Why Do So Many People Invest in Mutual Funds?
Chapter 7: Stocks and Other Assets 66
Recent Developments in Stock Exchanges
In recent years, improvements in technology, especially the use of
computers, have transformed the financial industry, including stock
exchanges. In this section, we will see what impact computers have had on
stock exchanges, and then see how investors have benefited by being able
to trade stocks internationally.
Stock Exchanges are Being Challenged by Technology
Chapter 7: Stocks and Other Assets 67
Stock exchanges have existed for hundreds of years. A stock exchange is
nothing more than a central location where people can buy or sell the stocks
of various companies. But in the late 1990s, the existing physical stock
exchanges were challenged by the growth in electronic trading. Electronic
communications networks, ECNs, are threatening to drive the major stock
exchanges out of business.
But, electronic trading has the potential to take away the franchise of the
existing stock exchanges and many of the people who operate them.
Electrons Aowing through computer circuits move much more quickly than do
the traders on the Aoor of the New York Stock Exchange. Imagine the
existence of a national computer system that matches buyers and sellers of
a stock 24 hours a day, with little cost. Our future is certainly one in which
just about everyone will be able to buy or sell stocks over the Internet.
Is there any value in keeping the current system of stock exchanges? Some
people think so, but to see that value, we need to look a bit deeper at the
way the stock exchanges work.
An investor can easily buy or sell a stock that trades frequently. Any time of
any day, there are many buyers and sellers of that stock. In such a market,
known as a deep market, a computer system could easily replace traders on
the Aoor of a stock exchange (such as Flo and Tayanda in our example of a
trade in General Electric stock).
Chapter 7: Stocks and Other Assets 68
If you own stock in Obscuro Company and trades of Obscuro occur only once
every few hours, you may have trouble selling your stock when you would
like to. But, with a specialist at the stock exchange, it will be easier for you to
sell your stock. An electronic trading system, however, would eliminate the
system of specialists, thus making it more diDcult to trade in thin markets.
How Global Are Stock Markets?
Chapter 7: Stocks and Other Assets 69
More on Price-Earnings Ratios
For most of the 1990s, the price-earnings ratio exceeded its historical
average. But, an investor who bailed out of the market in 1990 would have
missed the most impressive decade for stock returns ever. Why was the
increase of the price-earnings ratio above its historical average not a danger
sign? There are many reasons: (1) interest rates on debt securities were very
low in the 1990s; (2) corporate earnings might have been understated; (3)
the risks of a severe recession became lower than before; (4) the average
tax rate on investment income fell; and (5) transactions costs became lower.
Second, corporate earnings may have been understated. The accounting
rules for measuring intangible investments (such as research and
development) make profits appear smaller than they really are. In addition,
accounting treatment of such items as software purchases, which are treated
as an expense rather than an investment (which would result in the
expenditure being depreciated over time) leads to understatement of profits.
However, there are some accounting rules that lead to overstatement of
profits, such as the manner in which stock options given to employees are
counted. In addition, accounting scandals revealed in 2002 suggested that
some firms had greatly overstated their earnings in earlier years. But overall,
the impact of not counting intangible investments was probably the
dominant effect, so earnings were probably understated a bit. Because
investors knew this, they were willing to pay a higher price for a given
amount of reported earnings.
Chapter 7: Stocks and Other Assets 70
because inAation was lower, the interaction of inAation and the tax system
has become less distortionary. With the returns on investment taxed at a
lower rate, the price of stocks was higher relative to earnings, because
investors’ demand for stocks is higher.
Fifth, transactions costs on stocks were lower. As a result, buying and selling
stocks was easier. With fewer funds going towards transactions costs,
investors were willing to pay a higher price for stocks relative to their
earnings.
alternative investments.
An Alternative to Dividends
One clever way that corporations have available to them to avoid paying
dividends, but to distribute funds that they may not need for investment is to
buy back their own stock in the market. Investors might prefer selling off a
few shares of stock to obtain funds rather than receiving dividends. But,
selling shares means investors will incur capital-gains taxes; the tax rate on
capital gains is now 15 percent, the same as for dividends.
What Is Wrong with Day Trading?
Chapter 7: Stocks and Other Assets 71
Does Risk Matter?
Tests for the Predictability of Stock Prices
Economists test for predictability of stock prices in a number of different
ways. Some of the tests are related to stock prices themselves. Others are
Chapter 7: Stocks and Other Assets 72
based on the returns to stocks as expressed by the capital-gains yield, which
is the percentage change in the stock price from one period to the next. (The
dividend yield is quite predictable and slow to change, so unpredictability of
the total return arises mainly from unpredictability in a stock’s capital-gains
yield.) So, tests based on returns are also tests of the randomness of stock
prices.
Third, high returns to a stock in a given period of three to five years are
associated with low returns in the subsequent three to five years, a
phenomenon known as mean reversion. If stock prices followed a random
walk, there should be no relationship between the returns to a stock in one
period and its return in the following period. But, there is a relationship in the
data: the stocks that rose the most in value during the preceding period
yielded a lower return, on average, than other stocks.
Using the CAPM in Practice
In practice, the CAPM is used in the following way. An investor gathers data
on the stock price that she is interested in, the interest rate on Treasury
securities, and the market’s average return over the longest period of history
Chapter 7: Stocks and Other Assets 73
Searching for Anomalies Means Some Will Be Found
Anomalies were discovered only after long and rigorous searches of the data.
In any set of data, there are likely to be aberrations. For example, the odds
that a golfer shoots a hole in one are quite low. Yet there have been several
instances of a golfer getting two holes in one on the same day. The odds that
a golfer on a particular day will shoot two holes in one are astronomically
low, but there are so many golfers on so many days that it occasionally
happens. By comparison, the standards for accepting anomalies are easy—
we generally accept an anomaly as valid if the odds are 1 in 20 or less that it
could happen even if stock prices were totally random. Because there are so
many researchers searching for anomalies, there is a good chance that
someone will find an anomaly even if stock prices really are random. But, an
investor is unlikely to be able to profit from such anomalies because the
anomaly may have arisen from an odd event or sequence of events, and
may not be repeated.
Are Anomalies Large Enough to Allow Pro,t Opportunities?
Chapter 7: Stocks and Other Assets 74
Derivatives and Their Uses
Derivative securities are financial securities whose value depends on the
value of other securities, often shares of stock or bonds. There has been a
large increase in investment in derivative securities in recent decades. But,
there have also been a disquieting number of problems associated with
derivatives trading, including losses by firms such as Procter and Gamble,
which lost $137 million, and local governments such as Orange County,
California, which lost $1.7 billion. These large losses have led people to fear
derivatives as a bad invention that makes financial markets unsafe. Students
may wish to search a site such as http://scholar.google.com for the terms
“derivatives financial crisis 2008 2009.”
Derivatives have both benefits and risks, and magnify an investor’s exposure
to risk. When such investments go bad, the security tends to get the blame
rather than the investor.
There are four types of derivatives: forward contracts, futures contracts,
options, and swaps. The first two types, forward contracts and futures
contracts, are methods investors use to lock in a price for selling or buying
something in the future. For example, a wheat farmer can use a futures
contract to lock in a wheat price at which to sell his future harvest. The
derivative thus helps him to insure his income against the risk that the price
of wheat will change. An investor sells the futures contract to the farmer,
promising the farmer a given price for his wheat. Then, if the market price of
wheat rises above the futures price, the investor profits by buying the wheat
Chapter 7: Stocks and Other Assets 75
The third type of derivative security is an option, which gives one person the
right, and the other the obligation, to sell or buy something at a given price.
These days, corporations often offer stock options to their employees. The
employees can buy stock in their firm at a given price, called the strike price,
at a given future time. Of course, they will only exercise their option to buy if
the stock is trading in the market at a price above the strike price (otherwise
it would be cheaper to buy the stock in the stock market). By offering such
options, firms give the employees the incentive to work hard for the firm. The
Investors can use options to hedge against a decline in the price of an asset
(stocks or bonds) or to profit if the price of an asset rises. For example,
suppose you own 1,000 shares of stock in a company. The shares are
currently priced at $52, but you are worried that the price will fall sharply
when the company releases its next earnings report. To protect yourself
against that possibility, you could buy a put option, which gives you the right
to sell 1,000 shares at $50 each during the next month. With a put option,
you have a right to sell your stock at the strike price, but you are not
obligated to do so. As a result, if the price of the stock falls below $50 per
share, you will exercise the put option and sell your shares for the strike price
of $50 each. (Doing so gives you $50 × 1,000 = $50,000; but because your
stock is worth less than that, you are better off exercising the option.) If the
stock price does not fall below $50, then it would not make sense to exercise
the option, because your stock is worth more than $50 per share. As a result,
you simply let the option expire and keep your stock. Thus the option
protects you from losing very much if your stock falls in the price, but you
still gain if the stock rises in price.
The fourth type is a popular derivative called a swap. A swap, as the name
suggests, is a trade of one type of financial asset for another. Swaps are used
often by investors in the market for foreign exchange and also by large
banks. For example, banks in the United States often make loans at fixed
interest rates, whereas banks in Europe often make loans with variable
interest rates that change with market conditions. These banks would each
prefer a more diversified loan portfolio, so European banks often swap
payments from their variable-rate loans in exchange for payments made to
U.S. banks on fixed-rate loans.
From this description, you can see that derivatives come in many varieties.
The benefits of derivatives are (1) to lower transactions costs, because
derivatives are a cheaper way of engaging in transactions than other
methods that could be used to do the same thing; (2) to hedge, because
Chapter 7: Stocks and Other Assets 76
they can be used to lower risk; (3) to speculate, because they can be used to
magnify risk and returns; and (4) to profit, if prices in different markets are
set inconsistently with each other.
Derivatives are more complicated than most financial securities, and an
investor in derivatives must understand the risks of using them. Risks to
derivatives include (1) inaccuracies in pricing the derivatives (described
brieAy below); (2) the risk that someone involved in the transaction might fail
to deliver the proper payment; and (3) the risk that it may be hard to sell
your derivative security when you want to, because the markets for
derivatives sometimes do not have many participants.
On the whole, derivatives are neither evil nor benign. Their benefit depends
on who is using them— and why. For example, Orange County, California, lost
$1.7 billion when its finance manager made big bets using derivatives. But,
banks and farmers greatly benefit from reducing their risk using derivatives.
Should The Social Security System Invest in the Stock Market?
In recent years, some economists and politicians have proposed that the
Social Security system invest in the stock market. The proposal is worth
considering because the returns to the stock market are much larger than
the returns on the government bonds that the system currently purchases.
But, the stock market is a risky place to invest, so does the proposal make
sense?
Chapter 7: Stocks and Other Assets 77
government’s returns to be lower than historical returns.
But, other economists are not as negative about the idea. One reason is that,
if you look at how much you “earn” from the Social Security system, you
realize that it is a bad investment. We saw earlier in this chapter that, after
accounting for inAation, the return to stocks averages about 6 percent per
year. The returns to Social Security are, on average, about 1 percent per
year. But, an individual’s returns to Social Security depend on year of birth
and income because the system is used to redistribute income in two ways:
(1) from rich to poor; and (2) from those born in later generations to those
born in earlier generations. Thus the return on Social Security to someone
In addition, the worry about government investment managers acting in a
political manner can be solved easily by allowing people to invest their own
shares in the system. Under one proposal, each person could invest (through
a licensed broker) a fraction of the value of their Social Security account in
the stock market (or in the bond market) or in a broad mutual fund. This
would prevent government’s direct involvement in the market. As Feldstein
suggests, “The notorious ineDciency of federal bureaucracies suggests that
the government could not operate a system of individual accounts at lower
cost than private managers would. . . . The best approach would be a system
of privately managed accounts regulated by the government, which would
also guarantee that retirees receive at least as much as Social Security now
promises.”
Chapter 7: Stocks and Other Assets 78
risk? We know from looking at the returns to the stock market over time that
there may be long periods in which the return to investing in stocks is very
small. The return is 6 percent on average, but that is over a very long period.
Are we, as a society, prepared to have a large chunk of our social wealth
invested in an asset whose value might decline 37 percent in a given year,
as happened in 2008? And might remain underwater for a decade?
Additional Questions
1. Why does an investment in Social Security return an average of only
about one percent per year after inAation? What factors determine this
return?
Chapter 7: Stocks and Other Assets 79
2. Explain what is meant by a “pay-as-you-go” system for Social Security.
3. Why is it easier for a pay-as-you-go Social Security system to exist in a
country where the population is growing 2 percent each year compared to
a country where the population is constant?
Preferred Stock
In this chapter, we will discuss only common stock. There is another type of
stock, called preferred stock that has some features similar to debt and other
similar to equity, which we will ignore.
Should Policymakers Worry About the Stock Market?
Chapter 7: Stocks and Other Assets 80
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Should Policymakers Worry About the Stock Market?
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Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter
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Ohanian, Lee. “When the Bubble Bursts: Psychology or Fundamentals?”
Federal Reserve Bank of Philadelphia Business Review,
January/February 1996.
Shiller, Robert J. Irrational Exuberance. Princeton, N.J.: Princeton University
Press, 2000.
Chapter 7: Stocks and Other Assets 81
Social Security and the Stock Market
“Fast Facts & Figures About Social Security, 2009. ” U.S. Social Security
Administration. On the Internet at: http://www.socialsecurity.gov;
downloaded on 1/18/2010.
Feldstein, Martin. “How to Save Social Security,” New York Times, July 27,
1998.
Feldstein, Martin. “America’s Golden Opportunity,” The Economist, March 13,
1999, pp. 41-3.
Geanakoplos, John, Olivia S. Mitchell, and Stephen P. Zeldes. “Would a
Privatized Social Security System Really Pay a Higher Rate of Return?”
in R. Douglas Arnold, Michael Graetz, and Alicia H. Munnell, editors,
Framing the Social Security Debate: Values, Politics, and Economics.
Washington, D.C.: Brookings Institution Press, 1998.
Lansing, Kevin. “Rates of Return from Social Security,” Federal Reserve Bank
of San Francisco Economic Letter, Number 99-34, November 12, 1999.
Malkiel, Burton G. “Separation of Stocks and Stock,” Wall Street Journal,
January 22, 1999.
Social Security and Medicare Boards of Trustees. Status of the Social Security
and Medicare Programs: A Summary of the 2009 Annual Reports. On
the Internet at: www.ssa.gov/OACT/TRSUM/trsummary.html;
downloaded on 1/18/2010.
Summers, Lawrence, and Janet Yellen. “Saving the Surplus Will Protect
Retirees,” Wall Street Journal, February 18, 1999.
Symposium: “Reforming Social Security in Theory and Practice,” Federal
Reserve Bank of St. Louis Review 80, March/April 1998.