When I was growing up in a blue-collar town just south of Boston, Wall Street seemed more of a concept than a place. Nobody that I knew had any idea how it worked. Stocks, hedge funds, and market portfolios were a species of exotica looked upon with suspicion. When I was a sophomore in college, my mother bought her first CD, or Certificate of Deposit, a risky business in the financially untutored eyes of our family. A year later, when I followed her example by buying a money-market fund, my impecunious college friends looked upon the act as truly novel. I had become, in their eyes, a high roller.
These days many Brown students develop a far more sophisticated relationship with their money. Most of them have known only the bull market of recent years, a context in which money-market funds are for timid greenhorns. Budding on-campus investors now form investing clubs and line up to take classes like Economics 177: Financial Markets 1, in which they learn such investor fundamentals as the pricing of stocks, bonds, options, and futures; the effect of the risk-return ratio on investment strategies; and the basics of portfolio management and market efficiency.
Assistant Professor Tom Krebs, who teaches one of the two sections of Econ 177 in the fall semester, confirms that the demand at Brown for such business-related economics courses is on the rise. His class, which meets three mornings a week in a cavernous room on the third floor of Rhode Island Hall, has an enrollment of just over seventy students, roughly the same number as those in another section taught by Associate Professor of Economics Allan Feldman. So many students were being turned away that the economics department offered an additional section of Econ 177 this semester.
Krebs, who has been teaching at Brown for a little more than a year, is surprised, and slightly bemused, by this undergraduate thirst for investment know-how. “Before I came here,” he says, “with everything I’d heard about Brown, I wouldn’t have expected it.” A native of Germany who came to the United States to study economics at Columbia, Krebs says he is at Brown to study the theoretical side of economics, not to offer investment advice. He is quick to stress that, much to his students’ dismay, Financial Markets 1 is not a how-to seminar for potential financial moguls. Day trading is not discussed, and students expecting tips on where to invest their money are usually disappointed. “I teach them how to mathematically calculate risk,” Krebs says, how to “develop a basic theory of investing.”
Still, as the popularity of Financial Markets 1 underscores, knowing the theory behind the operation of financial markets is a big help in figuring out where to put your money. Students adopt the point of view of an average investor with a modest amount of cash and no understanding of Wall Street. Krebs begins by introducing the different asset classes and their relative risks, from money-market funds and fixed-income securities to stocks, real estate, and precious metals. The next step is to identify your desired level of return. The key to investing at any level, Krebs says, is knowing how much risk you can tolerate and then choosing just the right mixture of high- and low-risk assets for your portfolio. Investors looking for stellar returns generally take more risks, but they also face a higher likelihood of losing their money. Krebs demonstrates all this with complicated mathematical formulas aimed at predicting the relationship between risk and return.
Econ 177’s success, Krebs knows, lies in balancing the academic rigor of statistical calculation with plain talk about portfolio management. On a brisk, late-November day, he is posing the question of whether it is better, all things considered, to manage a portfolio of investments actively or passively. A passive management strategy might involve buying into an index fund that samples a broad range of stocks that show up in, say, the S&P 500, and sticking with them for the long term.
Such an approach, Krebs tells the furiously scribbling students, is “definitely a boring investment strategy,” but one with definite advantages. If the market is doing well, he says, “you know you will do well, too. But you will never do exceptionally well.” Your earnings will only reflect the average earnings of the market. An active investing strategy, on the other hand, involves trying to beat the market by picking “winning” stocks the stocks that you or your broker think are going to do better than the market average. Portfolio managers research companies in the hope of making the big killing, or at least beating the market.
Which is the better strategy: active or passive management? According to the numbers, Krebs says, portfolio managers over the long run might as well be throwing darts at the Wall Street Journal’s stock tables. What’s more, active portfolio management involves a high volume of trading, and each trade costs money. The costs of the research and the trading often cancel out the profits.
But the dream of the big killing dies hard, nudged along by stories of the somebody who, every now and then, gets lucky. Krebs illustrates the point by describing what would have happened if in 1927 an investor had taken $1,000 and invested it for fifty years in three different vehicles. Placing the money into such a risk-free asset as, say, treasury bills, the investor would have seen it jump to $3,600. The same money invested in an index fund would have yielded $67,500 over the same half-century. But if the investor had taken an active strategy and picked every winner with perfect timing, that little $1,000 investment would have mushroomed into an astonishing $5.37 billion. Students gasp at this story. “However,” Krebs continues, “actual performance is never that good.”
How are Krebs’s students doing in the market after being exposed to all this theory? As an economics and psychology concentrator, Susan Dolhun ’02 seems particularly well qualified to assess financial performance while understanding the natural human urge to think “I’m different. I know how to beat the market!” Dolhun, who is from Nahant, Massachusetts, says that she’s been concentrating on Internet stocks she won’t say which and that they’re doing “okay.” When it comes to investing, she says, she doesn’t rely much on Krebs’s economic theories. “I just watch the markets and check up on my stocks every day,” Dolhun says, sounding like millions of other small investors around the United States. Her start as an investor came after watching her parents work the stock market and doing an internship at the Boston investment firm Bear, Stearns & Co. “I figure when you’re young is the time to experiment,” she says, adding that “doing this has been terrifying.”
Joshua Krongold ’01 has followed a more conservative route, investing in an IRA, an index fund, and, “just for fun,” a few individual stocks. Like Dolhun, he plays his investment choices close to the vest but gladly admits that, over the year in which he’s been in the market, he’s doubled his money. Krongold’s method of picking stocks is similar to Dolhun’s; instead of using theory, he watches the news and follows the stock pages. “It’s interesting to learn how the professionals do it,” he says. “But now, with on-line investing, you don’t have to go through a broker you can start small, on your own, with a little money.”
Krebs, whose specialty is macroeconomics, has no illusions about where many of his students’ true interest lies, and he doesn’t entirely approve. But he does hope that at least some of them will see economics as more than a guide to making money, as “one approach to understanding human behavior and human variables.” Besides, he adds, economists have always been “bad at predicting the future and better at reconstructing the past.”