Indices or Investment Managers?
Historically, the indices have proven themselves to be a very affective way to organize investment portfolios. In order underscore their significance, we will present two facts with significant ramifications for people investing in the stock market.
- The S&P 500’s average annual yield between the years 1,926 and 2,001 (including dividends) was 10.7%.
- Less than 5% of all investment managers (including those who manage mutual funds) were able to outperform the S&P 500 during that same period.
Private investors that do not have the proper knowledge to pick stocks often prefer to link their money to indices such as the S&P 500. There are a number of financial tools that allow an investor to do just this. Two of these, mutual funds and exchange traded funds, will be discussed in upcoming chapters.
The major investment banks all have research departments. These offices house dozens of analysts that follow the thousands of public companies in America. Each analyst is generally responsible for a specific sector of the economy. The analysts regularly publish reports on the companies in their sectors. These reports include recommendations on whether to buy or sell those companies’ stocks.
These reports can have immediate and dramatic impact on stock prices. When a respected analyst publishes a buy or sell recommendation, that stock can rise or fall sharply in a matter of minutes. These reports are backed up by the analysts’ professional knowledge and by their access to the companies’ management.
Every investment bank has its own hierarchy of recommendations. Table 11 details three typical rankings, listed from the best on top to the worst at the bottom.
3 Analyst Recommendation Hierarchies
|Bank A||Bank B||Bank C|
|Buy||Strong Buy||recommended List|
Analysts also publish forecasts about the profits of the companies they monitor. The bottom line of these complex forecasts is the expected Earnings Per Share (EPS).
A number of companies in America specialize in gathering and processing data from a number of different analysts. These companies compare information from hundreds of different analysts and calculate an average expected profit. This average is called the Consensus Estimate.
The consensus estimate expresses the general Wall Street expectation and serves as a way for measuring a company’s actual performance. When a company’s actual profits are different from the consensus, you can expect the stock price to rise or fall in accordance with how it deviates.
Three leading firms that publish consensus estimates are:
· First Call.