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Stock Market Investing for the 21 st Century Steven Thorley and Grant McQueen Lesson 1: Invest in stocks for the long-run Lesson 2: Free-ride on the market competition Lesson 3: Avoid the hidden price-tags of trading Lesson 4: Don’t fall into the data-mine

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stock market investing for the 21 st century steven thorley and grant mcqueen
Stock Market Investing for the 21st CenturySteven Thorley and Grant McQueen
  • Lesson 1: Invest in stocks for the long-run
  • Lesson 2: Free-ride on the market competition
  • Lesson 3: Avoid the hidden price-tags of trading
  • Lesson 4: Don’t fall into the data-mine
stock strategies four important lessons
Stock Strategies: Four Important Lessons
  • Topics not in this presentation
    • Personal finance
    • Get-rich-quick schemes
    • Beating the market
      • picking stocks
      • market timing
    • Hot tips
    • The things that matter most
      • family
      • health
      • gospel
stock strategies four important lessons3
Stock Strategies: Four Important Lessons
  • Lesson 1: Invest in stocks for the long-run
    • Stocks will have higher returns, on average
slide5
The Long-term Return on the Stock Market

Stock market risk-premium = market return - risk free return

7.13% = 11.88% - 4.75%

… but the U.S. in the last half-century has been “lucky” compared to other developed markets and time periods.

Going forward, the expected stock market risk-premium is about 5 percent. With the risk-free rate at about 3 percent, the long-term expected return on stocks is about

8 percent per year

(standard deviation of 20 percent per year)

stock strategies four important lessons6
Stock Strategies: Four Important Lessons
  • Lesson 1: Invest in stocks for the long-run
    • Stocks will have higher returns, on average
    • Stock market risks are acceptable, if you:
      • Diversify
      • Invest for the long-run
diversify across stocks
Diversify Across Stocks

49% -

24% -

19% -

Average annual standard deviation (%)

Diversifiable Risk

Total Risk

Nondiversifiable Risk

1 10 20 25

Number of stocks in portfolio

slide8
Based on compounding annual returns from Stocks, Bonds, Bills, and Inflation., 2007 Yearbook, Ibbotson Associates
slide9
Based on annual returns from Stocks, Bonds, Bills, and Inflation, 2007 Yearbook, Ibbotson Associates
stock strategies four important lessons11
Stock Strategies: Four Important Lessons
  • Lesson 1: Invest in stocks for the long-run
    • Stocks will have higher returns, on average
    • Stock market risks are acceptable, if you have a long enough time horizon
    • Question and Answer
stock strategies four important lessons12
Stock Strategies: Four Important Lessons
  • Lesson 2: Free-ride on the market competition
    • Most actively managed funds and brokerage accounts will under-perform index funds over the long-run
    • Choose “total market” index funds
slide14
Ten-Year Annualized Return on the 30 Largest Mutual Funds

Investor return for calendar years 1995 to 2004 (largest funds as of year-end 1994)

Average mutual fund return: 10.78%

Vanguard 500 Index fund return: 12.00%

Funds outperforming the index: 9 out of 30 (30%)

Correlation to prior decade return: -.250

index funds have low fees
Index Funds Have Low Fees

Performance comes and goes, but costs roll on forever.--Jack Bogle

Value of $100,000 investment

33% of your retirement to

manager

low fees or low amounts
Low Fees or Low Amounts

Vanguard is a pioneer in low cost index funds

(passively managed diversified mutual funds with fees often

below 0.2% per year)

www.vanguard.com

Homestead Funds is a pioneer in managing small

accounts(minimum of $200 for IRA and $500 for regular accounts—NO minimum if automatic scheduled investments)

homesteadfunds.com

slide18
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
slide19
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
stock strategies four important lessons22
Stock Strategies: Four Important Lessons
  • Lesson 2: Free-ride on the market competition
    • Most actively managed funds and brokerage accounts will under-perform index funds over the long-run
    • Choose “total market” index funds
    • The competition in stock-market research is intense, and will get more competitive going forward
    • Market indexing or “passive investing” is a free-ride on the competition
slide23
Stock Strategies: Four Important Lessons

An essential element of profitable economic activity …

- Barriers to entry (Porter’s five forces)

- Sustainable competitive advantage (Strategic Theory)

- Economic Rents (Microeconomic Theory)

- A “moat” (Warren Buffet)

trouble with timing
Period of Investment

NYSE/AMEX/NASDAQ Return Annualized

Value of $10,000 Invested in Jan. 1985

January 2, 1985 - December 30, 2005

+12.48%

$118,089

Less the 10 biggest days

+ 9.81%

$71,389

Less the 20 biggest days

+7.84%

$48,827

Less the 30 biggest days

+6.13%

$34,854

Less the 40 biggest days

+4.60%

$25,695

Data Source: CRSP Value-Weighted Index with Dividends

Trouble with Timing
stock strategies four important lessons28
Stock Strategies: Four Important Lessons
  • Lesson 2: Free-ride on the market competition
    • Bad reasons to not index
      • Passive investing is boring
      • War stories are fun to share with friends
      • Doing nothing about your portfolio is unnerving
      • Promotional material on indexing is lacking
      • Habit and tradition
    • Good reasons not to index
      • You are stuck in funds that have a high exit cost
      • Index funds are unavailable in some plans and foreign markets
      • Legal proprietary information is routinely available to you
      • In taxable accounts, complex tax/donation strategies are possible
    • Reason to index
      • Superior long-run performance
stock strategies four important lessons29
Stock Strategies: Four Important Lessons
  • Lesson 2: Free-ride on the market competition
    • Indexing alternatives
      • Mutual Funds (Vanguard, Fidelity, etc.)
        • Easy, no trading costs (commissions or bid/ask spread)
      • Exchange Traded Funds (SPDRs, WEBs now iShares)
        • Slightly lower management costs
        • Potential better tax effects
  • Trading throughout the day (ouch!)
stock strategies four important lessons30
Stock Strategies: Four Important Lessons
  • Lesson 2: Free-ride on the market competition
    • Question and Answer
stock strategies four important lessons31
Stock Strategies: Four Important Lessons
  • Lesson 3: Avoid the hidden price tags of trading
    • Transaction costs
      • Brokerage commissions
      • Bid-ask spread
    • Risk
      • Indexing is optimal diversification
      • Active funds are more volatile than the market as a whole
    • Taxes
      • Income taxes are triggered by buy and sell transactions
    • Time and energy
      • Beating the market requires a lot of both
slide32
Internal Revenue Service

Publication 586A

The Collection Process

(Income Tax Accounts)

stock strategies four important lessons33
Stock Strategies: Four Important Lessons
  • Grant’s day-trading buddy
    • $500,000 in stocks X 2% $10,000
    • 250 days X 1 trade X $15 - 3,750
    • $0.125 X 100 shares X 250 trades - 3,125
    • Gross Trading Profit 3,125
    • Tax @ 39.6% - 1,237
    • Net Profit $ 1,888
stock strategies four important lessons34
Stock Strategies: Four Important Lessons
  • Grant’s day-trading buddy
    • Trading Profit $1,888
    • 10 hours/week X 52 weeks 520 hours
    • Equals $3.63 per hour!
    • Not to mention the costs of an office, computer, internet fee, real time data fee, and …
  • …THE FACT THAT HE DIDN’T BEAT THE MARKET.
stock strategies four important lessons37
Stock Strategies: Four Important Lessons
  • Lesson 3: Avoid the hidden price tags of trading
    • Question and Answer
stock strategies four important lessons38
Stock Strategies: Four Important Lessons
  • Lesson 4: Don’t fall into the data mine
    • Intra-generational
the s p 500 1983 1993
The S&P 5001983-1993

S&P 500

Year

Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”

slide42
Overfitting the S&P 500Butter Production in Bangladesh and the United StatesUnited States Cheese ProductionSheep Population in Bangladesh and the United StatesR2=.99

S&P 500

Year

polynomial fit to the s p 500 big mistake or bad idea
Polynomial Fit to the S&P 500Big Mistake or Bad Idea?

S&P 500

Year

.25 1016 - .26 1013y + .12 1010y2 - 32000 y3 + 56 y4 - .0064 y5 + .49 10-6y6 - .24 10-10y7 + .69 10-15y8 - .88 10-20y9

polynomial fit to the s p 500 big mistake or bad idea44
Polynomial Fit to the S&P 500Big Mistake or Bad Idea?

S&P 500

Year

.77 1017 - .88 1014y + .45 1011y2 - .14 108y3 + 2700 y4 - .37 y5 + .000035 y6 - .23 10-8y7 + .99 10-13y8 - .25 10-17y9 + .28 10-22y10

stock strategies four important lessons45
Stock Strategies: Four Important Lessons
  • Lesson 4: Don’t fall into the data mine
    • Intra-generational
    • Inter-generational
      • No story/no future
stock strategies four important lessons47
Stock Strategies: Four Important Lessons
  • Lesson 4: Don’t fall into the data mine
    • Intra-generational
    • Inter-generational
      • No story/no future
      • Out-of-sample testing
slide48
From: Investment Strategy Claims: Don’t Fall into the Data Mine, AAII Journal, Feb. 2000, by McQueen and Thorley

Dow 30Foolish 4.0

In-sample (73-93) 14.8% 28.8%

Out-of-sample (July rebal.) 17.4% 18.9%

Out-of-sample (52-72) 12.7% 11.9%

Out-of-sample (Twins) 13.9% 14.9%

Out-of-sample (since the book)

1994 3.9% -6.1%

1995 37.6% 40.1%

1996 26.1% 37.3%

1997 22.4% 28.1%

1998 16.9% 17.0%

1999 15.8% -8.0%

2000 Opps!

stock strategies four important lessons49
Stock Strategies: Four Important Lessons
  • Lesson 4: Don’t fall into the data mine
    • Intra-generational
    • Inter-generational
      • No story/no future
      • Out-of-sample testing
      • Front runners
slide50
From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55, No. 2, pp. 61-72,

(March/April 1999).

Figure 1. Foolish Four Event Study, 1994-97

stock strategies four important lessons51
Stock Strategies: Four Important Lessons
  • Lesson 4: Don’t fall into the data mine
    • Question and Answer
stock investment strategies for individuals four important lessons
Stock Investment Strategies for Individuals:Four Important Lessons
  • Lesson 1: Invest in stocks for the long-run
  • Lesson 2: Free-ride on the market competition
  • Lesson 3: Avoid the hidden price-tags of trading
  • Lesson 4: Don’t fall into the data-mine
stock market investing for the 21 st century a review and update
Stock Market Investing for the 21st Century:A Review and Update
  • “For the love of money is the root of all evil …” 1st Timothy 6:10
  • “But before ye seek for riches, seek ye first the kingdom of God” Jacob 2:18
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