Download Being Warren Buffett - Smith College Mathematics Department.

Being Warren Buffett: a classroom
simulation of the stock market
March 24, 2009
Nicholas J. Horton
Department of Mathematics and Statistics
Smith College, Northampton, MA
[email protected]
http://www.math.smith.edu/~nhorton
Acknowledgements and references




Activity developed by Robert Stine and Dean Foster
(Wharton School, University of Pennsylvania)
Published paper: “Being Warren Buffett: A classroom
simulation of risk and wealth when investing in the stock
market”, The American Statistician (2006), 60:53-60.
More information, the handout form and copy of the TAS
paper can be found at:
http://www-stat.wharton.upenn.edu/~stine
A copy of these notes plus the R code to run the
simulation and results from 5000 simulations can be
found at:
http://www.math.smith.edu/~nhorton/buffett
Horton – Causeweb - 2009
Being Warren Buffett
2
Overview





The concepts of expected value and variance are
challenging for students
A hands-on simulation can help to fix these ideas, in the
context of the stock market
Allows students to experience variance first-hand
Can be implemented using dice (and calculators) in a
classroom setting
Computer generation of results complements the
analytic and hand simulations
Horton – Causeweb - 2009
Being Warren Buffett
3
Objectives





Understanding discrete random variables to model stock
market returns
Calculate and interpret expectations for return from a
given investment strategy
Calculate and interpret standard deviations of returns
from a given investment strategy
Compare the risk and return for these strategies
Spark thinking about diversification and rebalancing of
investments
Horton – Causeweb - 2009
Being Warren Buffett
4
Background information


Imagine that you have $1000 to invest in the stock
market, for 20 years
Three investment possibilities are presented to students
in groups of 2 or 3:
Investment
Green
Red
White

Expected annual return
8.3%
SD(annual return)
20%
71%
132%
0.8%
4%
Question: Which of the three investments seems the
most attractive to the members of your group?
Horton – Causeweb - 2009
Being Warren Buffett
5
Dice outcomes

The investments rise or fall based on the outcomes of a
6-sided die:
Outcome
Green
Red
White
1
0.8
0.05
0.95
2
0.9
0.2
1
3
1.1
1
1
4
1.1
3
1
5
1.2
3
1
6
1.4
3
1.1
Horton – Causeweb - 2009
Being Warren Buffett
6
Example:

Suppose on the first roll your team gets the following
outcomes (Green 2) (Red 5) (White 5), then on the
second roll, you get (Green 4) (Red 2) (White 6)
Round
Green
Red
White
Start
$1000
$1000
$1000
Return 1
0.9
3
1
Value 1
$ 900
$3000
$1000
Return 2
1.1
0.2
1.1
Value 2
$ 990
$ 600
$1100
Horton – Causeweb - 2009
Being Warren Buffett
7
Repeat the process for 20 years





1 student to roll the dice (green, red and white)
1 student to determine the return and calculate the new
value on the results handout
1 student to supervise and catch errant dice
At the end of class, each team enters their results on the
classroom computer
Find out who are the “Warren Buffett’s” of the class
Horton – Causeweb - 2009
Being Warren Buffett
8
Group results form
Horton – Causeweb - 2009
Being Warren Buffett
9
Usually, red doesn’t do as well as green
Horton – Causeweb - 2009
Being Warren Buffett
10
But occasionally it wins big!
Horton – Causeweb - 2009
Being Warren Buffett
11
Expected returns for 20 years

Use property that the expectation of a product is the
product of the expectation
GREEN: $1000*(1.083)^20= $
4,927
RED:
$1000*(1.710)^20= $45,700,632
WHITE: $1000*(1.008)^20= $
1,173

We’d always want to pick RED, no?



Horton – Causeweb - 2009
Being Warren Buffett
12
Observed returns (using simulation)


Used R to simulate 5000 20-year histories, available as
“res.csv”
Observed Q1, median, Q3




GREEN: $2,058 $3,621 $6,269
RED:
$
0 $ 16 $1,993
WHITE: $1,011 $1,141 $1,321
Percentage ending with less than initial investment
($1000)



GREEN: 5.9%
RED:
72.7%
WHITE: 25.0%
Horton – Causeweb - 2009
Being Warren Buffett
13
Another strategy (“pink”)




Consider a strategy where you balance investments
between RED (dangerous) and WHITE (boring) each
year
Call this “PINK”
Smaller average returns, but far less variable
Can be calculated using existing rolls (average returns),
using space on the results form
Horton – Causeweb - 2009
Being Warren Buffett
14
How to implement PINK
3
$3000
0.05
$150
Horton – Causeweb - 2009
Being Warren Buffett
1
$1000
1
$1000
Pink
$1000
2
$2000
0.525
$1050
15
Connections to reality and thoughts on “pink”



GREEN performs like the US stock market (adjusted for
inflation)
WHITE represents the (inflation adjusted) performance
of US Treasury Bills
Quote from authors: “We made up RED. We don’t know
of any investment that performs like RED. If you know of
one, please tell us so we can make PINK!”
Horton – Causeweb - 2009
Being Warren Buffett
16
Boxplots of results (needs rescaling)
$80 billion!
Horton – Causeweb - 2009
Being Warren Buffett
17
Boxplots of results (where returns <=$50,000)
Horton – Causeweb - 2009
Being Warren Buffett
18
Teaching materials and checklist





Copies of handout describing the simulation (one per
student)
Copies of results sheet (one per group)
Set of three die (though one will work in a pinch, one set
per group)
Remind students to bring calculators (or run this in a lab
rather than lecture)
Time requirements: between 50 and 80 minutes
(depending in part on whether you calculate expected
values, motivate the simulation parameters in terms of
historical inflation and stock returns and whether “pink” is
introduced)
Horton – Causeweb - 2009
Being Warren Buffett
19
Extensions and assessment




The activity was developed for use in both an MBA and
PhD program
The paper introduces concepts of “volatility drag” and
“volatility adjusted return” as more advanced topics
(potentially applicable as a project at the end of a
undergraduate probability class), as well as connections
to calculus
Verifying the expected value and standard deviation of
one of the investment strategies is a straightforward
homework assignment (other assessments possible)
Students without formal exposure to expectations of
discrete random variables can still fully participate in the
simulation
Horton – Causeweb - 2009
Being Warren Buffett
20
Conclusions




Hands-on activity is popular with students
Helps to reinforce important but often confused concepts
in the context of a real world application
Small group work helps to address questions as they
arise
Students turn in results to allow review of results (in
addition to immediate display of summary and graphical
statistics)
Horton – Causeweb - 2009
Being Warren Buffett
21
Being Warren Buffett: a classroom
simulation of the stock market
March 24, 2009
Nicholas J. Horton
Department of Mathematics and Statistics
Smith College, Northampton, MA
[email protected]
http://www.math.smith.edu/~nhorton