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economy2
written on Nov.22, 2001
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First, I assume that you have substantial investment experiences. If not, please read good introductions [1,2,3]. A superficial understanding of these books is not sufficient. At least you should read [1,2] and point out good points and misleading points of these books. [3] provides reasons why one should not buy individual stocks or mutual funds.
You should set up correct investment goals. Many may say that my goal is to maximize my investment return. I will show you that such a goal is unreachable in a rigorous sense (at least until a superman comes). So a realistic goal should be to maximize your investment return at a reasonable cost (in time, energy, risk, etc.). The simplest strategy is to invest in a stock market index. In order to beat the market with discernable gains, you need great effort. If a stock market is relatively inefficient, you may need less effort. The US market is quite efficient.
One needs understand the meaning of owing stocks. Suppose a company needs funds to expend its business. It can get funding in several ways. One way is to sell a part of the company to the public through stock offerings. Take Intel as an example. Without issuing stocks, Intel would expand at a much slower rate and computing and internet revolution as we are experiencing now may be delayed many years. An ideal stock will be a win-win-win situation, i.e. win for company, win for shareholders, and win for customers. Buying a stock in principle is a partial ownership of a company. What about stock market and stock trading? There are several basic reasons for trading stocks. For an investor, you may sell a stock because (1) the business fundamentals of a company (management, economy environment, competition, growth, etc.) have changed too much; (2) better investment opportunities arise; (3) you need money or may need money in near future. Of course, there are many speculators in the stock market. This is expected because the stock market fluctuates greatly. For any market, it is difficult to determine price of an item objectively during a short time span. The price of each stock fluctuates according to earning expectations, industry outlook, competition, market psychology, economy outlook, and so on. The market movement is largely determined by mutual fund managers and hedge fund managers (individual investors contribute only a small portion). Although there are exceptions, compensations of most fund managers are determined by performance of their funds. Thus, most fund managers try very hard to maximize the returns. From the economy viewpoint, stock trading may facilitate fund allocation, i.e. transfer funds to companies with better prospects from those with poor prospects, thus, contributing to economy. Therefore, trading stock is not necessarily bad. However, stock market has two aspects: investment and speculation. For a non-professional, the temptation is great and speculation can trap you, especially too much is focused on the short term movement.
How much return one can expect from investment? The benchmark is a market index. There are several indices: Dow, SP 500, NASDAQ. SP 500 is most widely used because of its diversification. Return of SP 500 in late 1990s has been 20%. However, long term SP 500 has been about 10-15%. Warren Buffet has a well known talk in which he expected investment return to be in the range of 6-8%. I would say that expected return really depends on economy (US and world). If economy is in a long period of stagnation, even 6-8% return is doubtful. Note that PE of SP 500 is still very high from a historical PE ratio perspective. On the other hand, if US and world economy recovers and grows within 2 years, SP 500 can return 10-15% annually in the next economic cycle.
Those novices may be puzzled. Since many stocks may be up and down 5-20% in a few days. The problem is it is extremely difficult to profit from such fluctuations. In a short period, stock market is a zero-sum game. Some loose and some win. And it is extremely difficult to be always on the winning side. Every rise and fall of a stock is the response of the market to certain information. Assuming that the market is fair and open, no one can get information earlier than the others. Anyone who buys a stock or establishes a portfolio of stocks is a bet that he can beat the market (unless his purpose is to achieve a below market return or to gamble). If a market prices a stock incorrectly (market inefficiency), i.e., either too high or too low, one can profit the market inefficiency by either long or short the stock. We know as a fact how difficult it is to beat the market. Sometimes, you buy a stock and it goes up 10-20% in a few days. It could be that you are lucky. If you had analyzed the company thoroughly and was convinced that the market overacted on certain information, then you can profit it by longing or shorting the stock. You really have to know the company well and have a correct estimate of the impact of new information (company specific, industry outlook, economy, market etc.). Moreover, you have to be better than most who buy and sell the stock (i.e., most fund managers). Even if you have done correctly this time, it has no bearing on the next move of this stock. The market learns and the market main participants are smart enough to adjust their strategies. In other words, the losers will learn not selling too cheap and others will want buy in front of you. Thus, the market is fluid and dynamic. To beat the market, you have to (1) know the companies you follow very well; (2) correct analyze each time whether or not there is market inefficiency; (3) know the main players always and are better than them; (4) act decisively.
Now let us see how difficult to beat the market consistently. In principle, this amounts to be the top 5% among all fund managers. The problem may be regarded as a mathematical optimization problem. The original problem is extremely difficult. If we simplify such a problem considerably, i.e. without dynamics, it becomes a problem known as NP-hard problem in computer sciences. So far no computer scientist or mathematician in the world can solve the NP hard problem. With dynamics, the problem is 100 times more difficult.
I will explain how others beat the market in the future. For most of you, a good investment strategy is to buy an index fund. Vanguard SP 500 is a good choice. It is boring but it works. It may be discouraging to think that you cannot beat the market. But think about it. Most professors and researchers in universities and most fund managers in the world cannot beat the market. You are not necessarily smarter but just wiser than them (and some Nobel prize winners as well).
Now turn to economy. There have been two competing types of economies: market economy and central planning economy. There is little doubt now that central planning economy does not work. Market economy is becoming the main stream. There are several important ingredients to a well developed market economy. (1) The market must have as little government intervention or unnecessary regulations as possible. (2) The market must be fair. (3) The market must be reasonably stable (from inflation, deflation, money supply, etc.). Although not stated, political and social stability is also crucial. The main philosophy of market economy is that the market participants as a whole are smarter than a few elite planners. In market economy when every participant works hard to maximize his/her results, the whole economy grows and everyone benefits.
We now can put the US bull market between 1993-2000 into perspective. The US economy grows only on the average 3-4%. However, the US companies and the US market are the earliest to reform (in the 1980s) and technology innovation puts US companies in the world leadership position. Former communist countries and developing countries moving to market economy (globalization) also benefit US companies because of their positions. These fuel the growth of leading US companies and the last US bull market.
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