Investment and Saving
20 c h a p t e r
In the last chapter on economic growth, we learned that the quantity of capital increases because of saving and investment. That is, the market for saving and investment determines the rate of growth in the quantity of capital. But how do households, businesses, and government determine their levels of investment and saving? What role do financial markets play in determining the quantity of capital and the real interest rate?
FINANCIAL MARKETS
Financial markets facilitate the interaction between households, firms, governments, banks, and other financial institutions that borrow and lend funds. In financial markets, households are the suppliers of funds and firms are the demanders. Government is a demander when it is running a budget deficit and a supplier when it is running a budget surplus. Banks and other financial institutions coordinate the plans of lenders (households) and borrowers (firms). The interest rate is determined in the financial markets.
Financial markets are global. For example, if the real interest rate is higher in England than in the United States, funds will move toward England, providing the risk factor is comparable. Lenders want to receive the highest possible real interest rate, and borrowers want to pay the lowest possible rate. The two most important financial markets are the stock market and the bond market.
STOCKS
The owners of corporations own shares of stock in the company and are called stockholders. Each stockholder's ownership of the corporation and voting rights in the selection of corporate management is proportional to the number of shares owned. Suppose a corporation has 1,000 shares of stock outstanding. If you own 10 shares, you own 1 percent of the corporation (10 is 1 percent of 1,000). Another stockholder who purchases only one share owns one-tenth as much of the corporation as you do. Therefore, she earns one-tenth the dividend income from the stock that you do and has one-tenth the number of votes that you do in annual stockholder meetings to select members of the board of directors. (The board provides overall supervision of the business and hires the management.)
Individuals and institutions buy shares of stock in the stock market, usually on one of the organized stock exchanges. The price of shares will fluctuate (often many times a day) with changes in demand and/or supply. Corporations sometimes use proceeds from new sales of stock to finance expansion of their activities.
There are actually two primary types of stock: preferred stock and common stock. Owners of preferred stock receive a regular, fixed dividend payment; the payment remains the same regardless of the profits of the corporation. No dividends can generally be paid to holders of common stock until the preferred stockholders receive a specified fixed amount per share of stock, assuming that funds are available after the debts of the corporation are paid.
Owners of common stock share in all profits remaining
after expenses are paid, including interest payments to owners of debt obligations of the corporation and dividend payments to owners of preferred stock. Dividends in common stock frequently vary with profits, often going up in years of prosperity and down in less prosperous years. If the corporation is sold or liquidated, the common stockholders receive all the corporate assets after all debts are paid and preferred stockholders are paid a fixed amount per share. Compared with preferred stockholders, owners of common stock assume greater risks because the potential rewards are greater if the company is successful.
WHO OWNS STOCK IN U.S. CORPORATIONS?
Individuals as well as institutions such as insurance companies, pension funds, mutual funds, trust departments of banks, and university and foundation endowment funds hold corporate stocks. To provide a perspective on the ease with which one can share in the ownership of a company, General Mo-
420 CHAPTER TWENTY | Investment and Saving
Financial Markets
s e c t i o n
20.1
_ What are stocks? _ What are bonds?
tors, IBM, and Microsoft have millions of individual stockholders. Indirectly, millions more are involved in stocks through their mutual funds, ownership of life insurance, vested rights in private pension funds, and so on.
BONDS
While a firm’s borrowing takes different forms (such as issuing stock or borrowing from a bank), corporations primarily borrow by issuing bonds.
The holder of a bond is not a part owner of the firm; rather, he is a creditor to whom the firm has a debt obligation. The obligation to bondholders is of higher legal priority than that of stockholders. Before the firm can pay any dividends, even to owners of preferred stock, it must meet the interest obligations to bondholders. If a firm is liquidated, bondholders must be paid the full face value of their bond holding before any disbursements can be made to stockholders. Bondholders have greater financial security than do stockholders but receive fixed annual interest payments, with no possibility to receive increased payments as the company prospers.
As a result, the bondholder is less likely to see a substantial increase in the value of his investment —a capital gain—than are stockholders.
THE STOCK MARKET
The two most important financial markets where savers can provide funds to borrowers are the stock market and the bond market. The values of securities
(stocks and bonds) sold in financial markets change with expectations of benefits and costs. For example, if people expect corporate earnings to rise, prospective stockholders increase what they would be willing to pay for the fixed amount of securities and existing stockholders become more reluctant to sell, leading to increased prices. If present business conditions and/or expectations about future profits worsen, stock prices fall. A variety of other concerns, such as the economic policies of the government, business conditions in foreign countries, and concern over inflation also influence the price of stocks (and, to a lesser extent, bonds).
During periods of rising securities markets, optimism is generally great, and businesses are more likely to invest in new capital equipment, perhaps financing it by selling new shares of stock at current high prices.
During periods of pessimism, stock prices fall, and businesses reduce expenditures on new capital equipment, partly because financing such equipment by stock sales is more costly. More shares have to be sold to get a given amount of cash, diluting the ownership interest of existing stockholders.
Can You Consistently Pick Stock Winners?
Economists have a theory about the stock market.
They call it a random walk. That is, it is very difficult, without illegal inside information or a lot of luck, to consistently pick winners in the stock market.
Not too long ago, a chimpanzee in Sweden beat that country’s top analyst by throwing darts at a newspaper that included all the listings on the Swedish Stock Exchange. The fact remains that hot tips are only hot if you are one of only a few to know if a company’s stock is going to rise. Once that news hits the street, it will cease to be a source of profit. In sum, if markets are operating efficiently, the current stock prices will reflect all available information, and consistent, extraordinary profit opportunities will not exist. Many financial analysts think that the best stock market strategy is to diversify, buying several different stocks and holding them for long periods. At least that way
Financial Markets 421
By Dwight Lee and Richard McKenzie
Did you know that buying a tall drip instead of a latte every morning saves about $1 a day? If you put that money in a mutual fund for 10 years starting at age 22, you could have $90,000 more at retirement.
Try not to gamble away your future. Did you know that, statistically speaking, you are much more likely to be struck by lightning than to win the state lotto?
Stay healthy. A 22-year-old who exercises an hour a day could be worth an additional $250,000 at retirement, thanks to lower medical bills and a longer career.
Did you know that if you were just out of college and bought a used Honda instead of an Audi TT, then took the $25,000 you saved and invested it at 8 percent, you would have an extra $800,000 at retirement?
SOURCE: Dwight Lee and Richard McKenzie, “Getting Rich in America,”
USA Weekend Magazine, August 15, 1999.
CHOICES, COSTS, AND PERSONAL FINANCE
In The NEWS
CONSIDER THIS:
Life is about tough choices and their opportunity costs.
you don’t have to continue to pay commissions on additional trades. Besides, over the long run, the stock market has historically outperformed other financial assets.
READING STOCK TABLES
Most newspapers (and many Web sites) have financial sections that cover the prices of stocks so investors can have some of the information they need to make their decisions to buy and sell stocks. Some investors (day traders) watch this data by the second because they trade in and out of stocks many times in one day. At the other extreme, some investors pick a good company and hold the stock for a long time hoping that it will give them a better return than other assets—like saving accounts. Exhibit 1 is a reproduction of the Wall Street Journal
on May 30, 2003. Let’s look at the key indicators for one stock—Coca-Cola.
The first column shows the stock price percentage change in the calendar year to date. Columns two and three show the stock’s performance over the last 52 weeks—the highest price in the second column and the lowest price in the third column.
We see that Coca-Cola has been as high as $57.50 per share and as low as $37.01.
In column four we see the name of the stock, Coca-Cola, followed by the symbol for Coca-Cola, KO. In column five is the dividend—the annual amount the company has paid over the preceding year on each share of stock. Coca-Cola paid $0.88 per share. If we divide the dividend by the price of the stock, we get the figure in the sixth column called the yield—2.0 percent.
The seventh column has the price-earnings (PE) ratio, found by taking the price of the stock and dividing it by the amount the company earned per share over the past year. The price-earnings ratio is a measure of how highly a stock is valued. A typical price-earnings ratio is around 15. If the PE ratio is higher, it means that the stock is relatively expensive in terms of its recent earnings; the stock might be overvalued, or investors expect share prices to rise in the future. A lower PE ratio means that the stock is either undervalued or that investors expect future earnings to fall.
The last three columns measure the performance of the stock on the last trading day—how many shares changed hands, the closing price, and the net change from the closing price of the previous day.
422 CHAPTER TWENTY | Investment and Saving
Reading a Stock Table SECTION 20.1
EXHIBIT 1
YTD %CHG 52-WEEK HI - LO STOCK (SYM) YLD DIV % PE VOL 100s CLOSE NET CHG
1.8 23.0 –12.0 –31.8 –32.7 27.3 12.8 57.50 26.60 24.50 2.50 19.03 36.05 59.31 37.01 16.22 16.87 1.10 7.65 24.50 44.05 CocaCola KO CC Fensa ADS KOF CocaColaEnt CCE Coeur dAMn CDE ColeNtl A CNJ ColesMyer ADS CM ColgatePalm CL .88 .42e .16 1.22e .96f 2.0 1.9 .8 ...
...
3.4 1.6 27 ...
17 dd ...
26 72081 1348 26492 10383 63 6 20622 44.62 22.01 19.12 1.31 7.67 35.65 59.14 0.46 0.01 0.51 0.02 –0.11 –0.40 –0.21
SOURCE: Wall Street Journal, May 27, 2003
© 1997 United Features Syndicate/Universal PressSyndicate
Financial Markets 423
Misinterpreting random sequences is common in sports and investing.
In both arenas, the statistical facts collide with commonsense intuition.
Every basketball player and every fan intuitively “know” that players have hot and cold streaks. When [psychologists] Thomas Gilovich, Robert Vallone, and the late Amos Tversky interviewed members of the Philadelphia 76ers, the players estimated they were about 25 percent more likely to make a shot after they had just made one than after a miss. In one survey, 9 in 10 basketball fans agreed that a player “has a better chance of making a shot after having just made his last two or three shots than he does after having missed his last two or three shots.” Believing in shooting streaks, players will feed the ball to a teammate who has just made two or three shots in a row.
The only trouble is (believe it or not), it isn’t true! When Gilovich and his collaborators studied detailed individual shooting records, they found that the 76ers—and the Boston Celtics, the New Jersey Nets, the New York Knicks, and Cornell University’s men’s and women’s basketball players—were equally likely to score after a miss and after a basket. A typical 50 percent shooter averages 50 percent after just missing three shots and 50 percent after just making three shots. It works with free throws, too. Celtics star Larry Bird made 88 percent of his free throws after making a free throw and 91 percent after missing.
Why, then, do players and fans alike believe that players are more likely to score after scoring and to miss after missing?
It’s because streaks do occur, more than people expect in random sequences. In any series of 20 shots by a 50 percent shooter (or 20 flips of a coin), there is a 50-50 chance of four baskets (or heads) in a row, and it is quite possible that one person out of five will have a streak of five or six. Players and fans notice these random streaks and so form the errant conclusion that “when you’re hot, you’re hot” (see Exhibit 2).
The same misinterpretation of random sequences occurs when investors believe that a mutual fund that has had a string of good years will likely outperform one that has had a string of bad years. Based on that assumption, investment magazines report mutual funds’ performance. But, as economist Burton Malkiel documents, past performances of mutual funds do not predict their future performance. If on January 1 of each year since 1980 we had bought the previous year’s top-performing funds, our hot funds would not have beaten the next year’s market average. Putting our money instead on the Forbes “Honor Roll” of funds each year would have gotten us an annual return over nearly two decades since 1975 of 13.5 percent (compared with the market’s overall 14.9 percent annual return). Of the top 31 Canadian funds during 1994, 40 performed above average and 41 below average during 1995.
“Randomness is a difficult notion for people to accept,” notes Malkiel. “When events come in clusters and streaks, people look for explanations and patterns. They refuse to believe that such patterns—which frequently occur in random data— could equally well be derived from tossing a coin.”
The point to remember: When watching basketball, choosing stocks, or flipping coins, remember that our intuition often misleads us. Random sequences frequently don’t look random.
Expect streaks.
SOURCE: David Myers, Psychology, 6th ed. (New York: Worth Publishers, 2001), p. 30.
HOT AND COLD STREAKS IN BASKETBALL AND THE STOCK MARKET
Who Is on Fire? SECTION 20.1
EXHIBIT 2
Here are 21 consecutive shots, each scoring either a basket or a miss, by two players who each make 11 baskets. Within this sample of shots, which player’s sequence looks more like what we would expect in a random sequence?
Player 1 Player 2
424 CHAPTER TWENTY | Investment and Saving
1. Corporate ownership and voting rights are dispersed among stockholders and are based on the proportion of shares owned.
2. Stock shares are bought and sold in an organized exchange—a stock market—with fluctuations in prices based on supply and demand.
3. Two different types of stock can be issued: preferred stocks and common stock.
4. Stockholders can consist of millions of individuals and institutions that hold an ownership stake in a corporation.
5. Bonds are a financial instrument used by corporations to raise money by promising to repay the amount borrowed and pay the holder fixed annual interest payments.
6. The expectation of future profits, as well as government economic policies, foreign market conditions, and inflation concerns influence the price of securities.
7. Investors obtain information about stocks from published stock tables that help them make purchasing and selling decisions.
8. Price tracking, dividends, and price-earnings ratio figures provide investors with indicators of the value of stock.
1. In financial markets, who are the primary suppliers and who are the primary demanders?
2. Why are financial markets appropriately considered to be global in scope?
3. Who has more voting rights in determining a corporation’s policy—an owner of 1% of the common stock or an owner of 10% of the corporation’s bands? Who is a larger owner of the corporation?
4. If you believed a company’s profitability was about to jump sharply, would you rather own bonds, preferred stock, or common stock in that company?
5. If almost all investors expected the profits of a company to jump sharply, would that make purchasing the stock today unusually profitable?
6. Why are issues of new stocks to finance business investments more common in periods of high and rising stock prices?
7. What are some of the reasons that stock prices rise and fall?
8. What is the random walk?
9. What is a dividend?
10. How do you calculate a price-earnings ratio?
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A brutal six months led to the worst showing for investment professionals in the 10-year history of the column’s stock picking contest—an average loss of 53 percent. The best of the four pro picks dropped 22 percent between July 11 and December 29, 2000. The worst plunged an eye-popping 90 percent.
Wall Street Journal readers didn’t do much better. The four readers, whose picks were selected at random from among e-mail submissions to WSJ.com, posted an average 43 percent drop. However, a portfolio of stocks chosen by flinging darts at the stock tables did the best, falling only 11percent.
SOURCE: The Wall Street Journal, January 11, 2001, page C1.
EXPERTS, DARTS, READERS TAKE A DRUBBING
If we put the investment demand for the whole economy and national savings together, we can establish the real interest rate in the investment and saving market. We begin by revisiting investment, and then follow with the introduction of the saving supply (SS) curve and equilibrium.
Exhibit 1 shows the investment demand (ID) curve for all the firms in the whole economy. The investment demand curve is downward sloping, reflecting the fact that investment spending varies inversely with the real interest rate—the amount borrowers pay for their loans. At a high real interest rate, firms will only pursue those few investment activities that have even higher expected rates of return.
As the real interest rate falls, additional projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises. In other words, the investment demand curve shows the dollar amount of investment forthcoming at different real interest rates. Because lower interest rates stimulate the quantity of investment demanded, governments often try to combat recessions by lowering interest rates.
SHIFTING THE INVESTMENT DEMAND CURVE
Several other determinants will shift the investment demand curve. If firms expect higher rates of return on their investments for a given interest rate, the ID
curve will shift to the right, as seen in Exhibit 2. If firms expect lower rates of return on their investments for a given interest rate, the ID curve will shift to the left, also seen in Exhibit 2. Possible investment demand curve shifters include changes in technology, inventory, expectations, or business taxes.
Investment Demand and Saving Supply 425
Investment Demand and Saving Supply
20.2
_ What is the investment demand curve?
_ What is the saving supply curve?
_ How is the real interest rate determined?
0 r1
r3
r2
Q2 Q1 Q3
Real Interest Rate, r (expected rate of return)
ID
Quantity of Investment (billions of dollars)
A C B
A B An increase in the real interest rate will lower the quantity of investment demanded.
A C A decrease in the real interest rate will raise the quantity of investment demanded.
The Investment Demand Curve
SECTION 20.2
There is an inverse relationship between the real interest rate and the quantity of investment demanded. At a higher real interest rate, firms will only pursue investment activities that have the highest expected return, and the quantity of investment demanded falls—a movement from point A to point B. As the real interest rate falls, projects with lower expected returns become potentially profitable for firms, and the quantity of investment demanded rises—a movement from point A to point C.
0 Q3
ID1 ID2
Q1 Q2
Real Interest Rate, r (expected rate of return) Quantity of Investment (billions of dollars)
A B C
A B An increase in the expected profit rate A C A decrease in the expected profit rate
ID3
r1
Shifts in the Investment Demand Curve
Investment demand depends on the expected rates of return.
For example, a higher expected profit rate causes an increase in investment demand, shifting the ID curve to the right from point A to point B. A lower expected profit rate causes a decrease in investment demand, shifting the ID curve to the left from point A to point C. Any change in technology, inventory, expectations, or business taxes can cause the investment demand curve to shift.
Technology
Product and process innovation can cause the ID
curve to shift rightward. For example, the development of new machines that can improve the quality and the quantity of products or lower the costs of production will increase the rate of return on investment, independent of the interest rate. The same is true for new products like handheld computers, the Internet, genetic applications in medicine, or HDTV. Imagine how many different firms increased their investment demand during the computer revolution.
Inventories
When inventories are high and goods are stockpiled in warehouses all over the country, there is a lower expected rate of return on new investment—the ID
curve shifts to the left. Firms with excess inventories of finished goods have very little incentive to invest in new capital. Alternatively, if inventories become depleted below the levels desired by firms, the expected rate of return on new investment increases as firms look to replenish their shelves to meet the growing demand—the ...
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