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MITOCW | watch?v=tL7Lcl90Sc0 The following content is provided under a Creative Commons license. Your support will help MIT OpenCourseWare continue to offer high quality educational resources for free. To make a donation or to view additional materials from hundreds of MIT courses, visit MIT OpenCourseWare at ocw.mit.edu. PROFESSOR: What I want to do today is to continue where we left off last time in talking about the empirical properties of stocks and bonds. I want you to develop an intuition for how to think about markets. We've already done that over the course of the last few lectures by looking at market prices and understanding how to price them, but I'd like you to get some kind of a historical perspective now on specific asset classes. Because we're going to be relying on market prices to make inferences about other kinds of securities and other decisions you're going to make. As I told you at the very beginning of the course, we're going to rely on markets for information, because it's the wisdom of crowds that really gets us the information we need in order to make good financial decisions. So I want to begin that process of now giving you the intuition about the wisdom of crowds by looking at the historical performance of stocks and bonds. And then we're going to talk about how to quantify risk more analytically and put it all together in the very basics of modern portfolio theory. So I want to start by asking the question, first of all, what characterizes US equity returns? How do we get our arms around the behavior of that asset class? And the way I'm going to do that is to give you some performance statistics about the volatility, about the average return, about how predictable they are, and also patterns of returns across different kinds of stocks. So we're going to look at some empirical anomalies before actually turning to the analytical work of trying to figure out how to make sense of this from a more formal mathematical framework. Before I do that, let me ask you to think about the following question, which is, if you are designing a market for stocks, what properties would you want that market to have? And I'm going to argue that there are a few properties that all of us, I think, can recognize as being good properties for stock prices. So the first is that stock market prices are random and unpredictable. Now, that might seem a little counterintuitive, and certainly I think you would acknowledge that over the last several weeks markets have been supremely unpredictable. And that doesn't feel so good. It doesn't seem like that's a good thing. But in a minute, I'm going to try to make that a little bit more clear by looking at the alternative of predictable-- or unpredictable, which is predictable. So let me come back to that point.
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The second property that I think you'll agree is a reasonable one for us to expect is that prices should react quickly to new information. It should adjust to new information really without any kind of delay. And finally, we'd like to see that investors shouldn't be able to earn abnormal
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  • Spring '17
  • Jim Angel

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