Managing Personal Wealth Quiz Part 2

1. Historically, what has been the impact (positive or negative) of inflation on stock returns:
a. In the short run? In the short term, stocks might be eroded by high inflation, but the definition of short can change this. During the late 70's and early 80's high inflation eroded a lot of the gains from stocks, but had people held those stocks, they would have come out ahead. How did this happen? Inflation causes higher interest rates, which in turn, drive down the prices of stocks (and bonds).
b. In the long run? In the long run, stocks have held up very well against inflation, meaning they have returned a higher return than what inflation would erode. In general, portfolio values have doubled every 10 years.

2. What does the Capital Asset Pricing Model (CAPM) say that tells us we should NOT buy individual stocks for our don't be poor objective?
CAPM is a way to determine the return necessary for a company to be seen as a worthy investment (or if a project is worth investing in). What it does, is measure the overall risk of the investment (this works because higher risk should equal higher returns and vice versa). It takes the "risk free" rate (usually a treasury bill rate) and the beta (the risk of the stock) and adds the market risk. By buying an individual stock, we are taking on a portion of risk that can be "diversified away" by holding a higher number of stocks with low correlation of movement to each other. If you don't want to be poor, than don't take on risk that can be diversified away (you won't be paid for it anyway).

3. If the P/E ratio for the stock market is 20, what would Siegel's reasoning tell us to expect (approximately) for the long-term rate of return for stocks?
Jeremy Siegel, in his book Stocks for the Long Run, believes that the P/E ratio is not a good indicator of longterm performance. At a multiple of 20, that would equal about a 5% (1/20) growth in stocks. He believes that a low 20's number for the entire market is justified based on historical data.

4. How can I be assured that an exchange traded fund (ETF) will trade at a price that is very close to the value of the index it tracks?
ETFs are similar to mutual funds in that they try to buy all of the stocks in the index they track. Because the authorized participant (AP) has the financial capital to buy these stocks, they are also in charge of making sure the price of the ETF shares match the equivalent fraction of the all of the stocks. If the price of the ETF rises, the AP sells more shares, bringing the price down. If the price falls, the ETF buys back the shares to keep the price the same. Either way the AP is making money.