financing innovation 2013

© 2009 Stanford Center for Professional Development

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Financing Innovation: Common Mistakes Even Great Investors Make

Welcome to:

Today’s webinar will begin at 10 a.m. PSTThe audio for this webinar will be broadcasted on your computer’s speakers

Hosted by Professor Peter DeMarzo


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Presenter

Paul MarcaPeter DeMarzo

© Peter DeMarzo 2013

Risk & Return: Insights from 86 Years of Investor History

$2,655,590

$10

$100

$1,000

$10,000

$100,000

$1,000,000

1925 1935 1945 1955 1965 1975 1985 1995 2005Year

Small Stocks

S&P 500

$2,041

Corporate Bonds

Treasury Bills

CPI

$1,261

$20,463

$275,240

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Return Volatility

• U.S. Markets (1925-)

0

10

0

10

0

10

20

30

0

10

20

30

40

50

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% >100%

Annual Return

Fre

qu

enc

y (#

of

year

s)

3-mo Treasury Bills

AAA Corporate Bonds

S&P 500

Small Stocks


Risk vs. Return: The Security Market Line

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Small Stocks

S&P 500

WorldPortfolio

CorporateBonds

Treasury Bills

Mid-CapStocks

0%

5%

10%

15%

20%

25%

0% 10% 20% 30% 40% 50%

Historical Volatility (standard deviation)

Madoff


Risk vs. Return: The Security Market Line

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Small Stocks

S&P 500

WorldPortfolio

CorporateBonds

Treasury Bills

Mid-CapStocks

0%

5%

10%

15%

20%

25%

0% 10% 20% 30% 40% 50%

Historical Volatility (standard deviation)

under-diversificationunder-diversificationmarket timingmarket timing

feesfeestrading coststrading costsmarket timingmarket timingadverse selectionadverse selection


How Do Individual Investors Behave?

• Small investors tend to be under-diversified Many hold just a few stocks Often hold stock of the

company they work for

• Investors sell stocks quickly when they go up, and hold on when they fall A tax inefficient strategy But perhaps they know

something?

• A recent study (Odean & Barber):

One-year Performance:

Winners Sold vs. Losers Kept

-1.06%

2.35%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

Rwin-Rmkt Rlose-Rmkt

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Individuals Trade A Lot

• Especially (single) men…

… do they know something?

Annual Turnover

0%10%20%

30%40%50%60%

70%80%90%

Married Single

Men

Women

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Annual Relative Return

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

Married Single

Men

Women

Individual Performance

• Their performance doesn’t show it … they underperform the market:

Net of transactions costs

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WSJ: Heard on the Street

• WSJ publishes info from analysts

Already given to clients

Is it useful once it is published?

Good news

Bad news

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Swimming with Sharks: Picking Stocks, or Picked Off?

• Active trading exposes an investor to “adverse selection” Whenever you buy, you’re filling someone else’s sell Only one of you can beat the market!

• IPOs Average first day return = 15% Let’s invest $10k in every IPO!

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Frequency First Day Return Your Allocation

80% 20% $500

20% -5% $8000

Average: 15% $0


Booyah!

• Mad Money recommendations (Engelberg, Sasseville & Williams 2009)

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Mutual Fund Performance

• Mutual funds don’t fare much better

Underperformance is closely correlatedwith fund fees

• This does not mean it is impossible to beat the market But it is either luck, or otherwise unsustainable Or involves hidden risks Or it is based on something that is hard to copy

• Access to information or unique investment opportunities• Investments in trading efficiency• Unique talent

Annual Alpha of U.S. Mutual Funds Relative to Broad-Based Market Index (1963-1998)

-2.13%

-8.45%-5.41%

-2.17%-0.39% -0.51%

-2.29% -1.06%

All Funds Small-company

growthfunds

Otheraggressive

growthfunds

Growthfunds

Incomefunds

Growth andincomefunds

Maximumcapital

gains funds

Sectorfunds

But in this case why would fund managers give it away?

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Institutional Fund Managers

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0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

-3 -2 -1 0 1 2 3Years Relative to Hiring Date

HiringDate

Average


Active vs. Passive Investing

• Why Passive Investing Must Win on Average

Avg. Passive Investor Earns: ?

Avg. Active Investor Earns: ? Less: Trading Costs (2-3%) Less: Tax Costs (2-4%)

Avg. Investor Earns: ?

• For some investors to beat the market, other investors must be willing to lose to the market

Market Index Return

Market Index Return

Market Index Return

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Are There “Hot Hands”?

• Can we use past performance to pick winning funds?

From 12/31/90 until 12/31/00, invest in the “model portfolio” from the best performing newsletter of the prior year

• S&P 500: $100,000 $513,000• Newsletter: $100,000 $ 70,752

Forbes Honor Roll of Outstanding Mutual Funds• Invest in Honor Roll funds each year for 25 years• Annual Return = 13.6% (not counting sales loads)• S&P 500 Return = 14.3%

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A Star has Fallen: Bill Miller’s Legg Mason Value Trust

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0

200

400

600

800

1000

1200

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Year End

LMVTXSP500

Morningstar “Manager of the Year”

Morningstar “Manager of the Decade”

Fortune “Greatest Manager of Our Time”


Are There “Hot Hands”?

• Can we use past performance to pick winning funds?

From 12/31/90 until 12/31/00, invest in the “model portfolio” from the best performing newsletter of the prior year

• S&P 500: $100,000 $513,000• Newsletter: $100,000 $ 70,752

Forbes Honor Roll of Outstanding Mutual Funds• Invest in Honor Roll funds each year for 25 years• Annual Return = 13.6% (not counting sales loads)• S&P 500 Return = 14.3%

There is, however, some persistence in mutual fund returns:• Bad funds tend to stay bad!

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Some Final Thoughts…

• We can’t all be above average! For one investor to beat the market, another must lose You’re “betting against Buffet” when

• You try to pick individual stocks, or time the market

• It pays to be passive Only be active when

• You have a good reason to be different• You have good reason to think you’re above average

• Beware of fees Active managers often take more than they add Even 1%/yr over your career > 1/3 of your retirement!

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For Further Details…

Corporate Finance

Jonathan Berk, Stanford University

Peter DeMarzo, Stanford University

Publisher: Prentice HallCopyright: 2013


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• Partnership of the Stanford School of Engineering and the Stanford Graduate School of Business

• Online lectures, completely self paced

• Exercises and assignments to insure practice and content retention

• TA feedback

• New and improved user interface

Stanford Innovation & Entrepreneurship Certificate


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Effective product innovation relies on clearly defined financial models and analysis. This course will explore the tools of financial valuation and their role in investment decisions faced by managers, entrepreneurs, and investors. You will learn the difference between earnings and cash flow, the importance of net working capital, and the determinants of a firm’s cost of capital. You will explore the sources and drivers of value and how to maximize created value. Finally, you will apply financial valuation tools to understand how firms are valued by investors, considering both publicly traded and venture-backed firms.

New Course Launching in September: Financing Innovation: Valuing Projects and Firms


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WebinarXINE001:How a Stanford Engineering Professor Engineered a StartupHosted by Professor Bob SuttonWednesday, September 18, 201310 a.m. – 11 a.m. PT

Save the Date: Upcoming Innovation Offerings

Learn more at: create.stanford.edu

WebinarGW025: Build an Entrepreneurial Culture within Your OrganizationSpeakers: Howie Rosen & Ricardo LevyTuesday, August 13, 201310 a.m. - 11 a.m. PT.

financing innovation 2013

Economy & Finance

professor peter demarzo

risk return

return volatility

year small stocks sp

day return

small investors

annual return frequency

annual relative return