Ch. 7:  Stock Investing with Index Funds

Chapter 7:  Stock Investing with Index Funds

7.0 Introduction

            In chapter 5, I laid out the general principles of stocks and what drives price changes in the market.  In that chapter, we learned a few key features:

1.       Stock prices usually rise:  As a species, we tend to get more productive over time.  As we get more productive, firms find ways to generate more profit, leading to higher stock prices.

2.       The market is forward-looking:  Investors make trades today based on the expectations of company profits far into the future.

3.       The market is risky:  Over a short time-horizon, the stock market is very unpredictable.

4.       Predicting the market is (almost) impossible.  It’s best to behave as if it is literally impossible to predict.

We can now apply these principles to build a sound investment strategy. 

7.1 Making Transactions

  You will make many stock transactions during your lifetime. Some transactions will happen within a tax-sheltered account like a 401(k) or health savings account (HSA).  You’ll just choose a contribution amount (e.g. $250 per paycheck) and your investment vendor will handle the rest.  These tax-sheltered accounts are great because of, you know, the tax sheltering that they offer.  But the downside is such investment accounts have many restrictions.  For example, you cannot withdraw from a 401(k) account until you are 59.5.[1]  A 401(k) is great for retirement planning, but if you are trying to save $50,000 for a downpayment on a house, a 401(k) is probably not a reasonable option.

  You will use tax-sheltered accounts, no doubt.  But you will also invest through a brokerage account.  A brokerage account (sometimes called a “taxable account”) has no tax shelter (bad) but provides the investor with more flexibility (good).  A few weeks ago, I had to unexpectedly replace my air-conditioning unit.  Using my brokerage account, I was able to withdraw $14,000 (sigh) and make the necessary payment.  Brokerage accounts provide liquidity, which is something we all need. 

  In your brokerage account, you will be the one making transactions, but it’s not too difficult.  There are only two types of transactions you need to make, buys and sells.[2]  When you make a purchase, you can do so at the “market price” or create a “limit order”.  A purchase at the market price means that you are buying stock right now at the current price.  This is called a market order. When you execute the order, the exact price is not certain since it takes a few moments for your order to go through.  So there is a tiny chance that the price could rise immediately after you make the buy-decision, and you will be forced to buy shares at an unexpectedly high price.  Nonetheless, my lazy ass always chooses this method.  I’m cool with buying at whatever price the market currently sees fit.  To avoid risk, you could instead buy at a price limit, making a limit order.  Your order will only be executed if you are able to buy at a price that is at or below this limit.  In my opinion, limit orders are only necessary when you are buying shares of a stock that are currently experiencing extreme volatility.

  Let’s look at an example.  Say you want to buy ten shares of Citigroup (ticker symbol: C), which is trading at $53.95.  If you make a buy order at the market price, you will pay whatever is the current price at the time your order goes through—this price will likely be very close to $53.95.  Thus, you will pay about $539.50 to buy ten shares.  Or, you could make a limit order to buy ten shares with a limit price of $55/share.  Unless the price rises above $55 very quickly, this order will also be processed at the current price of about $53.95.  If the price suddenly spikes to $56/share, your order will not be processed, and you will not spend any money or buy any shares.

  A similar process occurs when you sell shares.  You can sell at the market price or set a limit price—in this class, the limit will be below the market price.  For example, if you own 10 shares of Citigroup, which has a current price of $55.95, you could sell at the market price and the order would be executed almost immediately at the market price.  Or you could sell at a limit price of $55 and the order would executed as long as the market price is above $55 when the trade is executed.  These general principles apply with stocks and other funds that contain stocks, like mutual funds and index funds.

7.2 The Efficient Market Hypothesis

            As far as hypotheses go, there are few that have garnered as much attention as the efficient market hypothesis (EMH).  The efficient market hypothesis is an unprovable theory that the price of all stocks is efficient.  If EMH is true, investors cannot predict what will happen to individual stocks (or the stock market as a whole).  The developer of EMH, Eugene Fama, was awarded the Nobel Prize for his work.  It’s a big deal.

            Understanding EMH is key to being a good investor (even if you don’t fully believe the hypothesis is valid).  At the time of writing, the share price of Microsoft is $400.  Let’s think about the information that is inherent to this price.  As we learned in chapter 5, the market returns about 10% annually (but is volatile).  What would be a good guess for Microsoft’s stock price in one year?  Suppose we knew the price would be $420 in one year.  This would make Microsoft a weak investment as one would only earn a 5% return over the next year.  Investors would want to sell shares of this lackluster stock, leading to lower prices.  What if, instead, we knew the share would be worth $480 in one year?  This would make Microsoft a great investment, rewarding investors with a 20% return.  Investors would want to buy shares, driving the price up.  Let’s now invert our logic.  If the price of Microsoft is $400 today, then what do investors expect Microsoft to be worth in the future?  If investors require a 10% return to make an investment worthwhile, then they must expect the price to be $440 in one year.[3]   The price of a stock is a prediction of what the price will be in the future. 

            Microsoft’s current stock price is based on the collective wisdom of millions of investors, some of whom are constantly tracking the goings-on of the company.  The price—$400—represents the buying and selling of an entire market.  Millions of brains and all the available data led to this price.  When you say something like, “I think Microsoft stock is about to plummet”, what I hear is, “I think I know more than millions of brains.” 

            Similarly, there is only one appropriate answer to the question that I often get, “What do you think is going to happen in the stock market?”  The answer is always, “I don’t know”.  If investors believed stock prices were going to sharply rise in the near future, they would buy shares now (driving up the price).  If they believe prices will soon plummet, they will sell shares (causing price to drop now).  The current price already reflects all these beliefs and actions and anyone that thinks they know what will happen to the market is saying they believe they know more than everyone else.  It’s an embarrassingly arrogant position to take.

            Some try to invalidate the EMH by pointing out extreme events in the market.  For example, in 2021, Gamestop (GME) stock rose from $1/share to $500/share in less than one month.[4]  But such a huge price increase is consistent with EMH!  When prices can rise so dramatically, it just goes to show how unpredictable the market can be.  If investors were able to predict the future, massive changes in share prices would not occur.  The “efficient” part of EMH, doesn’t mean the market operates perfectly or predictably.  It just means that no one can consistently predict what will happen with future prices.

            Truth be told, we cannot prove that the EMH is valid (or invalid).  Unlike the “theory of gravity”, which can be demonstrated to be true, the EMH cannot be proven true or false.[5]  But there are reasons to believe that the EMH is a nice approximation of reality.  Specifically, we know that most active investors fail to beat the market.  If markets are inefficient (meaning that investors could beat the market consistently), then those with more information (professionals) should be able to gain an edge.  But, almost every year, those that try to beat the market perform worse than the market.  The market must be super difficult to predict.  Proponents of EMH use passive management, allowing their funds to be invested on a value-weighted basis across all companies in a given index.  For example, you might invest in a passively managed fund that contains all US tech stocks or all stocks in the entire world!  Investors using passive management are intentionally performing at the average-level, which is good enough to beat most active managers. 

            EMH is hotly-debated and there are plenty of smart people that believe EMH is not fully correct in explaining the inner workings of the market.  From an academic standpoint, these arguments are fascinating and worthy of discussion.  But as an individual investor, this debate is of no use.  It is my strongly-held belief that you will be a better investor if you behave as if EMH is completely valid.  You aren’t special.  You can’t predict the market.  But that’s fine, you can still get rich. 

7.3 Sound Investments (US)

            Using EMH as a starting point, we can painlessly build an investment thesis.  Generally speaking, investors should expect that all stocks, on average, will offer a return that is at the market-level.  Let’s make sure we understand.  If investors believe the market will offer a 10% return, then the current price of all stocks must be aligned with this belief.  If the current price of Church and Dwight (CHD) is $100 today and investors expect the market as a whole to return 10%, then investors must collectively believe the share price of CHD will be about $110 in one year.[6]  If investors expected the price to rise to $120 next year, then the price today would not be $100! 

  But each stock is extremely risky.  While investors expect the CMD price to be $110 next year, investors also know that reality is unlikely to perfectly match expectations.  Perhaps there is a 50% chance that the price will rise to $220 and a 50% chance the stock will be worth nothing—this is consistent with a $100 price today.  If the stock market returns 10% annually, as a whole, then the average return of each individual stock must be 10%.[7]  

  Let’s consider two investors.  One investor (Pierce) buys $100,000 worth of one company’s stock.  The other investor (Ellie) spends $100,000, buying shares in 50 different firms.  What is the expected return of Pierce’s stock?  10%.  What is the expected return of Ellie’s portfolio?  Also 10%.  But Pierce takes on more risk without generating any extra return!  This useless risk—the type that doesn’t generate extra returns—is called idiosyncratic risk.  Risk that is necessary to generate more return is called systematic risk.  An investor’s goal should be to only have systematic risk.  Investing in stock is always more risky than putting your money into a savings account, but the extra risk is rewarded with higher returns.  However, Pierce’s extra risk is not rewarded.  He earns the same expected return as Ellie but does so without extra compensation.  Let’s go ahead and the beat the dead horse… take a look at the table below.

The more one diversifies, the less risk they will have.  One can only achieve the goal of completely eliminating idiosyncratic risk if they fully diversify by buying shares of all firms.[8]

            Buying shares in thousands of different firms sounds like a daunting task.  Thankfully, there are financial assets that allow investors to buy shares of many, perhaps even all, companies with just one purchase—index funds.  Index funds (which we have defined before, but screw it…) are financial assets that track the performance of an index.  The choice of which stocks to buy is not made by a fund manager, but rather is based on rules set forth by the index fund when it is created.  Because they are so easy to manage, index funds usually charge low fees.  A simple one is the S&P 500, which mirrors the performance of the S&P 500 Index.  If you invest $100 in an S&P 500 Index fund, you are buying the 500 largest US corporations on a value-weighted basis. 

The table provides the name and ticker symbols of five different S&P 500 Index Funds, along with expense ratios and the fund’s performance over the last ten years.  The final column shows the future value of $1,000 invested today if the S&P 500 grows 10% annually, before fees. 

  Looking at the table, you might be asking yourself, why would anyone choose the last two funds?!  For one, financial advisors and other money managers may receive a kickback from the fund if they sell this fund to their clients.[9]  But even you may end up investing in such bad funds.  If you work for a company that offers a 401(k), SPICX might be the best turd in a pile a dogcrap options.  On average, an S&P 500 Index fund with a 1.28% expense ratio is still better than a mutual fund with a 1.28% expense ratio.  As an employee, you might try to fight for better index fund options, but the firm may be unwilling or unable (under a long-term contract with their current vendor) to change their offerings.  The last column shows the impact of said fees.  This is not a novel concept to this e-book, but it’s worth revisiting.  Fee-avoidance is one of the key principles of personal financial planning.

***Index funds do not perfectly match the S&P 500.  These index funds may need to hold some cash in order to quickly payout clients that withdraw funds.  Also, to match the index perfect, these funds would need to constantly buy and sell shares as prices of stocks rise and fall. This is not possible.  Because of factors like these, it’s possible for a fund like VOO to outperform SWPPX, which charges a lower fee.  This is not an important issue, so don’t waste any brain cells thinking about it further.***

  S&P 500 Index funds get a lot of attention, but there is nothing particularly special about them, aside from their ubiquity in tax-sheltered accounts, like 401(k) plans.  Personally, I’d like to diversify as much as possible.  Total stock market index funds track the entire US stock market on a value-weighted basis.  So, it’s the S&P 500 plus mid-caps and small-caps.  Because the S&P 500 stocks make up 80% of the entire US stock market’s market cap, the performance of S&P 500 funds and total stock market funds will be similar.  Nonetheless, I’d rather have more diversification than less, and I’d like to have exposure to smaller firms, which have, historically, generated a slightly higher return than large caps.[10]  Here are few great examples.

There are other fine vendors out there, but Fidelity, Schwab, and Vanguard are hard to beat.  Frankly, I feel privileged to be able to buy these investments.  These gloriously lost-cost index funds were not widely available a few decades ago.  In 2023, passively managed fund hold more assets under management (invested money) than actively managed mutual funds.[11]  The public is catching-on!

            7.4 Sound Investments (International)

            You xenophobic little devil, you… you thought you could get away with just investing in US stocks?  Well, you aren’t alone.  Jack Bogle, founder of Vanguard and developer of the first publicly available index fund, argued that investors need-not invest internationally.  Since US firms can sell overseas, Bogle argued, investing in the US is effectively investing in the world.  There’s some logic there, but I also think Bogle, rest his soul, is showing a behavioral bias.  If Jack Bogle were, say, a resident of Japan, do you think he would have the same investment philosophy?  I seriously doubt it.  I’m sure he would have bought Japanese stock. 

            There is no perfect answer to how much international stock one can buy.  Hell, there isn’t really even a straightforward academic stance one can take.  But we can discuss the pros and cons.  One of the greatest advantages of investing in international stocks is to reduce risk.  While the US stock market is correlated with international stocks, it’s not a perfect correlation, so mixing-in some international stocks with your domestic equity can ease your portfolio’s volatility.  But you don’t want to overdo it.  The international stock market is more volatile than the US, so investing, say, 60% internationally, is actually riskier than a US-only portfolio.  To minimize risk, while still earning a high return, one might consider a portfolio with 75% US and 25% international.[12]  However, this isn’t a portfolio mix that I can steadfastly recommend.  Since US stocks have outperformed international stocks over the last 30 years, one could argue to invest 100% in US stocks.   But if we’re going to make that case, why not invest 100% in Australian stock, which has outperformed the US since 1900?[13] 

            Personally, I don’t want to get into the trap of chasing historical returns.  Foreign stocks could outperform US stocks over the next 10 years, just as they did during the first decade of the 21st century.  Like many investors, I have trouble landing on an ethos.  About 15% of my portfolio is held in international stocks and I don’t have a great explanation as to why I’ve chosen this specific allocation.  I know I want some international assets in my portfolio. 

           To make things even more muddled, investing internationally creates unique and surprisingly complex tax concerns.  For example, if I buy shares of National Australia bank, dividends from the stock will be taxed by the Australian government.  But then I am eligible to receive a US tax credit for paying a foreign tax.  However, I may also be subject to pay state taxes on the foreign investment earnings.  The relative taxes you will pay by investing internationally vs. domestically depends on your income, the country of the foreign investment, whether your investment is held in a tax shelter or a brokerage account, and your state of residence.  It’s a convoluted mess and I’m not even going to pretend to act like I understand it all.  From my readings, it appears that there isn’t too much of a tax difference between US and international investing for most.  But if you have a very high income, this may deserve more attention.

           If you want to invest in foreign stocks, there are some great index funds available, such as those shown below.  But, be forewarned that sound foreign index funds are often unavailable in employer-provided tax-sheltered accounts like 401(k) plans.  So, if you want to invest in these funds, you might have to do so in a brokerage account.

Note that the last ten years have not been kind to international stocks.  But history has no obligation to repeat itself. 

  If you really want to simplify the process, you could find an investment fund that combines US and international stocks—a world stock market index fund.  There aren’t many of these funds available and you are very unlikely to find such an offering in a 401(k).  Vanguard offers a few, such as the Vanguard Total World Stock Index Admiral (VTWAX).  Investing in VTWAX means you are buying the entire global stock market on a value-weighted basis (expense ratio = 0.10%).  Since one could effectively achieve the same portfolio by buying two funds (one US index fund and one international index fund), and pay a lower overall expense ratio, I’m not sure that there is any strong argument for using VTWAX.  But you could do A LOT worse. 

7.6 Sound Investments (Target Date Funds)

            We aren’t prepared to fully have this discussion yet, but another fantastic asset that you might consider buying is a target date fund.  Target date funds contain US and international stocks as well as domestic and foreign bonds—you’re getting a little bit of everything.  As you age, the fund automatically adjusts towards more bond ownership to reduce risk.  These are great set-it-and-forget-it funds to buy, which will be fully described in chapter 9.

7.7 Conclusions and a word from Warren Buffett

            In this chapter, I gave you lots of suggestions on what to buy.  Many stock funds are crap.  Knowing how to find the good ones is important, but avoiding the sucky investment funds is even more useful.  In your 401(k) plan (or whatever tax shelter you have), you may find that not a single investment listed in this chapter is available to purchase.  You need to develop the skills to slog through all the options and find the best one (or the least-worst).  Before you accept a job, learn about the employer’s benefits and investment options.  One day you will be a millionaire—how fast you get there will largely depend on your investment choices you make in your 20s and 30s.

            One final note… Some choose to invest in individual stocks—buying shares of individual stock.  Unless you have some special ability to beat the market (I can’t rule out this possibility), then buying individual shocks is probably not a reasonable choice.[14]  The average performance of individual stocks is the same as the performance of the entire market.  If the market returns 10%, then individual stocks will, on average earn 10%.  But, the fewer companies you own, the more risk you will have.  To minimize risk while still earning market returns, index funds are your best option.  I have plenty of students that insist upon trading individual stocks.  Some do so simply because they enjoy it and I have no fundamental problem with that (I play around with individual stocks myself)!  But others think they really do have an edge in investing.  I’m afraid that it will take a painful lesson for many of these irrationally confident to see the light. 

            If you won’t listen to me, maybe you’ll at least consider the advice of Warren Buffett, famed investor and CEO of Berkshire Hathaway.  In a letter to shareholders of his company, Buffet once wrote,

By periodically investing in an index fund (…) the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.[15]

As a person that is frequently forced to acknowledge his own limitations, I really identify with this quote.  When it comes to stock investing, accepting average performance is a key step on the path to wealth.

  Buffett even made a $1 million bet with a hedge fund (a specific type of investment that tries to beat the market) manager to show the merits of passive management.[16]  Buffett asserted that a simple index fund would outperform the hedge fund over a ten-year period. Buffett’s investment, an S&P 500 Index Fund, slaughtered the hedge fund, who were charging expense ratios in excess of 2%.  Fees matter, but even after taking out this fee, Buffett’s simple index fund generated much greater return than the hedge fund manager.  Professional investors can’t consistently beat the market (or even keep up with it!), yet some of my college students think they can.  Puh-lease. As Warren Buffett said, “Both large and small investors should stick with low-cost index funds.”[17]  If you follow his advice, you’ll have a better life. 

Endnotes

[1] Okay, this isn’t entirely true.  More details in chapter 13.

[2] You may hear of friends that short-sell stock or screw around with options contracts.  These investments, on average, lose money.  If you like money, steer clear of these.

[3] Dividends play a role too.  If Microsoft pays-out $10 in dividends each year per stock share, then Microsoft’s price one year from now will only need to be $430 to provide a 10% return to investors.

[4] Check out the reasonably good movie, Dumb Money, if you want to learn more.

[5] If you want to learn more, search for “joint hypothesis problem” and you will find loads of information.

[6] This doesn’t mean they expect the share price to be exactly $110.  Rather, this would be a good point-estimate of the future price. 

[7] I’m simplifying again.  In reality, very risk stocks do offer investors with a slightly higher return.  Investors need to be compensated for extra return so risky firms (mostly small caps) have provided slightly higher average historical returns.  Some young investors might benefit from investing more heavily in such companies, but this is a minor concern. 

[8] Admittedly, the benefits of diversification shrink as the number of stocks you hold rises.  Holding 1,000 different firms is not much different than holding 2,000 firms.

[9] I have no idea if this is true for these specific funds, but I know that such practices do happen, generally.

[10] A nice discussion of performance by market cap can be found here. 

[11] Source 

[12] I’m tempted to explain why, but I don’t want to make things unnecessarily complicated.  The 70/30 portfolio is shown to be on the efficient frontier and minimizes risk.  You can learn about these concepts here. And you can play around with portfolio mixes here. 

[13] A simple little video that discusses this topic can be found here. 

[14] Unless you are using individual stocks in brokerage account to take advantage of tax loss harvesting. 

[15] Source 

[16] Source

[17] Source 

Key Terms

Brokerage Account:  Investment account that is not held inside a tax shelter.  Sometimes called a “taxable account”.

Efficient Market Hypothesis:  The theory that all knowable information about a stock is already “priced-in”.  If EMH is valid, then no one will be able to consistently beat the market.

Idiosyncratic Risk:  Investment risk one takes that does not yield additional returns.  Suppose you can invest in only two stocks—A or B.  Both are expected to generate a 10% return but B has more risk.  If you invest in B, the extra risk you have chosen to take is called idiosyncratic risk.  Unless you love gambling, you should seek to eliminate idiosyncratic risk.  In real-life stock investing, idiosyncratic risk can be eliminate by fully diversifying.Sim

Index Funds:  Simple investment vehicles that mirror the performance of a predetermined set of stocks, such as those in the S&P 500.  Because index funds usually hold shares of many firms and charge very low fees, these are typically great investment options.

Limit Order:  Stock purchase (sell) order that will only execute if the price is below (above) a certain level that you choose when setting-up the order. 

Market Order:  Stock purchase (or sell order) that will execute at the current price at the time of the order.   

Passive Management:  Investing strategy of investing in an entire market (or industry) in order to earn average returns.  Investors using passive management (usually by buying index funds), earn returns that are higher than most active managers.

Systematic Risk:  Investment risk that is necessary to generate a given level of return.  Suppose you can invest in only two stocks—A or B.  Both are expected to generate a 10% return but B has more risk.  If you invest in A, you have minimized risk. The only risk you are taking-on is the systematic risk, which is unavoidable if you want to generate a 10% return. 

Target Date Fund:  Super useful investment vehicle that (normally) holds stocks and bonds from all over the world.  As you get older, the fund will naturally transition to holding progressively more bonds to reduce risk.  This chapter merely introduces the topic. 

Tax-sheltered account:  Investment account that has special tax privileges, such as 401(k) accounts, HSAs, IRAs, etc.  Tax-sheltered accounts, especially those offered by employers, have fewer investment options than brokerage accounts.

Total Stock Market Index Funds:  Investment vehicles that contain all stocks on a value-weighted basis.  These are usually excellent investment options.  For US investors, funds named “total stock market funds” or something along those lines will contain only US stocks. 

Vendor: Investment firm.  When you use a brokerage account, you can choose what vendor to use.  When using an employer-provided tax shelter, the employer has chosen a vendor and you have no choice.  Some vendors are good; some suck.

World Stock Market Index Funds:  Investment vehicles that contain all stocks worldwide on a value-weighted basis.  This allows an investor to have full diversification, but there may be disadvantages to these funds.

Practice Problems

1. Are you likely to make limit orders in a tax-sheltered account?  Discuss.

2. Meghan invests $8,000 in an S&P 500 index fund that charges a 0.3% expense ratio.  Mollie invests $8,000 in an S&P 500 index fund that charges a 0.02% expense ratio.  They both invest at the same time and the S&P index earns an annualized return of 11.3% over the course of their investments.  In 20 years, how much more money will Mollie have in her account, compared to Meghan, if you had to estimate?  Solve.

a. Suppose you find that Mollie only has $3,100 more.  What might explain this?

3. Are index funds becoming more popular over time?  Explain.

4. At present, the share price of Disney is $48.91.  I execute a market order to buy 5 shares.  What will happen?  How much money will I spend? 

5. At present, the share price of Disney is $48.91.  I execute a limit order to buy 5 shares at a price of $49.  What will happen?  How much money will I spend? 

6. At present, the share price of Disney is $48.91.  I execute a limit order to buy 5 shares at a price of $48.  What will happen?  How much money will I spend? 

7. At present, the share price of Disney is $48.91.  I execute a limit order to sell 5 shares at a price of $48.  What will happen? 

8. If history repeats itself, which of the following portfolios would have the lowest risk?  Highest return?

9. On March 5th, Nike unexpectedly announces that it will release a new Air Jordan shoe on April 1st.  Investors know this will make loads of profit for the firm.  When will the stock price increase?  Now, April 1st, or what?

Solutions

1.       Are you likely to make limit orders in a tax-sheltered account?  Discuss.

No.  Tax-sheltered accounts will normally handle all stock purchases and sales on your behalf.  So you will not be making any orders.  Rather, you will set contributions and select specific funds in which to invest and the vendor will take care of the stock transations.

2.       Meghan invests $8,000 in an S&P 500 index fund that charges a 0.3% expense ratio.  Mollie invests $8,000 in an S&P 500 index fund that charges a 0.02% expense ratio.  They both invest at the same time and the S&P index earns an annualized return of 11.3% over the course of their investments.  In 20 years, how much more money will Mollie have in her account, compared to Meghan, if you had to estimate?  Solve.

Meghan:   FV = $8,000(1 + 0.113 – 0.003)20     = $64,498.49

Mollie:   FV = $8,000(1 + 0.113 – 0.0002)20 = $67,831.64

So, Mollie is expected to have $3,333.15 more. 

a.       Suppose you find that Mollie only has $3,100 more.  What might explain this?

Index funds do not perfectly track the index.  Funds hold a bit of cash and while S&P 500 Index Funds closely mirror the S&P 500 Index, it’s not perfect.  So, there can be some deviations in performance.

3.       Are index funds becoming more popular over time?  Explain.

Yes.  Passive funds now have more assets under management than active funds.  This fact was provided in the chapter write-up.

4.       At present, the share price of Disney is $48.91.  I execute a market order to buy 5 shares.  What will happen?  How much money will I spend? 

I will buy five shares at the market price, but the price could change in the few moments between the time I “click” my mouse to submit and the time that the order is executed.  With five shares, I will spend about $244.55, but I won’t be shocked if it’s a bit more or less than this.

5.       At present, the share price of Disney is $48.91.  I execute a limit order to buy 5 shares at a price of $49.  What will happen?  How much money will I spend? 

As long as the price doesn’t rise above $49, the answer to this question will be the same as question 4.  If the price suddenly rises to $49.05 immediately after I submit my order, then I will buy nothing and the order will be cancelled.

6.       At present, the share price of Disney is $48.91.  I execute a limit order to buy 5 shares at a price of $48.  What will happen?  How much money will I spend? 

Unless the price drops to $48 or lower immediately after I submit, the order will be cancelled, and I will buy nothing.  This is extremely unlikely to result in a purchase.

7.       At present, the share price of Disney is $48.91.  I execute a limit order to sell 5 shares at a price of $48.  What will happen? 

I will sell the five shares at the market price unless the price drops below $48 immediately after I submit my order.  If the price does drop below $48 (which would be shocking), I don’t sell the shares.

8.       If recent history repeats itself, which of the following portfolios would have the lowest risk?  Highest return?

Highest Return:  C—US stocks have outperformed international stocks over the last few collective decades.

Lowest Risk:  B—This is discussed in the chapter.

This isn’t a great question, to be honest.  There’s no compelling reason to expect history to repeat itself. But it’s good to think about the role of international stocks in your portfolio. 

9.       On March 5th, Nike unexpectedly announces that it will release a new Air Jordan shoe on April 1st.  Investors know this will make loads of profit for the firm.  When will the stock price increase?  Now, April 1st, or what?

If it is truly unexpected, the price will rise on March 5th, immediately after (or even during) the announcement.  The stock market responds to new information.  When the shoe is actually released on April 1st, the stock price won’t change much unless something else unexpected happens on that date.