INSEAD Library

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Stocks for the long run Stocks for the long run Foreword xv Preface xvii Acknowledgments xxi PART 1 THE VERDICT OF HISTORY Chapter 1 Stock and Bond Returns Since 1802 3 "Everybody Ought to Be Rich" 3 Financial Market Returns from 1802 5 The Long-Term Performance of Bonds 7 The End of the Gold Standard and Price Stability 9 Total Real Returns 11 Interpretation of Returns 12 Long-Term Returns 12 Short-Term Returns and Volatility 14 Real Returns on Fixed-Income Assets 14 The Fall in Fixed-Income Returns 15 The Equity Premium 16 Worldwide Equity and Bond Returns: Global Stocks for the Long Run 18 Conclusion: Stocks for the Long Run 20 Appendix 1: Stocks from 1802 to 1870 21 Appendix 2: Arithmetic and Geometric Returns 22 Chapter 2 Risk, Return, and Portfolio Allocation: Why Stocks Are Less Risky Than Bonds in the Long Run 23 Measuring Risk and Return 23 Risk and Holding Period 24 Investor Returns from Market Peaks 27 Standard Measures of Risk 28 Varying Correlation between Stock and Bond Returns 30 Efficient Frontiers 32 Recommended Portfolio Allocations 34 Inflation-Indexed Bonds 35 Conclusion 36 Chapter 3 Stock Indexes: Proxies for the Market 37 Market Averages 37 The Dow Jones Averages 38 Computation of the Dow Index 39 Long-Term Trends in the Dow Jones 40 Beware the Use of Trend Lines to Predict Future Returns 41 Value-Weighted Indexes 42 Standard and Poor's Index 42 Nasdaq Index 43 Other Stock Indexes: The Center for Research in Security Prices (CRSP) 45 Return Biases in Stock Indexes 46 Appendix: What Happened to the Original 12 Dow Industrials? 47 Chapter 4 The SandP 500 Index: A Half Century of U S Corporate History 51 .. Sector Rotation in the SandP 500 Index 52 Top-Performing Firms 58 How Bad News for the Firm Becomes Good News for Investors 60 Top-Performing Survivor Firms 61 Other Firms That Turned Golden 62 Outperfonnance of Original SandP500 Firms 63 Conclusion 64 Chapter 5 The Impact of Taxes on Stock and Bond Returns: Stocks Have the Edge 65 Historical Taxes on Income and Capital Gains 66 A Total After-Tax Returns Index 66 The Benefits of Deferring Capital Gains Taxes 69 Inflation and the Capital Gains Tax 70 Increasingly Favorable Tax Factors for Equities 72 Stocks or Bonds in Tax-Deferred Accounts? 73 Conclusion 74 Appendix: History of the Tax Code 74 Chapter 6 The Investment View of Stocks: How Fickle Markets Overwhelm Historical Facts 77 Early Views of Stock Investing 79 The Influence of Smith's Work 80 Common Stock Theory of Investment 82 A Radical Shift in Sentiment 82 The Postcrash View of Stock Returns 83 The Beginning of the Great Bull Market 85 Warnings of Overspeculation 86 The Top of the Bubble 88 The Bear Market and Its Aftermath 89 PART 2 VALUATION, STYLE INVESTING, AND GLOBAL MARKETS Chapter 7 Stocks: Sources and Measures of Market Value 95 An Evil Omen Returns 95 Valuation of Cash Flows from Stocks 97 Sources of Shareholder Value 98 The Value of Stock as Related to Dividend Policy 100 Earnings Concepts 102 Earnings Reporting Methods 102 The Employee Stock Option Controversy 104 Controversies in Accounting for Pension Costs 105 Standard and Poor's Core Earnings 107 Earnings Quality 108 Downward Biases in Earnings 109 Historical Yardsticks for Valuing the Market 110 Price-Earnings Ratios 110 The Fed Model, Earnings Yields, and Bond Yields 113 Corporate Profits and National Income 115 Book Value, Markef Value, and Tobin's Q 117 Markef Value Relative to the GDP and Other Ratios 219 Conclusion 121 Chapter 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave 123 GDP Growth and Stock Returns 124 The Gordon Dividend Growth Model 126 Economic Growth and Stock Returns 127 Factors That Raise Valuation Ratios 128 Factors That Impact Expected Returns 129 The Equity Risk Premium 130 More Stable Economy 131 New Justified P-E Ratios 132 The Age Wage 133 Demography Is Destiny 134 The Bankruptcy of Government and Private Pension Systems 135 Reversal of a Century-Long Trend 135 The Global Solution: A n Opportunity to Make a Trade 136 Capital 137 Attraction of US. Conclusion 138 Chapter 9 Outperforming the Market: The Importance of Size, Dividend Yields, and Price-to-Earnings Ratios 139 Stocks That Outperform the Market 139 Small- and Large-Cap Stocks 141 Trends in Small-Cap Stock Returns 142 Valuation 144 Value Stocks Offer Higher Returns Than Growth Stocks Dividend Yields 145 Other Dividend Yield Strategies 247 Price-to-Earnings (P-E) Ratios 149 Price-to-Book Ratios 150 Combining Size and Valuation Criteria 152 Initial Public Offerings: The Disappointing Overall Returns on New Small-Cap Growth Companies 154 The Nature of Growth and Value Stocks 157 Explanations of Size and Valuation Effects 157 The Noisy Market Hypothesis 158 Conclusion 159 Chapter 10 144 Global Investing and the Rise of China, India, and the Emerging Markets 161 The World's Population, Production, and Equity Capital 162 Cycles in Foreign Markets 164 The Japanese Markef Bubble 165 The Emerging Market Bubble 166 The New Millennium and the Technology Bubble 167 Diversification in World Markets 168 Principles of Diversification 168 "Efficient" Portfolios: Formal Analysis 168 Should You Hedge Foreign Exchange Risk? 173 Sector Diversification 2 73 Private and Public Capital 177 The World in 2050 178 Conclusion 182 Appendix: The Largest Non-U.S.-Based Companies 182 PART 3 HOW THE ECONOMIC ENVIRONMENT IMPACTS STOCKS Chapter 1 1 Gold, Monetary Policy, and Inflation 187 Money and Prices 189 The Gold Standard 191 The Establishment of the Federal Reserve 191 The Fall of the Gold Standard 192 Postdevaluation Monetary Policy 193 Postgold Monetary Policy 194 The Federal Reserve and Money Creation 195 How the Fed's Actions Affect Interest Rates 196 Stocks as Hedges against Inflation 199 Why Stocks Fail as a Short-Term Inflation Hedge 201 Higher Interest Rates 201 Nonneutral Inflation: Supply-side Effects 202 Taxes on Corporate Earnings 202 lnflationay Biases in lnterest Costs 203 Capital Gains Taxes 204 Conclusion 205 Chapter 12 Stocks and the Business Cycle 207 Who Calls the Business Cycle? 208 Stock Returns around Business Cycle Turning Points 211 Gains through Timing the Business Cycle 214 How Hard Is It to Predict the Business Cycle? 216 Conclusion 219 Chapter 13 When World Events Impact Financial Markets 221 What Moves the Market? 223 Uncertainty and the Market 226 Democrats and Republicans 227 Stocks and War 231 The World Wars 231 Post-1945 Conflicts 233 Conclusion 235 Chapter 14 Stocks, Bonds, and the Flow of Economic Data 237 Economic Data and the Market 238 Principles of Market Reaction 238 Information Content of Data Releases 239 Economic Growth and Stock Prices 240 The Employment Report 241 The Cycle of Announcements 243 Inflation Reports 244 CoreInflation 245 Employment Costs 246 Impact on Financial Markets 246 Central Bank Policy 247 Conclusion 247 PART 4 STOCK FLUCTUATIONS IN THE SHORT RUN Chapter 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options 251 Exchange-Traded Funds 252 Stock Index Futures 253 Basics of the Futures Markets 255 Index Arbitrage 257 Predicting the New York Open with Globex Trading 258 Double and Triple Witching 260 Margin and Leverage 262 Using ETFs or Futures 261 Where to Put Your Indexed Investments: ETFs, Futures, or Index Mutual Funds? 262 Index Options 264 Buying Index Options 266 Selling Index Options 267 The Importance of Indexed Products 267 Chapter 16 Market Volatility 269 The Stock Market Crash of October 1987 271 The Causes of the October 1987 Crash 273 Exchange-Rate Policies 274 The Futures Market 275 Circuit Breakers 276 The Nature of Market Volatility 277 Historical Trends of Stock Volatility 278 The Volatility Index (VIX) 281 Recent Low Volatility 283 The Distribution of Large Daily Changes 283 The Economics of Market Volatility 285 The Significance of Market Volatility 286 Chapter 17 Technical Analysis and Investing with the Trend 289 The Nature of Technical Analysis 289 Charles Dow, Technical Analyst 290 The Randomness of Stock Prices 291 Simulations of Random Stock Prices 292 Trending Markets and Price Reversals 294 Moving Averages 295 Testing the Dow Jones Moving-Average Strategy 296 Back-Testing the 200-Day Moving Average 297 The Nasdaq Moving-Average Strategy 300 Distribution of Gains and Losses 301 Momentum Investing 302 Conclusion 303 Chapter 18 Calendar Anomalies 305 Seasonal Anomalies 306 The JanuaryEffect 306 Causes of the January Effect 309 The January EfJect Weakened in Recmt Years 310 Large Monthly Returns 311 The September Effect 311 Other Seasonal Returns 315 Day-of-the-Week Effects 316 What's an Investor to Do? 318 Chapter 19 Behavioral Finance and the Psychology of Investing 319 The Technology Bubble, 1999 to 2001 320 Behavioral Finance 322 Fads, Social Dynamics, and Stock Bubbles 323 Excessive Trading, Overconfidence, and the Representative Bias 325 Prospect Theory, Loss Aversion, and Holding O n to Losing Trades 328 Rules for Avoiding Behavioral Traps 331 Myopic Loss Aversion, Portfolio Monitoring, and the Equity Risk Premium 332 Contrarian Investing and Investor Sentiment: Strategies to Enhance Portfolio Returns 333 Out-of-Favor Stocks and the Dow 10 Strategy 335 PART 5 BUILDING WEALTH THROUGH STOCKS Chapter 20 Fund Performance, Indexing, and Beating the Market 343 The Performance of Equity Mutual Funds 342 Finding Skilled Money Managers 346 Persistence of Superior Returns 348 Reasons for Underperformance of Managed Money 348 A Little Learning Is a Dangerous Thing 349 Profiting from Informed Trading 349 How Costs Affect Returns 350 The Increased Popularity of Passive Investing 351 The Pitfalls of Capitalization-Weighted Indexing 351 Fundamentally Weighted versus Capitalization-Weighted Indexation 353 The History of Fundamentally Weighted Indexation 356 Conclusion 357 Chapter 21 Structuring a Portfolio for Long-Term Growth 359 Practical Aspects of Investing 360 Guides to Successful Investing 360 Implementing the Plan and the Role of an Investment Advisor 363 Concluding Comment 364 Index 367