Finance Professors vs. Day Traders
April 28, 2000

Last year, as the Nasdaq kept climbing relentlessly, the success enjoyed by day traders appeared to have consigned the old rules of finance to the dustheap of history. The iron-clad relationship between a portfolio's risk and its expected return, so beloved of finance professors, had finally been severed. Or so it seemed, as month after searing month, the returns of technology-laden portfolios soared, while risk - the likelihood of loss - evaporated.

Several of Sylvia's friends, who had rarely given more than a passing thought to stock trading in the past, now were glued to their E*Trade accounts, buying and selling dot-com stocks with gay abandon. Some, pleasantly surprised by their acumen at picking winners, relinquished their boring 9-to-5 jobs altogether in order to devote more time to their newfound hobby - amassing immense wealth with a few computer keystrokes.

All through this excitement, professors like Hossein Varamini stuck to the dull, conventional wisdom of their finance textbooks. Sure, a portfolio bulging with Internet stocks promised superior returns, learned Varamini's students, but it also came with above-average risk. Moreover, the dot-coms were largely unprofitable enterprises, their income statements bleeding red ink as far as the eye could see - and not a single valuation model described in those stodgy textbooks provided support for the lofty prices they commanded. A high price for a company's stock implied that the company made large profits -- or soon would. Very few Internet companies met the test. The conclusion, according to the finance profs, was that many of the tech stocks were headed for a fall.

But in those heady days of 1999 and the early part of 2000, several analysts were convinced that the New Economy had arrived, carried triumphantly aloft the technological advances spawned by the ubiquitous Internet. Some of Sylvia's more intrepid friends, washed away by the exuberance of the argument, felt that merely picking stocks in this golden age was not sufficient, and ventured into the more exotic financial realm of margin trading and options.

Margin trading and options trading, Sylvia had learned in Prof. Varamini's class, were not for the faint of heart. In the case of margin trading, one used borrowed funds from one's stock broker to finance the purchase of a stock. If the stock price rose subsequently, all would be well, for the loan could be repaid with the profits made by selling the appreciated stock. But a decline, especially a sharp decline, could be devastating. The stock broker might "call in the loan," sometimes at very short notice, forcing the investor to raise the necessary cash by liquidating other holdings. But as long as the stock market kept scaling new heights, the possibility of margin calls seemed remote -- and hardly cause for concern.

Similarly, trading in options afforded the investor the opportunity to reap much higher gains, but these gains, noted Sylvia, were also far from certain. In the event the stock price failed to move in the expected direction, the investor's losses could be substantial.

Her friends often narrated stories of vast gains made in mere days. But, as Prof. Varamini pointed out to Sylvia, they rarely spoke of losses incurred. Nor did they mention the capital gains taxes and trading fees that would gnaw away at their gains. The importance of a portfolio's after-tax return, stressed often by Prof. Varamini, was clearly lost in the excitement.

Sylvia wondered whether the much-ballyhooed success of some day traders ever shook the confidence of the finance profs. If it did, Sylvia decided, Prof. Varamini did not show it. In his classes, he resolutely stuck to his textbook's valuation models and portfolio theories, and his students, Sylvia among them, duly took copious notes.

Then in March, the Nasdaq came crashing down. The day traders held their breath, hoping it was a momentary blip. But the market continued to fall, inexorably, and the astronomical returns racked up by the traders began to vanish. Brokerage firms called in margin loans. Options turned worthless. In a matter of days, the gains of many a New Economy portfolio had turned to dust.

"If we needed any confirmation that risk is alive and well in the stock market," said Varamini in his class, "look at Nasdaq's plight." Sylvia could have sworn that her professor's eyes fairly gleamed. "One measure of the risk of a portfolio," Varamini continued, "is the standard deviation...."

"Hell hath no fury like a trader scorned," confided Sylvia to Prof. Varamini one day. "My friends don't talk much about their trades any more." Prof. Varamini smiled enigmatically.

.....

Hossein Varamini has taught finance at St. Norbert College for 13 years. A highly regarded professor, Varamini will be joining a college on the East Coast in the fall where he will continue to educate students about the perils of ignoring the risks of investing in the stock market.