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Week 1: Introducing Markets, Participants and Performance

Introducing MarketsWeek 1: Introducing Markets, Participants and Performance 

“Overview for the Week … Real versus Financial Assets … History of Stock Markets, Players, Funds … Financial Analysts … Role for Retail Investors … Rates of Return – Review and More”
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Summaries

  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Real versus Financial Assets > Lecture: Real Versus Financial Assets
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > History of Stock Markets, Players, Funds > Lecture: History of Stock Markets, Players, Funds
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Financial Analysts > Lecture: Financial Analysts
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Role for Retail Investors > Lecture: Role for Retail Investors
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return - Review and More > Lecture: Rates of Return - Review and More: Part 1
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return - Review and More > Lecture: Rates of Return - Review and More: Part 2
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return - Review and More > Lecture: Rates of Return - Review and More: Part 3
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return - Review and More > Lecture: Rates of Return - Review and More: Part 4
  • Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return - Review and More > Lecture: Rates of Return - Review and More: Part 5

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Real versus Financial Assets > Lecture: Real Versus Financial Assets

  • Some people have even traded houses like other people trade stocks.
  • Flip back in time a few hundred years, and there is this thing called the ‘Tulip Bubble’ where people were actually getting rid of their real-estate and buying tulips, because the prices of tulips in Holland appreciated 300% in the course of a few months.
  • What I guess I am trying to say with stories like that is that sometimes investments, as we call them, tend to have a bubble-like or a mania-like quality, but that is not what our entire story here is today.
  • Even though many of you may have been informed by things like that from perusing the popular media.
  • With that said, let’s think in terms of what types of assets are we talking about? So, the first distinction that we make is between real assets and financial assets.
  • When we talk about real assets, you’re thinking about things like assets which create value.
  • Whether you thought of them for investment purposes, or otherwise, the value of these assets tends to fluctuate in terms of depending on demand and supply.
  • As opposed to real assets, which many of you may have more than passing familiarity with, my focus here today is, and in this course is, financial assets which are, really, legal claims on benefits created by those underlying real assets we were talking about.
  • Things like stocks, things like bonds, things like derivatives.
  • These assets derive value from a future claim on benefits, financial benefits that are created down the road, uncertainly, by some real asset.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > History of Stock Markets, Players, Funds > Lecture: History of Stock Markets, Players, Funds

  • Before we start thinking about financial assets, particularly equities, it might be useful to get a sense of the stock of financial assets as they exist around the globe.
  • The bulk of those assets are fixed income paper of various kinds: some of it is public debt, some of it is financial institution debt, some of it is loans either securitized or unsecuritized, but the proportion of equities as a part of the global financial asset base in terms of market capitalization alone is about 20-25 percent, historically.
  • If you look again at the chart at the Americas, obviously they are the largest chunk of the equity market base, but Asia Pacific and Europe are a pretty close second with market valuations that are kind of comparable.
  • If you think of that separation from a market’s trading type of perspective, the NYSE and the NASDAQ, which are largely American exchanges, comprise the bulk of those market capitalizations.
  • London, Japan, Shanghai, Shenzhen come in second and third place respectively, and then this is just the top ten that the slide refers to; there are other markets around the globe there are you know, all of you have heard talk of the BRIC markets, there is now recently talk of even further markets like in places in Africa, they refer to them as frontier markets now: these are all places where much more capital that is much more sensitive to, that is seeking much more risk tends to go.
  • The bulk of funds that are invested in financial assets tend to be mutual funds, pension funds, and insurance funds-all accounting for roughly about a 30 trillion base.
  • Pension funds, as the name implies and you might know already, are funds that are retirement assets from different parts of the planet, that are invested in a broad range of financial assets.
  • Some of the more recent entrants into the sovereign wealth fund space are funds in China.
  • Hedge funds are the kinds of pools of money that seek alternative investments away from the beaten sort of financial asset track.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Financial Analysts > Lecture: Financial Analysts

  • A distinction that the world sometimes makes is between sell-side and buy-side and what I think you should know, if you don’t already, is that the people that you tend to see on financial television are sell-side guys, these are people who work for investment banks and their recommendations, their research, their analyses of these financial analysts is geared towards selling stocks, rather than buying them.
  • What then continuing on with what these analysts do: they tend to listen to all kinds of news about the company, they talk to individuals who work for the firms in the industries that they specialise in, they assess the strength and weaknesses of the company’s financial picture, their relationship with suppliers, their interactions with product markets, especially, in the sort of more technically oriented sector like biotech and pharma.
  • Through the process of generating recommendations and analyst reports, they generate orders for the sales force that the investment banks employ in order to go out and sell stocks, hence sell-side.
  • How do you judge, given that there are so many different types of financial analysts out there? Different sectors, I mean, some sectors might have 20-30 analysts following the stock, one employed at each major investment bank; how do you distinguish between the recommendation of analyst A vs. analyst B? In the US, at least and I am told in other parts of the world, this kind of practice is becoming more popular.
  • The ones with the best track record of having made good recommendations, tend to be called star analysts, and they usually tend to be the ones that the investors, institutional or retail, and the media tend to go to, to follow, in terms of getting worthwhile investment advice.
  • Despite all of that, there has been historically, and there will always continue to be over time as well, some conflict-of-interest issues between the investment banks that employ these analysts to make sell-side recommendations and the other aspects of businesses that those investment banks themselves might be engaging in.
  • In the US, in the late 1990s, there was this move towards a regulation fair disclosure, where the securities in Exchange Commission of the US required analysts and firms to disclose information to the market, at the same time not to pick and choose who they selectively transferred information towards.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Role for Retail Investors > Lecture: Role for Retail Investors

  • Beat the market, again going back to that notion of relative performance, is an idea of beating some broad-based market index like the Dow Jones Industrial Average or the S&P 500- in fact, that’s the one that’s most commonly used.
  • If these institutions, with all of their technological resources and brain power and assets behind them, cannot beat the market, why should it be the case that you as individuals might even try to? In fact, the entire body of academic research on the subject, if you go and look at a lot of investments textbooks, the mantra, the prescription that they tend to make is: Look, most people don’t think you’ll be able to beat the market in the long run.
  • Why do you want to even try? You can’t beat the markets- become the market.
  • Go, hold an index fund, which is just a portfolio of assets that is invested in some broad-based index of your choice, and just let it ride; let the market do its thing, and you become the market rather than try and beat one.
  • Is there any role for active-investing, or is there any role for research that individuals might do? You know, again, all investors don’t come in one shape or size; there are all kinds: there are people who are short-term traders; there are people who are long-term investors; there are people who, short-term sometimes even means as little as a day, sometimes even a few hours, there are people who take lots of risks put for short periods of time; there are people who take little bits of risks for long periods of time.
  • What type of investor you want to be kind of does depend on a complicated amalgam of preferences, tastes, risk-taking abilities that you might possess, but as this course unfolds and as you learn more and more about the kinds of investment choices and risk profiles that are available to you, pick one that seems to fit, and as we talk through this course, I will tell you about, you know, different things that I do personally as an investor.
  • I’m not going to even pretend sitting here that you should be doing the same kinds of things.
  • For you, you should try as retail investors to pick these things up.
  • Again, I say this also partly motivated by the fact that even though we talked about financial analysts and people like that, a little while earlier, the bulk of stocks in most publicly- traded equity markets around the world do not have any analyst coverage.
  • May be homework, your homework, done diligently, done assiduously might help you discover them.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return – Review and More > Lecture: Rates of Return – Review and More: Part 1

  • With that said, let’s take a look at rates of return and more.
  • The most obvious thing, the basic thing is to think in terms of an investment of a 100 dollars that compounds over a period of one year to a value over 120, we all know how to calculate the percentage rate of return in this world that we are now learning to live in.
  • It’s sometimes called an HPR or a Holding Period Return, and it’s basically just a percentage change from a 100 to a 120 in whatever units you want to think about it, rupees, dollars, other currencies.
  • The 120 to a 100 as a capital gains return or a capital gains yield and the 5% as a dividend yield.
  • That’s how you, kind of, decompose your 25% rate of return into its two component parts.
  • In the annualized rate of return idea, let’s say you’ve agreed to borrow $9,900 and repay 10,000 in a month.
  • How do you convert that one month’s interest into an annual rate of return, and why do you do that? If you convert it as a percentage, the way we just saw how to do it, it’s actually 1.01% holding period for a holding period of one month.
  • To convert it to an annual rate, do you just multiply it by 12, or do you compound it over 12 months? The APR, which is what most credit card companies like to quote for you when you borrow money, and remember how credit card processes work, you typically repay at the end of each month some portion of your balance.
  • Then the EAR or the Equal Annual Rate of Return is a little higher.
  • Your effective rate of return, if you don’t pay out your full balance on the credit card at the end of each month, is actually what the EAR says it will be.
  • The HPR was 1.01% for that month, multiplying by 12 gave you the APR of 12.12%. The effective annual rate where you’re compounding the 1.01% over 12 months and that’s kind of a compounding formula that you all know already.
  • How do you go to multiple periods of return, would be the next question that comes along, right? So, go back to my initial example.
  • The compounding formula basically says that you have to compound at some rate of return ‘X’ over two periods.
  • That’s your annual rate of return, or a holding period rate of return for a one year period.
  • The money does not, you know, I didn’t tell you in the first slide where what happened in the intervening period in the middle here, but supposing it was appreciated by 8% to a 108, the first period and then to a 121.
  • You have 8% returns in the first period, here and 12.04% returns in the second period, compounds to 21 but the 21 is decomposed into 8 for the first and 12 for the second.
  • The geometric average, which is just another way of averaging things is to take the two individual return pieces, take a square root because it’s averaging over time now.
  • The first year, your return was a negative 50%. The second year, your return was a 100%. You take an average.
  • The geometric average is the correct one, and you can think of that as a proof that the geometric average is the best way to average returns over time.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return – Review and More > Lecture: Rates of Return – Review and More: Part 2

  • Have I actually made that money? The distinction that you want to think in terms of and we will address this along as well, is it’s when you sell something, you bought something for a 100, you sell it at 120; when you sell it, you realize a gain or loss is the situation where the stock actually dropped below a 100.
  • If I were to sell it, then I would make 20%. So, we don’t really, think in terms really of realized and unrealized at this stage of the game; it is how much something has appreciated by.
  • When it starts coming to things like paying taxes, that’s when the notion of realizing a return and paying taxes on profits, or, you know, realizing a loss and using that loss to offset other things that the notion of realization and not realization, tends to matter; so, let’s take a look at that case.
  • It’s the same example again, now, a 100 dollars that you started with or a 100 rupees compounded to the 120 except that now, the wrinkle that’s been introduced is that you have a tax rate of 30%, that you pay and it’s a tax rate that you pay as you go.
  • So you can think of a pre-tax rate of return of 10% and then after-tax rate of return of 7% for that first year.
  • Now, that you have imposed taxes and you have actually taken the game, the assumption implied in here as well, is that you reinvest that 107 back in the same stock.
  • Now, you pay taxes the second year as well but now you pay taxes on 10.70, which is the appreciation in the price.
  • So you can think of it cumulatively, a 100 goes up at 7 and again at 7 to a 114.9 or you can think of it as something compounding 10% before taxes, take out the 30% return from that, as 10 times 1 minus the tax rate and you end up with the 7% after-tax return.
  • When you account for taxes, you can either do it this way or you can do it that way.
  • Do not forget, that the assumption that’s important in here, is you go from a 100, to a 110, you pay taxes, you re-invest, you pay taxes again.
  • That’s what I think the note here says, “The assumption implicit in this calculation is that taxes are paid as you go.” If you have a tax advantage investment, say you have money in a pension fund, for people in the West, an individual retirement account or an IRA or a rollover account of any kind, that’s tax advantage and those are issues, we will get to, in a little bit.
  • Then the way that which you account for taxes tends to change a little.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return – Review and More > Lecture: Rates of Return – Review and More: Part 3

  • Another, sort of, tax wrinkle that commonly shows up and it, sort of, keep in mind this, sort of, different alternative tax characteristics of different investments that I was alluding to a little while ago.
  • In the US, the US tax laws, municipal bonds that are issued by states are exempt from federal and state taxes.
  • In my illustration here on the slide, a state of California municipal bond for a resident of that state has a yield of 6%, it is both exempt from federal taxes of 30 and state taxes of 10%. How do you compare this tax advantage bond with a corporate bond-on which you pay taxes on everything? The way you think about this, which becomes, sort of, commonplace in the business, is to think of making it, think of it in terms of a fully equivalent taxable yield.
  • You’ve got the tax advantage bond and a tax disadvantage bond.
  • In one case, you take out the taxes as appropriate and look at both of them in an after-tax sense: Both apples.
  • Or, you could put the taxes back into the one that didn’t have taxes and look at them as oranges: Pre-tax.
  • If you were to pay 40% taxes on the 6% tax advantaged bond, then its pre-tax return would be 10.
  • Let’s say if you invested a 100 dollars and it grew to a 9% return, its future value is a 109.
  • The rigorous formula for which to do this is to, sort of, take the nominal return and discount it by one plus the inflation rate.
  • A rough calculation would be to just take nine minus two and call that an real rate of return.
  • So why do I talk about taxes? Why do I talk about inflation? Think about it for a minute.
  • As investors, as retail investors, and we were alluding to this a little while earlier, you measure performance in terms of absolute values growing.
  • You measure it in terms of how much more your investment rupees or investment dollars were able to generate for you.
  • You adjust for taxes because that is the amount that you pay away as a cost of being a citizen in your country, right? So as investors, what is the number that is the bottom-line number? The bottom-line number is always the real, inflation-adjusted, or after-tax rate of return that you should…real, inflation…both real and after- tax adjusted rate of return that you should consider.
  • Of these two things think briefly for a moment about which one do you take out first? Do you take out inflation first and then take out taxes, or do you take out taxes first and then take out inflation? The obvious answer should be that in most domiciles, taxes are paid on nominal dollars, not on real dollars.
  • You take out taxes, then you take out inflation, and then you measure to see whether your investment actually increased the amount of baskets you were able to buy.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return – Review and More > Lecture: Rates of Return – Review and More: Part 4

  • But by default, I mean, you know, I think the answer is, sort of, there that if you have, if you are in a tax bracket where a tax-advantage investment makes sense for you to consider of course, you should apply that sort of principal to it.
  • There are Education IRAs, Roth IRAs, things of that sort, but I’m just starting with a plain-vanilla, basic, simple, baby IRA, if you will.
  • Just for illustrative purposes that, what would happen if you had to do taxes on both things? a) You pay taxes on the 2000 in income, and b) You pay taxes on the 12% interest that was levied on you per year.
  • Now, when both principal and interest are taxed, you’re taxed on the income at 30%. So, notice how we did amount times one minus the tax rate.
  • Imagine if you were able to put away 2,000 dollars tax free every year for those 25 years.
  • The value of the tax deferral and eventual payment of taxes would compound as well.
  • You know, by default, it’s probably the, you know, if you are eligible for IRA-type investments, it’s something that you should really consider taking advantage of.
  • There are, you know, individuals below a certain tariff bracket can avail in the US at least under tax law currently of the tax deferral benefits but beyond a certain income bracket.
  • You don’t get access to the tax with deferral of the IRA.
  • That’s what I meant earlier when I said there are different wrinkles here, but the power of the tax deferral and compounding taken together is really what the point of my illustration was.
  • One way to think about it, and this is,I would argue, the investment persons mind-set way of thinking about it is to ask the question this way.
  • Rather than say, “Look what the IRA does versus outside the IRA.” Ask the question this way, “What rate of return should I earn outside the IRA to make the two after-tax values comparable?” So, in other words, if I want to get 28,900 out of this investment, what rate of return should it compound assuming that I’m only starting with 1,400 of after-tax money? So, the 1,400 is outside the IRA.
  • What should my rate of return be? And when I calculate that, and this is simple time-value-of-money-type calculations, the X number is also after-tax now, because it’s outside the IRA, is 12.8% after-tax.
  • Adjusting for taxes, I’m playing with the same formulae, the same equation we were playing with a little while ago, just re-working them in a creative way to get you to think about how you compare different types of tax-advantaged then disadvantaged investments.
  • If you go back a couple of slides, the IRA investment had an after-tax value of 28,900.
  • Why is this significant? You’re asking for 6% per year for 25 years higher returns in order to make up for the tax disadvantage of having to invest outside the IRA.
  • There are lots of ways to skin the cat here, but the point that I want to make is just pure tax changes can be couched in different ways and I would argue to you that this kind of question, this kind of comparability is the way you should start getting your minds to work as you become investments people going forward.
  • So if you do, just to round off the IRA, kind of, story, so if you do have…if you are…if an IRA account is available to you, what types of investments would you put in it? This is a question I ask my students all the time offline as well.
  • Municipal bonds already give you a tax advantage, why would you want to hide it in a tax-advantaged instrument? You don’t need to.
  • You want to throw investments into IRAs that have tax consequences, because that’s what you get trying to share to them from, right? Stocks, if you buy stocks that don’t pay dividends, then you don’t need to hold them in an IRA, you can hold them outside.
  • Because there’s no dividend income, there’s no tax consequence, why do you want to put it in IRA, anyway? That’s exactly my point here, stocks have tax implications.
  • If you have dividends and only if you sell them, if it’s a long-term investment and you’ve got to hold them for a long period of time, you don’t have to worry about it.
  • Why do you need to put it in an IRA? But again, those are the kinds of investment choices that come along.
  • We were talking about IRAs and tax advantages of IRAs and things of that nature.

Week 1: INTRODUCING MARKETS, PARTICIPANTS AND PERFORMANCE > Rates of Return – Review and More > Lecture: Rates of Return – Review and More: Part 5

  • Let’s say, that inflation runs in this world at 3% a year, for the next 55 years from 30 onward to 85.
  • 3% a year is roughly what US inflation rates have run at, historically.
  • In other parts of the globe, of course, inflation rates are sometimes significantly higher.
  • So you would have to tweak the numbers to correspond to a more real world version of your situation.
  • With inflation thrown in at 3% a year, think about that last year of consumption when this individual is 85 years old.
  • What would $40,000 buy them at age 85? Doing the calculations, all you’re essentially doing is discounting the 40 grand of payment by 3% a year, compounded over 55 years.
  • What does it tell you? It tells you something quite surprising that in terms of today’s dollars, what cost you 7870 today, would cost you 40,000 at retirement.
  • The 40,000 is nominal, the 7870 is inflation- adjusted or real.
  • Going back to the example we did a few slides ago, building inflation into these rate of return calculations.
  • ” You know, at 3% a year, a bottle of your favorite alcohol is probably going to cost substantially more.
  • What are the real world issues that throw in there? Life expectancy, obviously people are living longer, advances in healthcare, and all of those sorts of things, inflation-adjustment, I just showed you.
  • We could rework the problem in real terms instead of assuming that this person’s salary was constant at $50,000 in nominal terms.
  • We could assume that it grew in real terms, that it grows with inflation-adjustments, so that the numbers are a little more complicated.
  • In some parts of the world, there is social security payments that factor into all of this.
  • The slide lists several recent and not-so-recent versions.
  • Get a sense of what the numbers might actually look like.
  • I know it’s a boring thing to think in terms of a long-term retirement plan, especially when you’ve just started working, as some of you probably have.
  • It’s a good exercise in terms of trying to give you a sense of reality.

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