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Special Topic 3
The Stock Market: Its Function, Performance, and
Potential as an Investment Opportunity
OUTLINE
I. The Economic Functions of the Stock Market
A. The stock market provides investors, including those who are not interested in
participating directly in the operation of the firm, with an opportunity to own a
B. New stock issues are often an excellent way for firms to obtain funds for growth and
product development.
C. Stock prices provide information about the quality of business decisions.
II. Stock Market Performance: The Historical Record
A. The stock market allows nearly anyone to participate in the risks and opportunities of
corporate America. Real returns for the past two centuries have averaged 7 percent per
year.
III. The Interest Rate, the Value of Future Income, and Stock Prices
A.
net earnings, or profit.
B. The value of a share depends on
1. the expected size of future net earnings,
2. when these earnings will be achieved, and
3. the interest rate by which the investor discounts the future income.
C. If D represents dividends (and gains from a higher stock price) earned during various
future years (indicated by the subscripts) and i represents the discount or interest rate,
the present value of the future income stream is:
IV. The Random Walk Theory of the Stock Market
A. When considering the future of stock prices, many economists stress the implications
of the random walk theory.
1. Investor expectations about an uncertain future determine current prices, and no
one can forecast future stock prices with precision or certainty.
V. How the Ordinary Investor Can Beat the Experts
A. Buying and selling individual stocks without specialized knowledge for quick profit is
very risky.
1. Holding a diverse portfolio of unrelated stocks and holding them for long periods
of time greatly reduces the risk of investing in the stock market.
278 Special Topic 3/ The Stock Market: Its Function, Performance, and Potential as an Investment
Opportunity
B. An equity mutual fund that is tied to a broad stock market index like the S&P 500
provides an attractive method for long-term investors to obtain relatively high yields
with minimal risk.
1. Indexed mutual funds have substantially lower operating costs than managed funds
C. Should you invest in a fund because of its past performance?
OBJECTIVES
This special topic considers several issues regarding the stock market. First, it discusses the
economic functions of the stock market and historical performance. Second, the relationship
between stock prices and the interest rate is analyzed. Third, a discussion of the random walk theory
of stock prices is provided. Lastly, the special topic discusses how the individual investor can profit
from stock market investments.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Review Exhibit 4. It indicates that the risk of a poor return from a holding a diverse portfolio of
stocks declines as the length of the holding period increases. Small investors can obtain a diverse
2.
ure net earnings, or profit. The value of a share depends
3.
heir advisors and fund
Special Topic 3/ The Stock Market: Its Function, Performance, and Potential as an Investment Opportunity
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HINTS FOR ANWERING CRITICAL ANALYSIS QUESTIONS
2. It will lower the value of stocks. Higher nominal interest rates will reduce the discounted