Stock Market Simulation and Analysis DZT-1003 An Interactive Qualifying Project Report Submitted to the Faculty of Worcester Polytechnic Institute in partial fulfillment of the requirements for the Degree of Bachelor of Science By Toby Callahan Nandakumar Iyer Date: July 6, 2010 Advisor: Professor Dalin Tang 1 Abstract Among numerous investment strategies in the stock market, this stock market simulation focused on the conservative strategy of John Bogle, which states that stock trading is a losing game and investment in index funds is a more profitable strategy. The theory was tested by comparing the performance of an actively managed portfolio in an online simulator to index funds approximating the market. The outcome was a draw, with both active and passive strategies resulting in depreciation over a down market. 2 Table of Contents Abstract ............................................................................................................................... 2 Table of Contents ................................................................................................................ 3 List of Figures ..................................................................................................................... 5 List of Tables ...................................................................................................................... 6 Chapter One: Introduction .................................................................................................. 7 1.1: Goals and Overview ................................................................................................ 7 1.2: Brief History of the Stock Market in the United States ........................................... 7 1.3: Definition of Stock and Shares ................................................................................ 8 1.4: Influences on the Price of Stock ............................................................................ 10 1.5: Stock Purchasing Methods .................................................................................... 11 1.6 Derivatives .............................................................................................................. 12 1.6.1 Futures and Forwards ....................................................................................... 12 1.6.2 Options ............................................................................................................. 13 1.6.3 Swaps ............................................................................................................... 14 1.7: Bonds ..................................................................................................................... 14 1.8: Purchasing Bonds .................................................................................................. 15 1.9: Mutual Funds ..................................................................................................... 17 Chapter 2: Investment Approaches ................................................................................... 19 2.1 Investment Tactics .................................................................................................. 19 2.1.1 Technical Analysis ........................................................................................... 20 2.1.2 Fundamental Analysis ...................................................................................... 20 2.2 Lessons From The Past ........................................................................................... 21 2.2.1 The Dot Com Bubble ....................................................................................... 21 2.2.2 Mortgage Backed Security Crisis, Credit Crunch ............................................ 22 2.2.3 Long Term Capital Management ..................................................................... 27 2.3 Lessons .................................................................................................................... 28 2.4 Our Approach ......................................................................................................... 33 2.4.1 Rationalizations ................................................................................................ 33 2.4.2 Criteria to Evaluate Stocks ............................................................................... 36 2.4.3 Evaluation of Choices ...................................................................................... 38 Chapter 3: Simulation Results .......................................................................................... 40 3.1 Week 1 Data: .......................................................................................................... 40 3 3.2 Week 2 Data: .......................................................................................................... 44 3.3: Week 3 Data .......................................................................................................... 48 3.3.1 Short Selling..................................................................................................... 50 3.3.2 Hedging on Apple ............................................................................................ 52 3.3.3 Losing Google, New Ventures ......................................................................... 54 3.3.4 Biotechnology Firm Selections ........................................................................ 55 3.4: Week 4 Data .......................................................................................................... 60 3.4.1: The Apple Hedge ............................................................................................ 62 3.4.2: Missing the Tesla IPO Boat ............................................................................ 63 Chapter 4: Results ............................................................................................................. 65 Chapter 5: Conclusions & Discussion .............................................................................. 68 5.1 Diversification ........................................................................................................ 68 5.2 Conclusion .............................................................................................................. 68 5.4 Investment Emotions and the Daily Grind ............................................................. 71 References ......................................................................................................................... 72 4 List of Figures Figure 1: NASDAQ Index (Into The Weeds ................................................................................ 22 Figure 2 CDO Issuance 1997-2007Q1 .......................................................................................... 25 Figure 3: "Winners, Losers, and Failures: Long-term Returns of Mutual funds, 1970-2005" ..... 28 Figure 4: Investment Return versus Market Growth - Growth of $1, 1900-2005 ........................ 31 Figure 5: Ford Stock Prices, Sep. ’08 – May ‘10.......................................................................... 34 Figure 6: Apple Stock Prices, July ’09 – May ‘10 ........................................................................ 34 Figure 7: Google Stock Prices, July ’09 – May ‘10 ...................................................................... 35 Figure 8: BP Stock Prices, Last Three Months ............................................................................. 36 Figure 9: Graph of portfolio value vs. S&P 500 index value throughout Week 1 (6/7/10 – 6/11/10) ................................................................................................................................. 44 Figure 10: Graph of portfolio value vs. S&P 500 index value at the end of Week 2 (6/14/10- 6/18/10) ................................................................................................................................. 48 Figure 11: Portfolio Value vs. S&P 500 Index Over Week 3 (6/21/10 – 6/25/10) ...................... 50 Figure 12: Google vs. Apple, Percent Change in Value, Mar. 29 - June 25 ................................. 54 Figure 13: Biotechnology Market Capitalization, 1994-2005 ...................................................... 55 Figure 14: First Days of Tesla IPO and Actions ........................................................................... 64 5 List of Tables Table 1: Bond Ratings .................................................................................................................. 16 Table 2: Fund allocation ............................................................................................................... 36 Table 3: Selection criteria, selected four stocks ............................................................................ 38 Table 4: Portfolio information for Week 1 (6/7/10-6/11/10) ........................................................ 40 Table 5: Portfolio value throughout Week 1 (6/7/10 – 6/11/10) .................................................. 44 Table 6: Portfolio information for Week 2 (6/14/10-6/18/10) ...................................................... 47 Table 7: Portfolio value throughout Week 2 (6/14/10 – 6/18/10) ............................................... 47 Table 8: Portfolio information for Week 3 (6/21/10-6/25/10) ...................................................... 48 Table 9: Portfolio value throughout Week 3 (6/21/10 – 6/25/10) ...............................................