High-Level Thoughts

A fine intro to investing if you think you can reliably beat the market or that active trading is a good use of energy. If you're already bought in on index funds though, you won't find much here.

Summary Notes

A speculator buys stocks hoping for a short-term gain over the next days or weeks. An investor buys stocks likely to produce a dependable future stream of cash returns and capital gains when measured over years or decades. (Page 28)

The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. (Page 31)

The castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 1936. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castlebuilding and then buying before the crowd. (Page 33)

A call option conferred on the holder the right to buy tulip bulbs (call for their delivery) at a fixed price (usually approximating the current market price) during a specified period. He was charged an amount called the option premium, which might run 15 to 20 percent of the current market price. An option on a tulip bulb currently worth 100 guilders, for example, would cost the buyer only about 20 guilders. If the price moved up to 200 guilders, the option holder would exercise his right; he would buy at 100 and simultaneously sell at the then current price of 200. (Page 38)

The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored. (Page 54)

Most bubbles have been associated with some new technology (as in the tronics boom) or with some new business opportunity (as when the opening of profitable new trade opportunities spawned the South Sea Bubble). The Internet was associated with both:it represented a new technology, and it offered new business opportunities that promised to revolutionize the way we obtain information and purchase goods and services. The promise of the Internet spawned the largest creation and largest destruction of stock market wealth of all time. (Page 77)

When I took out my first home mortgage, the lender insisted on at least a 30 percent down payment. But in the new system loans were made with no equity down in the hopes that housing prices would rise forever. Moreover, s0-called NINJA loans were commonthose were loans to people with no income, no job, and no assets.Increasingly, lenders did not even bother to ask for documentation about ability to pay. Those were called NO-DOC loans. Money for housing was freely available, and housing prices rose rapidly. (Page 95)

Technical analysis is anathema to much of the academic world. We love to pick on it. We have two main reasons: (1) after paying transactions costs and taxes, the method does not do better than a buy-and-hold strategy; and (2) it's easy to pick on. And while it may seem a bit unfair, just remember that it's your money we're trying to save. (Page 139)

Although there is some short-term momentum in the stock market, as will be described more fully in chapter 11, any investor who pays transactions costs and taxes is unlikely to benefit from it. (Page 140)

Human nature likes order; people find it hard to accept the notion of randomness. No matter what the laws of chance might tell us, we search for patterns among random events wherever they might occur-not only in the stock market but even in interpreting sporting phenomena. (Page 147)

By following any technical strategy, you are likely to realize short-term capital gains and pay larger taxes (as well as paying them sooner) than you would under a buy-and-hold strategy. Simply buying and holding a diversified portfolio will enable you to save on investment expense, brokerage charges, and taxes. (Page 158)

And Peter Lynch, just after he retired from managing the Magellan Fund, as well as the legendary Warren Buffett, admitted that most investors would be better off in an index fund rather than investing in an actively managed equity mutual fund. Buffett has stipulated in his will that cash from his estate be invested solely in index funds. (Page 181)

Systematic risk, also called market risk, captures the reaction of individual stocks (or portfolios) to general market swings. Some stocks and portfolios tend to be very sensitive to market movements. Others are more stable. This relative volatility or sensitivity to market moves can be estimated on the basis of the past record, and is popularly known by-you guessed it the Greek letter beta. (Page 206)

If a stock has a beta of 2, then on average it swings twice as far as the market. If the market goes up 10 percent, the stock tends to rise 20 percent. If a stock has a beta of 0.5, it tends to go up or down 5 percent when the market rises or declines 10 percent. Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive. (Page 207)

Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. Basieally, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion. (Page 227)

First and foremost, many individual investors are mistakenly convinced that they can beat the market. As a result, they speculate more than they should and trade too much. Two behavioral economists, Terrance Odean and Brad Barber, examined the individual accounts at a large discount broker over a substantial period of time. They found that the more individual investors traded, the worse they did. (Page 230)

It is this illusion of control that can lead investors to see trends that do not exist or to believe that they can spot a stock-price pattern that will predict future prices. In fact, despite considerable efforts to tease some form of predictability out of stock-price data, the development of stock prices from period to period is very close to a random walk, where price changes in the future are essentially unrelated to changes in the past. (Page 233)

One of the most important lessons of behavioral finance is that individual investors must avoid being carried away by herd behavior. (Page 239)

There was a clear disposition among investors to sell their winning stocks and to hold on to their losing investments. Selling a stock that has risen enables investors to realize profits and build their self-esteem. If they sold their losing stocks, they would realize the painful effects of regret and loss. (Page 242)

Behavioral finance specialists have found that investors tend to be overconfident in their judgments and invariably do too much trading for their own financial well-being. Many investors move from stock to stock or from mutual fund to mutual fund as if they were selecting and discarding cards in a game of gin rummy.Investors accomplish nothing from this behavior except to incur transactions costs and to pay more in taxes. Short-term gains are taxed at regular income tax rates. The buy-and-hold investor defers any tax payments on the gains and may avoid taxes completely if stocks are held until distributed as part of one's estate. Remember the advice of the legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever. (Page 251)

J. P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, "What should I do about my stocks?" Morgan replied, "Sell down to the sleeping point." He wasn't kidding. Every investor must decide the trade-off he or she is willing to make between eating well and 66 sleeping well. The decision is up to you. High investment rewards can only be achieved by accepting substantial risk. Finding your sleeping point is one of the most important investment steps you must take. (Page 304)

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