Students will be able to:
- Explain the impact that efficient markets have on attempting to correctly time the stock market and why stocks are treated as long-term investments.
In this economics lesson, students will partake in an interactive simulation of the stock market from WW II to 2001.
Today you will once again be given another chance to make millions. If you are able to time the market correctly in today’s exercise, you could end up with over $2 million dollars! Ask students “What should you keep in mind as you decide whether to invest your money in the stock market or keep it in your bank?” Discuss answers with the class.
Review the Key Statistics terms document from Part 2.
Have the students complete the Market Guru Interactive. Tell students they will each start with $1,000, and their goal will be to see how much money they can make by saving or investing in the stock market. As in Part II, the preceding five-year average will be given for the P/E ratio and the dividend yield. This will give them a historical context in which to judge these two statistics and make at least an educated guess as to whether the statistics are relatively high or low.
Once the students complete the interactive activity, have them write down the responses to the following questions (as they did for Part 2):
- How much money did you end up with?
- Did you tend to invest in the stock market or save your money in the bank more often? Explain why.
- Based on the end slide, how did you do timing the market correctly? Why might it be difficult to time the market, based on your experience today? When all students are done responding to the questions, discuss as a class their answers.
Then to conclude, recap that in Part I of this exercise, the concept of market efficiency was explained. You then had a chance to see if you could predict which way prices were going for individual stocks based on historical charts. Choosing stocks in this way is called technical analysis, and it is generally considered to be unreliable at best. How well did you do?
In Parts II and III you could choose when to invest in stocks and when to place your money in the bank. It is likely that you missed a few predictions–maybe more than a few–and your predictions here were based on records from the past. Predicting the future is even more difficult.
If you did manage to guess right more often than not, try the following exercise. Each evening, write down a prediction telling whether the Dow Jones Industrial Average is going to increase or decrease the next day. (The Dow Jones Industrial Average is an index of 30 stocks which gives an indication of how the overall stock market performed. Information on this index will be given on the front page of any business section in any newspaper.) Given my confidence in market efficiency, I am willing to predict that you will guess correctly no more than 7 out of the 10 days. A few of you may be able to guess correctly more often than that, but in these cases the good guessers might simply be lucky.
The market efficiency theory does not mean that investing in the stock market is futile. It does mean that outperforming the stock market is extremely difficult. Market efficiency is an economic good. It is extremely beneficial to investors, businesses, and to our economic growth. Businesses are assured of raising capital for building plants, expanding output, hiring workers, etc., at minimal cost. Stock investors are assured of a fair stock price and return on their investments. And economic growth is enhanced as capital flows freely from those who have excess capital to those who need it most.
Finally, I hope you have seen that although timing the stock market correctly is difficult, making money is not. If the historical returns in the stock market are any indicator of future returns, investing in the stock market over the long haul will eventually earn you your millions
Have students complete an exit ticket by answering the following questions:
- If a company reported $2 in earnings last year and its PE ratio is 15, what is its stock price?
- Assume the average PE ratio for the stock market is 28 and dividend yields are less than 2%. In the recent past, the PE ratio has averaged around 18 and the dividend yield was 4%. The Federal Reserve begins to raise interest rates. Based on these facts, do you think stock prices will rise, stay the same or fall? Why?
- PE = Price/earnings, thus Price = PE * earnings or $2 * 15 = $30.
- This was actually the situation in 2000. Stock prices were valued at very high levels relative to historical averages and when interest rates began to rise, stocks began to tumble. The bursting of the technology bubble led fuel to the fire but fundamental analysis based on PE ratios, dividend yields, and interest rates should did portend some decline in the future. Unfortunately, most people ignored these factors and thought earnings and PE ratios would continue to rise. When reported earnings begin to not meet expectations, stock prices began to fall.
Not yet satisfied with picking stocks based on the past. See how well you can do in the future by playing one of the many stock market games run on the Internet. A good place to start by trying The Stock Market Game. This is an excellent Web site to learn the fundamentals of trading stocks. Participants start out with 100,000 virtual dollars in a cash account. Game players can take the Stock Market Basics course offered and learn the techniques to research companies in order to decide which stocks to buy or sell. Sign up for the game more than once with different login names and trade different stocks in each account to test various investing strategies. Each day, the site generates a list of the players’ rankings so you can see who builds the stock portfolio with the greatest value.