The stock market is endlessly fascinating to millions of people. CNBC, the cable TV channel that bases most of its programs on the stock market, is one of the most popular channels on cable. Why? Because the stock market is just about the only way that the average person has to “beat the bank”. Average return on investments in the stock market over the last century has exceeded 10%, even though that includes the Great Depression of the 1930s, and the bear market of the past three years. ( A bear market is a market in which most prices are going down. A bull market is a market in which most prices are going up. There is no time, however, when all prices go the same way.) The mechanism of the publicly traded corporation allows everyone to buy a little piece of Microsoft, General Electric, Johnson and Johnson or other famous company and to share in the fortunes of that company for good or ill.
In addition, since the 401(k) plan was created in 1978, even people who were never interested in the stock market have necessarily become interested. Prior to the 401(k), and to a lesser extent, the IRA, most individuals still didn’t invest. Those companies that paid pensions managed the investments of the funds, and the employee got a percentage of some pay base after staying with the company for 30 years. With the 401(k), the investment decision was suddenly in the hands of the individual employee, most of whom were ill-equipped to make investment decisions. Some of the matching money in these 401(k) plans was in the form of stock in the employing company, which most employees tend to just hold, not making a real portfolio decision. Unfortunately, by not making a decision, they are by default deciding to concentrate in their own company’s stock, not a good portfolio strategy.
What all this means to you is that even if you never become a corporate financial manager worried about the price of your company’s stock as part of your job, you will probably be worrying about your company’s stock price anyway. Therefore, it pays for you to learn how the markets work and something about what determines the price of a stock. Then when you make a decision about your 401(k), you won’t be making the decisions (or not making a decision) out of ignorance.
When you finish your study of this chapter, you should know:
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Dividend growth model
Capital gains yield
“Buying the election”
Classes of Stock
Don’t forget! Homework is due by 6:30 PM on class day by e-mail to firstname.lastname@example.org! Don’t suffer a zero by being late.
The text doesn’t necessarily make it clear that the dividend growth model does not fully explain how stocks are priced, although it is the most favored theory at this time. Be aware that there is a psychological factor that makes prices not completely rational. There is a famous book, Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, that explores past examples of insane overpricing of shares and even Dutch tulip bulbs. The entire book is available for free online at http://www.econlib.org/library/Mackay/macEx.html. It is written in the language of the early 1800s when it was published, but if you can get past that, it is fascinating. This is a free service of the Library of Economics and Liberty. Note that their logo includes the earliest known written appearance of the word “freedom” or “liberty” in any language. It is in cuneiform, and was taken from a clay tablet from the Sumerian city of Lagash.
Note that there are templates at the www.mhhe.com/rwj website for Excel Spreadsheets to solve homework problems 1, 12, and 13. All you have to do is insert the formula in each of the three yellow highlighted cells. You will know if you have done it correctly if the right answer comes up.
Remember, to put a formula in a cell in Excel, FIRST put in the equal sign. For example, if I have 2 in Cell A1 and 5 in Cell C4, and I want to add them, what I will put into the cell where I want my answer is
Excel will then calculate the answer for me.
In a corporate setting, you will be expected to use Excel to justify your conclusions. Get skillful with it now so that you will shine when you are working in business.