Chapter 7: Stocks and Other Assets 65
CHAPTER 7
Stocks and Other Assets
TEACHING OBJECTIVES
Goals of Chapter 7
A. Examine how the stock market works, the major influences on stock
prices and returns, and data on stock prices and returns over time since
1875.
B. Look at whether investors can follow pro”table “nancial investment
strategies.
C. Show how an investor should compare stocks with other “nancial
investments, such as bonds or real estate.
TEACHING NOTES
A. The Stock Market
1. Issuing and Investing in Stock
a) Shareholders (or stockholders) are investors who own stock in a
corporation
b) A stock exchange or stock market is a place where people buy
and sell stocks
2. An Investor’s View of Stock Returns and Prices
a) Introduction: stock investors care about total return, which equals
dividend yield plus capital-gains yield.
b) How investors view dividends: advantages and disadvantages to
investors
c) How capital-gains taxes lead to the lock-in effect: distinguish
Chapter 7: Stocks and Other Assets 66
and transactions costs may have a higher return after taxes and
transactions costs if it has less trading and less capital gain
3. Historical Returns and Stock Prices
a) Data beginning in 1875 on the S&P index show that real stock prices
change dramatically over time, with huge losses over some periods
B. Data Bank: The Explosion of Tech Stocks in the Late 1990s and Their
Implosion in the Early 2000s
1. The NASDAQ stock index tripled in value from October 1998 to March
2000 because of investor excitement over tech stocks that was not
justi”ed
2. Without the pro”ts to back up such high stock prices, investors realized
that the prices were not justi”ed, and stock prices plummeted in 2000;
see Figure 7.A
C. How Can an Investor Pro”t in the Stock Market?
1. If there are many buyers and sellers, the stock market conforms to the
stock prices follow a random walk
3. Are Stock Prices Unpredictable?
a) Research shows that stock prices are somewhat predictable:
relationships exist between stock prices at different times
b) So either markets are ine9cient or investors care about risk
4. Are Stock Returns Predictable Only Because of Risk?
a) Anomalies exist even after researchers carefully account for risk
b) Can an investor pro”t from an anomaly?
c) Models of risk may not be accurate (CAPM, APT)
Chapter 7: Stocks and Other Assets 67
5. A Random Walk with a Crutch
a) Malkiel’s view of the stock market is that although the market is
close to being e9cient, it is not wholly e9cient; the market
6. What Determines Average Stock Prices and Returns?
a) A simple model of stock prices, based on the present-value formula,
shows that stock prices can be explained reasonably well according
D. Application to Everyday Life: Comparing Stocks with Bonds and Other
Financial Investments
1. Comparing Stocks with Debt Securities: The Equity Premium
a) Long-run average returns to the stock market are much higher than
the returns to bonds; use Table 7.3 to explain why the equity
premium exists
2. Other Assets as Investments
a) Alternative investments include real estate, precious metals, and
3. How Investors Can Diversify Their Portfolios
a) Investors can diversity by holding different types of assets
Chapter 7: Stocks and Other Assets 68
E. Is the Equity Premium So High Because the United States Is Lucky?
1. One dollar invested in the U.S. stock market seventy-“ve years ago
(and with reinvested dividends) would be worth $118 today (adjusted
for inflation)
2. But, that extraordinary return may be due to luck, as the U.S. economy
has not su8ered major crises like those in other countries