1. © 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. PST
The audio for this webinar will be broadcasted on your computer’s speakers
Hosted by Professor Peter DeMarzo

2. © 2009 Stanford Center for Professional Development
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Presenter
Paul MarcaPeter DeMarzo

3. © 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 2005
Year
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
Frequency(#ofyears)
3-mo Treasury Bills
AAA Corporate Bonds
S&P 500
Small Stocks

5. © Peter DeMarzo 2013
Risk vs. Return:
The Security Market Line
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Small Stocks
S&P 500
World
Portfolio
Corporate
Bonds
Treasury Bills
Mid-Cap
Stocks
0%
5%
10%
15%
20%
25%
0% 10% 20% 30% 40% 50%
Historical Volatility (standard deviation)
Madoff

6. © Peter DeMarzo 2013
Risk vs. Return:
The Security Market Line
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Small Stocks
S&P 500
World
Portfolio
Corporate
Bonds
Treasury Bills
Mid-Cap
Stocks
0%
5%
10%
15%
20%
25%
0% 10% 20% 30% 40% 50%
Historical Volatility (standard deviation)
under-diversificationunder-diversification
market timingmarket timing
feesfees
trading coststrading costs
market timingmarket timing
adverse selectionadverse selection

7. © Peter DeMarzo 2013
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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11. © Peter DeMarzo 2013
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

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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 correlated
with 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
growth
funds
Other
aggressive
growth
funds
Growth
funds
Income
funds
Growth and
income
funds
Maximum
capital
gains funds
Sector
funds
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 3
Years Relative to Hiring Date
Hiring
Date
Average

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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
LMVTX
SP500
Morningstar
“Manager of the Year”
Morningstar
“Manager of the Decade”
Fortune
“Greatest Manager of Our Time”

18. © Peter DeMarzo 2013
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 Hall
Copyright: 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

23. © 2009 Stanford Center for Professional Development
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