason you do not need to invest in a global stock portfolio is that a portfolio of European stocks have consistently the 500 by about annually . Europe does not have the tech stocks like Apple or Google that are included in an 500 mutual fund . In any case , most of the largest European companies like Nestle , or Mercedes are also listed on the stock exchanges . Investing in Money Markets Money market mutual funds are alternatives to savings accounts or certificates of deposit in banks or credit unions . Their annual returns are higher than bank and credit union savings accounts , but your funds do not have the government guarantee ofthe or . Money market mutual funds invest your money in bonds , and these returns fluctuate with the market . Vanguard Mutual Funds reports that the average annual return on its money market fund was . Unless you want to money and not really invest it , you do not need to put your investment dollars in a money market fund . 215

Investing in Bonds You can find quotes on bond yields and prices in The Wall Street Journal or on Market Data Center . A bond is basically an . or promissory note . A government or a company issues bonds in order to borrow money directly from investors . This is cheaper than borrowing from a bank because the bank adds overhead and profit to its loans . A bond is a promise to pay interest to the investor every year and then to pay back the investor at the end of a specified time period . A bond time period is also known as its length , term , or maturity . For example , the US . Government issues Treasury Bonds in order to finance the ongoing annual deficit . Currently , a newly issued Treasury Bond would likely have the following characteristics Face Value Amount or Par Coupon or Yield Maturity or Term 10 years This means that the owner ofthe bond will receive interest payments every year of until maturity and will receive the back at the end of the ten years . The interest payment is calculated as 0007 . The current 07 yield of the Treasury Bond is extremely low and was manipulated by the Federal Reserve Bank in the last two . The Fed purchased trillions of dollars worth of Treasury Bonds and , due to supply and demand , brought down interest rates . Even though the investor may have purchased the Treasury Bond when it was first issued , they do not have to hold the bond for the next ten years . They can sell the bond in the secondary market . On average last year , 600 billions worth of Treasury Bonds were bought and sold every day in secondary bond markets . The US . government is constantly issuing new Treasury Bonds to finance the fiscal deficit and to refinance existing Treasury Bonds as they mature and must be repaid . The total amount of outstanding US . Treasury Bonds is the National Debt and is currently about 18 trillion . According to the Institute , as , 2020 ofthe 18 trillion outstanding Treasury Bonds trillion were held by US . households , companies , and governments 216

trillion by asset managers trillion by the Federal Reserve trillion by banks and insurance companies Nearly trillion ( 40 ) were held overseas , mostly by foreign central banks When bonds are sold in the secondary market , the price at which the investor buys them may not be the Face Value of Par ( typically ) That is because the price adjusts to reflect the current interest rates in the marketplace . For example , in the table below , you see that although the coupon remains constant at the same annual payment as when the bond was first issued , the marketplace bids up or down the price to achieve the desired yield Table . Bond Prices and Yields Fixed Dollar Amount Example Bond Price Coupon Yield year 900 900 i , year i , You may have read in The Wall Street Journal that bond prices and bond yields move in opposite directions . This is because the coupon is fixed at the issuance date ofthe bond and when the price goes up , the yield goes down and vice versa . The above example used a fixed dollar amount for the interest paid annually on the bond . However , the coupon is an actual interest rate that will be paid annually , and the yield fluctuates the same way as in the table above Table . Bond Prices and Yields Coupon Example Bond Price Coupon Yield 10 ( year ) 900 10 ( 900 i , 10 ( year )

The US . Treasury issues Treasury Bonds of many different for their different borrowing needs ( tax anticipation , long term deficits , The daily yields of these treasuries are depicted in a yield curve . The yield curve is published every day in The Wall Street Journal . Treasury Bonds Yield Curve 02 , mo . Figure . US . Treasury Bonds Yield Curve . Source US . Department ofthe Treasury data . The graph above shows that the historical yields US . Treasury Bonds have been significantly higher in the past . Because inflation is a component of nominal interest rates , we can use the Treasury to see how the market anticipates the rate of inflation in the future . In 1997 , The Treasury Department began to issue what are called Treasuries with Inflation Protection ( TIP ) in response to investor demand . In addition to the coupon yield , the Treasury protects the TIP owners by increasing the principle of the bond after the end of the year , based on inflation . The Consumer Price Index is used as a gauge for inflation , thus guaranteeing that 218 i

the purchasing power of the original investment will not decrease . Nominal interest rates on regular Treasuries have both a of money component ( the real interest rate ) and an inflation component . lO year contain only the real interest rate . Therefore , using the difference between the yield on the regular lO year Treasury Bond and the TIP , we can accurately gauge expected inflation . Below , I have added a graph showing the two different yields . For current quotes , visit The US . Department of the Treasury . my i , a ' i ' am zone was am am ams Shaded Areas indicate Source Board at Governors of me Reserve System ) Fred Figure . Board of Governors of the Federal Reserve System ( US ) Treasury Constant Rate and Constant Maturity retrieved from FRED , Federal Reserve Bank Louis October , 2027 . There are other types of bonds besides Treasuries . Bonds are classified according to the type of issuer Treasury Bonds Corporate Bonds Municipal Bonds Federal Agency Bonds 219

State Agency Bonds Corporate Bonds If a company is solid and financially secure , bonds they issue will have a lot of demand . Amazon , General Motors , and all other large public companies issue bonds , because the yield they pay is much cheaper than borrowing from a bank . The yields on top rated corporate bonds ( rated ) has been , on average , above the Treasury bonds . You can see the difference between Treasury Bonds and Corporate Bonds in the graph below . The higher yield is due to the fact that corporate debt is not as safe as US . Treasury Bonds . Companies that are less financially strong also issue bonds but must offer higher interest rates to entice investors . Even some very risky ventures can offer bonds but may have to offer yields of 10 or more . Bonds with a yield of 10 or more are called junk bonds . For example , Donald Trump offered junk bonds to refinance his casinos in Atlantic City at a 14 interest rate . The casinos went bankrupt , and the lost 50 of their money and ended up taking over ownership ofthe casinos . Municipal Bonds Cities and townships can issue bonds to borrow for projects they want to undertake , such as a new sewer treatment plant or a new school . However , in all states except Hawaii , cities , townships , and states can not borrow money to finance operating deficits the way the federal government does . They must have balanced budgets every year . Investors in municipal bonds get a break from the IRS interest on municipal bonds is tax free ( federally , but often not on state income tax ) Bond can then pay a lower interest rate . For example , if the municipality anticipated paying on their bonds , and the average federal income tax rate is 25 , the yield that is equivalent would be or . This is an approximation , of course , because the final yield is determined in the municipal 220

bond market and depends on current interest rates and the credit worthiness ofthe issuer . Federal Agency Bonds There are many federal agencies that also issue bonds . This could be to build highways ( Federal Highway Administration ) or to provide mortgages to residential housing buyers ( Freddie Mac and Mae ) Most ofthese Federal Agency Bonds have a US . Government guarantee behind them . The yields are low and comparable to US . Treasuries . Because of the federal guarantee , investors have a big appetite for these types of bonds . During the past two , the Fed bought trillions of Mae and Freddie bonds , and now the rates on home mortgages ( around for a mortgage ) are the lowest they have ever been . State Agency Bonds States have to build highways , regional sewage treatment plants , and other projects . In addition , states often guarantee the bonds of their public universities , so the colleges can borrow at a much lower rate . Interest on some state bonds is exempt from state and federal taxes . When buying state bonds , ask ifa particular bond issue is exempt from federal state income taxes . Bond Ratings Standard and Poor and Moody are financial services companies that provide risk ratings on bonds . The risk is whether the bond issuer will default on either the interest payment , on repaying the principle , or both . These ratings range from for Standard and Doors and from to for Moody . New bond issues almost always will ask one of these agencies to provide a rating . Bonds with a rating of ( on the Standard Poor ) or ( on Moody ) or better are considered . Bonds with 22 '

lower ratings are considered speculative and often referred to as or junk bonds . Investing in Stocks Quick tip Yahoo Finance is a good place to get price quotes on stocks and their historical price charts . Most students who have taken my financial literacy courses have wanted to learn as quickly as possible how to become a millionaire ( or preferably a billionaire ) by investing in stocks and bonds . Ifthis is your goal , lucky for you , as I can show you how to do it . However , you need to know how to evaluate stocks and bonds , and it takes time . To whet your appetite , in the next chapter , I show you how to become a millionaire by investing wisely in the stock market early in your career and then being patient . First , however , you need to understand how to evaluate stock prices . The most used tool for assessing stock prices ( that is , whether the market is or undervaluing a stock ) is the Ratio ( Ratio ) This is the simplest formulation ofthis ratio ' Ratio as Last year earnings per share year earnings per share means the total net income of the company divided by the outstanding number of shares . For example , the closing price of 222

one share of stock you are looking at is per share , and the earnings ( or net profit ) per share is . The Ratio would look like this Price per share a 10 Earnings per share 10 or That means you are paying for every in earnings , or to put it another way , you are receiving return for every you invest . Your ROI could then be calculated like this ROI 10 annual return To see ifa Ratio is a good , we need to look at the historical averages of the stock markets Ratios . I have summarized a few similar historical Ratios below 223

Table . Ratios of 500 Stocks Ration Source Dates Average Yea a Robert 1872 to 2015 Year Robert 1818 to 2013 One Year Estimate 2000 to 2019 To calculate what returns these averages would give , plug the known numbers into the formula and solve for the unknown price . Then you can calculate the annual return . To simplify , we can assume that the earnings are per share . One year trailing Current price of a share of stock Ratio , Last year earnings per share Current price earnings per share Current price paid for one share ofthis company stock to own per share of net earnings , our ROI would be 224

earnings per share per share price order to reconcile this with numbers we saw above , we need to add to use his formula Total return Price appreciation of stock Dividend The price appreciation of stock is a direct function of the annual growth in earnings per share , and the average annual dividend paid on the 500 stocks is approximately . However , Ratios are volatile . Below is a chart of what is as the trailing Ratio of 500 stocks from 1929 to 2019 . The trailing Ratio is an historical Ratio that is , it is calculated as such Trailing Ratio End of year price of a share of stock Last year earnings per share Note the volatility ofthe historical ratio . It certainly gives us pause to think 225

that we could predict the value next year with this tool , even though we have already discussed previously that the average of the trailing Ratio from 1872 to 2015 is . Nevertheless , this data gives us the base for expected ratios in the future . However , there are serious theoretical and practical flaws in projecting this historical Ratio into the future , even on the average . 500 Ratio 90 Years 120 100 80 60 40 20 ( ea 90 90 90 ) a eu , Figure . 500 DE Ration 90 Year Historical Chart by Fred Rowland is used under a License . Source data ( One year trailing estimate 226 i

Calculating the ROI for the average of the One Year Estimate , we get the earnings per share per share Using the trailing Ratio as a principle forecasting tool is flawed , due largely in part to the real world . Investors do not buy a stock for its past earnings but for its expected earnings and dividends . Simply , buying stock today does not entitle you to past earnings or dividends , but you will receive a proportionate share of future net earnings and dividends . Given an historical Ratio , investors are looking to buy a share of stock at a Ratio , but the earnings that are used to calculate the Ratio are expected earnings based on the following years earnings . This ratio is usually called the Estimate and is calculated as follows Estimate Current price of a share of stock Estimated next year earnings per share Real world investors price stocks this way , causing a lot of the trailing ratio volatility . Let say investors estimate that next year earnings will be per share . want to buy a share at the average Ratio , they would pay for each one . Now , let us say that they paid for each share and were wrong about their estimate of next year earnings . The trailing Ratio would be quite different from a Ratio . If the investor overestimated 227

next year earnings and the earnings per share were 50 , the trailing Ratio would look like this Price paid for a share of stock Trailing Ratio Actual year earnings per share 31 If , on the other hand , the investor underestimated next year earnings and earnings per share were instead of , the trailing Ratio would be this Price paid for a share of stock Trailing Ratio Actual year earnings per share Estimated Ratios can vary significantly across industries . Let say professional investors were able to accurately predict the future earnings per share ofthe 500 and that they were looking for a return . The Estimate would be constant at approximately times earnings . The high volatility of the Estimate simply attests to the fact that it is impossible to accurately predict future earnings . 228

CAPE 10 year The calculation ofthe ROI for the CAPE Ratio is earnings per share per share price The Cyclically Adjusted Price Earnings Ratio ( CAPE Ratio ) is based on the average earnings from the years . Nobel Laureate Robert created this ratio with economist John Campbell and detailed this in his book , Irrational ( 2000 ) uses an inflation adjusted ( or real earnings ) average is to smooth out the cyclical volatility of corporate earnings over periods of the business cycle . Divide today closing stock price by real earnings per share and you have the CAPE Patio . CAPE ratio Current price of a share of stock average real earnings per share Below is a graph of the CAPE Ratio compared to 229

interest rates . Note that even though the average CAPE Ratio is for the period 1818 to 2013 , it is still quite volatile a measure ofthe value of stocks . Ratio Long Term Interest Rates Ratio ( um ) so 15 45 15 14 as 12 30 10 25 20 ' 15 ' 10 ?

I ) 990 ' 330 270 350 Ska go 990 000 090 Figure . Ratio compared to long term interest rates by Fred is used under License . Source data ( The Current One Year Estimate Note that on all the graphs above , the values of all three Ratios are significantly above their averages . This is also true as 2020 230

Table . Ratios Ratio Source Dates Average 31 ' 2020 Robert 1872 to 2015 15 261 Trailing ' 10 Yea Robert 1818 to 2013 One Year Estimate 2000 to 2019 1911 What does this mean ?

Well , first of all , let see why the Ratio I recommend to watch ( the Estimate ) is so high . According to John Butters of , one year prior ( January 18 , 2019 ) the forward ratio was . Over the following 12 months ( January 18 , 2019 to , 2020 ) the price of the 500 increased by , while the forward Earnings Per Share estimate increased by . Thus , the increase in has been the main driver ofthe increase in the ratio One year estimate Current price of a share of stock ( increased by ) Estimated next year earnings per share ( increased by ) This means that prices of the 500 stocks are overvalued which usually to a correction through a drop in 500 share prices . We will have to watch the stock market to see ifthat is true . In a recent New York Times article , Robert notes that his CAPE reached 33 in January 2018 and was 31 at the time of publication ( 2020 ) further pointed out that it has only been as high or higher at two other , 1929 and 1999 . In 1929 , the high CAPE immediately preceded he Stock Market Crash , during which the stock market lost 85 of its value . in 1999 , the high CAPE ratio preceded another Bear Market 231

stocks lost 50 of their value . According to , some pundits blame exceptionally low interest rates for the stock market highs . However , states that low interest rates do not correlate well with the CAPE Ratio . The opposite is also true high interest rates do not correlate well with subsequent market crashes . attributes the current Bull Market to what John Maynard Keynes describes as Animal Spirits . According to , he has seen a proliferation of narratives since 1960 of going with your gut as opposed to using your brain to make decisions . This attitude includes people like President Trump ( I have a gut and my gut tells me more sometimes than anybody else brain can tell me ) and inexperienced entrepreneurs in Silicon Valley . It fuels the mania in the market . This is not the method of investing that advocates We have a stock market today that is less sensible and less orderly than usual , because of the disconnect between dreams and expertise ( 2009 ) However , no matter the outcome of the 500 share prices , no one can accurately predict the timing of the market over the long term . For those investing in the market over the long haul , especially those who are putting regular amounts each month in their retirement plan , the best strategy is to stay the course . As we saw above , over the long term , the 500 has returned on average 10 per year . The 500 includes five hundred companies , but six of them play an outsized role . These are Meta ( Facebook ) Amazon Apple Netflix Alphabet ( David Lynch discussed this in a recent Washington Post article with a combined market value exceeding trillion , these six companies account for more than of the entire 500 . That explains how so few companies can lift an index of 500 stocks . Since 232 i

the is weighted by each stock value , or market capitalization , gains by these larger companies have a greater effect than gains by an equal number of less valuable companies ( 2020 ) These six companies led the 500 Index from a drop of 35 during the pandemic to a return to near its high on , 2020 . It took about six weeks to fall into a Bear Market ( defined as a drop of 20 or more from a previous high ) and this was the fastest drop in history . The 500 Index then climbed back in 126 days to where it was before the Pandemic Recession . This is likewise the fastest recovery from a bear market in history , according to Wall Street Journal . Bubbles and Busts in the Stock Market As much as the professional stock traders would like us to think that they are rational of expected future cash flows and ratios , there is still a great deal , gambling , and herd behavior in the stock markets . For example , take a look at the activity of since the beginning of the year 2020 233

Tesla Stock Price 700 600 500 400 300 200 100 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Figure . Stock Price by Fred Rowland is used under License . Source Yahoo Finance doto ( There is no rational reason for the stock to rise almost 250 in 2020 . Tesla had been announcing good news about vehicle deliveries , but there was no reason to expect earnings per share to increase 250 anytime in the near future . Tesla stock is clearly in a bubble . Tesla , of course , is just one of many instances of speculation and gambling in the stock market . Bitcoin went from under per coin in December 2016 to almost per coin in December 2017 , an increase of . It then dropped to under per coin and now trades around per coin . was a chip maker for smart phones , and its from per share to over 90 per share in just the one year ( a increase ) because investors saw it as the only major supplier of chips . When competition entered and the bust happened , dropped to a price in the teens . Fortunately , it stayed viable and over the next 20 years , the company has 234

grown , and the stock is now approaching 90 again . We are not going to spend a long time on bubbles , so for classic analysis of historical bubbles and busts , read Monies , and A History Crises , Seventh Edition , by Robert and Charles . Investing in Commodities I recently was with a good friend of mine who is a retired finance professor . Prior to teaching at Temple University , he had a career as a stock trader at a big investment house . While we were talking , he was constantly looking at his cell phone . After a while , I asked him what was so interesting on his phone . He told me now that he was retired , he was trading commodities . Wow , I said , have you made any money ?

Not yet , he replied . Commodities are generally unprocessed goods used to make other things . They do not have a dividend as stocks and bonds do , so the only return is its increase ( or decrease ) in value . Here are some examples Grains ( wheat , corn , soybeans ) Metals ( gold , silver , copper ) Meat ( beef , pork bellies ) Oil Natural gas Foreign currencies Commodities prices are determined by the interaction of supply and demand in the marketplace , and they are often subject to large price swings . Droughts increase the prices of grains and meats . The fracking of oil and natural gas in the US . caused a dramatic drop in the world price and gas . Gold is somewhat special in that its only practical use is for jewelry , but it is seen as a store of value in good and bad times . Investors turn to it for safety when the stock market drops ( especially during ) Likewise , when bond returns decline , safe asset investors turn to buying more gold , increasing its price . When inflation accelerates , the price of gold tends to rise , because it i 235

takes more dollars to buy an ounce of gold . Gold price when there are wars , natural disasters or , it increases in value and vice versa . However , it does not evidence huge returns over time . For example , during the Great Recession , stocks dropped 30 but gold only rose . When stocks roared back over the next couple of years , gold did not rise much at all . However , the performance of gold in the Pandemic Recession has been extraordinary . It has increased 25 since the beginning of 2020 . I believe we can attribute this to the amount and uncertainty caused by the Pandemic , since the price always reacts to fear . See the graph below for the price of gold since 1970 . The big spikes are in recession years . Gold Price 52500 2000 1500 1000 500 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Figure . Gold Price by Fred Rowland is used under a License . Source Yahoo Finance data ( Because oftheir volatility , commodities are a risky investment , and you should 236

consider them like betting on a roulette wheel at a casino . Many factors outside of your control affect the price of commodities . Investing in Art The stories most of us hear about art investments come in headlines about the prices of fine art at auction houses . In 2015 , the most expensive Picasso ever sold , Les Femmes ' Version ' went for 179 million at Christie Auction House . In 2019 , a lost Leonardo da Vinci was sold to the Prince of Saudi Arabia for 450 million , although experts disagreed about its provenance . Despite these prices , the are quite mundane . In the 2015 article , it Pa to Invest in Art ?

A Returns Perspective a group of finance professors from top universities examined the returns on paintings sold repeatedly at art auction houses from 1960 to 2013 . They found returns ( adjusted for selection bias ) to be annually . They conclude that art isjust not a good investment compared to stocks and other assets . They also computed returns on other assets and compared them to the investment returns for fine art , or what we might call investment art . For most of us , we will almost assuredly not even get what we paid for a piece of art when we sell it . When we buy art , we are paying the retail price which is typically double what the gallery paid for it . If we are going to sell it to a gallery , we will receive a wholesale price from the gallery . If we sell it on eBay , it depends on the fads of the day . So , ifyou want to buy art to hang on your wall , buy something because you love it , not because you expect to make money from it . Day Trading Many now advertise to individual investors to get them started in trading stocks online . These include notjust places like , and , but also major mutual funds such as Fidelity Investments . Due to competition , online trading now has zero trading fees , and the ease of trading online is incredible . Several online stock are criticized 237

because they make stock trading feel like a video game and give customers access to large credit lines to trade with . With these options , can we as individual investors do better than the actively managed mutual funds by picking our own stocks ?

The answer is a resounding no ! Mark in his Wall Street Journal article , When Day Traders Do Well Probably Just Luck , says There little doubt that day trading has mushroomed in popularity in recent months , or that some day traders have produced extraordinary profits . According to statisticians , however , there also little doubt that most of these day traders good performance is due to luck . They essentially would have just as good a chance of success going to the casino ( 2020 ) Investing in Stock Options An option is a right to buy or sell a specific amount of stock at a specific price of a specific company ( or group of companies ) Options always have a set time period in which they may be exercised . In his Wall Street Journal article , More Investors Play the Lottery , Randall Smith reports that due to individual investors jumping into the market , stock market volume has more than doubled since the year 2000 . However , the volume of stock options trading has grown to more than six times what it was in 2000 ( 2020 ) According to the Options Clearing Corporation , the average daily trading in options on stocks was about . On September 13 , 2020 , the Wall Street Journal reported that options trading on shares was 120 of the buying and selling of stock shares . These options are mainly on companies that are flying high right now , directly as a result of and the switch to online shopping . Further , the Wall Street Journal reported that share values optioned by small investors was 500 billion . There are two main types of options Call Options and Put Options . A Call Option gives you the right to buy shares of a stock . A Put Option gives you the right to sell shares of a stock . lfyou decide to invest in options and are convinced that the price of a certain stock will go up , you will buy a Call Option . The way you make money is to wait until the stock price goes up and then exercise the right to buy at the lower price . Alternatively , the price of the option will rise as 238

the price of the stock rises , so you do not have to even exercise the option to reap your profits . You can just sell the option on the market at a higher price . lfyou are convinced that the price of a certain stock will go down , you will buy a Put Option . The price of the Put Option will rise when ( and if ) the price of the stock drops , and you can reap your by selling the option in the market . Let look at an example of a Call Option . On , you purchase 100 Call Options to purchase Apple stock at 250 per share to expire on March 31 . The price ofthe options is each . 100 call options at cost stock rises to the options price will typically rise by the same amount . 100 Call options price per call option in value You sell the options on the market , and your profit and return are thus 239

250 Return The value in buying options rather than Apple stock is that your returns are multiplied . Ifyou bought 100 shares of Apple stock at 250 , and its price rose to 255 , your profit and return can be expressed like this Profit ( 255 100 25 , 250 100 25 , Return reat , huh ?

The problem is that your timing could be off . If Apple does not rise in price by March 31 ( or drops in value by March 31 ) your Call Options will expire as worthless , and you will lose your 200 . The 200 per option that you paid is called the time premium or premium , and it decays or decreases the closer you get to the expiration date . This means that the option that you paid for is worth on the expiration date if the stock price has not risen above your exercise price . For every buyer of a Call Option , there must be someone willing to sell a Call Option . There will be some sophisticated investors on the other side ofyour Call 240

Option betting that Apple stock will not go up ( or will decline ) in price by the end of March 31 . According to Smith Wall Street Journal article , online brokers such as and Trade are aggressively promoting options trading to small investors . It is much more profitable to them to sell options as opposed to stocks . My advice for the individual investor is to stay away from options . Think about it this way if about two thirds of individual investors lose money in options , you would do better to place your money on red or black on the roulette wheel at your local casino . On that bet , your odds are , and you double your money ifyou win . Buying Your Company Stock Sometimes , if you work for a large public company , you are given the opportunity to buy your company stock . If you believe your company is doing well and will do well in the future then you should buy some of their stock . This could be an especially good deal if the company sells it to employees at a discount or helps finance the purchase for you out of a payroll deduction . However , the general rules of portfolio investing apply here . Do not put more than or 10 of your investment in your company stock . The rest of your savings should be in an 500 Mutual fund . Perhaps a cautionary tale that is relevant here is the employee pension fund . was an energy company headquartered in Houston , Texas . In the late it almost deregulated energy markets through lobbying and reaped huge profits by buying and selling electricity and natural gas . However , it was fraudulently hiding losses that it was making in other diversified investments , and when that was discovered by the Wall Street Journal , its stock tanked . It declared bankruptcy in December 2001 . had encouraged its employees to invest their entire pension fund in stock . Consequently , when went bankrupt , not only did all the employees lose theirjobs , but they also lost all their pension funds . Investing in Real Estate The most accurate way to look at the returns on real estate is to look at the 24 '

publicly traded Real Estate Investment Trusts ( There are two general classifications of Equity and Mortgage . Equity buy properties and manage them for profits . Mortgage lend money to investors who buy real estate . According to the National Association of Real Estate Investment Trusts , the average annual returns on during the period 1972 to 2019 are as follows All annually Equity annually Mortgage annually Obviously , if you want to invest in a REIT , it makes more sense to invest in an Equity REIT , due to the higher historical average return . However , ifyou want to become a sophisticated REIT investor , you should realize that almost all Equity invest in only a single sector ofthe real estate market , office buildings or apartment buildings . Investors , especially institutional investors , want to be able to tailor their exposure or spread their exposure to specific segments ofthe real estate market they can do this by buying into a REIT that only invests in shopping centers , for example . As a beginning investor , you will not have enough money to buy a properly diversified portfolio of along with a properly diversified portfolio of stocks . You will be able to diversify safely by investing in a mutual fund that holds all of the 500 stocks , including a good number of real estate stocks . Diversity is the key to reducing risk . The Biggest Investment Mistakes , in his Wall Street Journal article , The Mental Mistakes That Active Investors Make , has a good catalogue ofthe biggest mistakes that active amateur investors make ( 2020 ) According to , the biggest mistake of all is believing that you can beat the market ( achieve annual returns in excess ofthe appropriate market index ) Here arejust some ofthe indices that are used as benchmarks of how your stock picks performed 242

Table . Indices Index Types of Assets Measured 500 US . Stocks 500 large representative stocks Barclays Aggregate Bond Index . Bond Prices US . largest US . industrial Companies Russell 2000 Index US . Stocks small capitalization companies Index Stocks of developed EE International Stocks markets There are also appropriate indices that track a mixture of stocks and bonds . When you invest in a mutual fund , its quarterly and annual reports should inform you of the appropriate index to measure its performance against . The only reason to invest in individual stocks or a specified portfolio of stocks is if they will beat the market . Broker fees or fees for an actively managed portfolio of stocks will be significantly larger than those for a passively managed mutual fund that invests in , say , all 500 stocks . Therefore , if your fund can not beat the 500 fund , you should put your money in the 500 fund and save the fees . goes on to say that for amateur investors , the best bet is index funds . then asks , if amateur investors can not beat the market , even when they invest in an actively managed mutual fund , why do so many try ?

He blames it on our minds . The mental shortcuts we use to make decisions , according to , turn into mental errors . Below are some common errors . Framing According to , amateur investors think of stock trading as a skill that improves with practice , like surgery , carpentry , or driving . However , this is not the case , because the amateur investor has millions of other professional traders working against them . Whereas a rising stock market can be a for every investor , it would be better to frame an individual stock trade as a war . For everyone buying a stock , there is someone selling the stock . What does the 243

seller know that the buyer does not ?

Also , the returns that amateur investors achieve in their trading should not be compared to zero , which is often what they do . The returns should be compared to the appropriate benchmark index , which for stock portfolios is most likely the 500 Index . ce When asked , 80 of people think they are above average in intelligence and good looks . Of course , this is a statistical impossibility . One cause of overconfidence by amateur stock traders is that they see stock trading as a skill akin to plumbing or carpentry , instead of something more competitive , like tennis . Playing against Rafael would soon erode your confidence . Faulty Benchmark or Anchor If we were looking to sell our house , we would look at the prices of recently sold houses in our immediate neighborhood in order to set our asking price . Amateur investors often do the same with stocks that is , they hold the belief that the high and low of a stock define its range of trading and buy the stock at or near its low and often sell a stock at or near its high . Unfortunately , according to , this strategy fails to beat the market . Flip ofa Coin Even if an amateur investor invests in only mutual funds , some move their money regularly to the fund that beat the market last year . This is a losing strategy . As I will detail later , research has shown that out of mutual funds to invest in , no one beat the 500 more than two years in a row . While there are some mutual funds that beat the market , it is not consistently the same fund doing so . Picking the fund that will actually perform better than the 500 next year is no better than the flip of a coin . The Availability Heuristic The amateur investor makes decisions on the information currently available 244

to them . This information is limited . Often , the information that is available are newspaper articles about a stock or mutual fund . There is a high correlation between news coverage of a particular stock and trading in that same stock . There are plenty of stocks we do not hear about and plenty of information we do not know . Even worse , a stock price per share is a function of next year expected earnings . How accurately can an amateur investor predict next year earnings ?

The Thrill of the Hunt Fidelity Investments , one of the largest mutual funds , found in a survey that 54 of amateur investors enjoy the thrill ofthe hunt . Further , 53 enjoy learning new investment skills , and more than one half enjoy sharing trading news with family and friends . for fun and profit . Generally , I almost always hear about the wins but not the losses of friends who talk to me about their amateur trading . As is typical in situations of incomplete information , this used to give me the feeling that I was less than competent when a stock I bought was a loser . Having since become much more aware ofthe actual statistics involved , I do not feel so bad anymore when I lose , and I do not feel superior when I make a winning bet on a stock . However , given the lack of information of amateur investors , they are better off at the roulette wheel . How to Learn From Investment Mistakes If you make an investment mistake , learn from it instead of just beating yourself up . Everyone makes investment mistakes . You can recover . Behavioral economics tells us that many amateur investors hold onto stocks that have declined , hoping they will rise again to at least break even . The reason for this is loss aversion . When you sell the stock , you have to admit your mistake and feel the loss . A diversified portfolio like an 500 Mutual fund , will surely rise again with the market , but more than likely this will not happen for a or a small company . A diversified portfolio will sooner or later deliver average returns , but a single stock could go bankrupt . If a stock is significantly down , 245

and the company has fundamental financial issues , dump it and move to a better ( diversified ) portfolio . 246