This entry will analyze the reason for financial instruments and the basis of investment strategy.
Financial instruments are basically designed to cover “four simple needs”:
- “Raising capital”: “individuals, firms, and governments need capital to do things today that could not otherwise afford; the financial markets provide it to them at a price”.
E.g. micro-credits. A recent financial instrument designed to facilitate the access to small amounts of investment needed to launch many local businesses in developing countries.
- “Storing, protecting and making profitable use of excess capital”: inflation is the responsible that the money earned today has less purchasing power tomorrow so financial instruments have been invented to allow the allocation of the excess capital (bonds, funds...) to “some productive use”. This is the capital that will be raised by others to create new markets, firms or simply keep the country up and running.
- “Insuring against risk”: life is risky and an unexpected disaster may occur at any time. Imagine an accident that impairs you, an illness, a natural disaster, an investment crack down or a bad economic downturn that can make you lose all your capital, diminish the utility of you earnings, or even not been able to afford the payments needed to escape from such difficult situation.
Financial instruments have been created to mitigate such risk. Those include: insurances; futures contracts (“locks in a sale price for a commodity”, e.g – airlines and the fuel price or Starbucks and the coffee price, or farmers selling their crops before the corn is planted”) or instruments that allow to spread the risk such as catastrophe bonds (the cost of the insured catastrophic event is divided and spread all over the investment market. In the event of the catastrophe, the insurance company doesn´t go to bankruptcy but the losses are shared in small doses among the investors); funds that mitigate the risk of investing in a single stock or even the lately evil credit-default swap that cover the investor in case of a debt default.
- Speculation: “financial products are to speculation what sporting events are to gambling”, Speculation is what AIG and Lehman Brothers did with credit default swaps. The problem comes when there is a massive default due to an economic downturn or bubble burst and the financial resources become toxic-assets as it happened in USA in 2007. The financial instruments became so complex that the bank managers were unable to anticipate all the risks and the debacle (and regulators were unable to anticipate the bank managers´ loss of control of the situation)
The financial market is the vehicle for the flow of capital of those (individuals and companies) that have money in excess but do not have an idea to those that have an idea but not the means to implement it, and to promote such interchange in the safest possible way.
As Wheelan´s says: “Financial markets do for capital what other markets do for everything else: allocate it in a highly productive, albeit imperfect, way”.
And as in every market, the government can ease the things and provide a regulatory environment beneficial for all and lower the cost of doing business or can have negative effects via high taxes or regulations that burden any transaction.
When talking about investment strategies, it is really difficult to “become rich” trading with your capital in the long-term as well as to believe that a “bargain” is waiting there for us. The efficient market theory tries to explain it. ”Everyone else has access to the same information so the asset prices already reflect all available information and an investor cannot consistently achieve greater than average returns”. If the stock was really such a bargain, the seller would sell it at a higher price, but even if she sells at a lower price, it would attract a lot of purchasers that would increase its value during the acquisition process. Either this or the equities are a risky investment.
Notwithstanding that you could be successful once, it is difficult keep the highest turnover of your capital “betting only to one stock”, it is not safe to keep all the eggs in the same basket.
So, to minimize risk, moreover in the case of amateur investors with a full time job out of Stock Exchanges, the advocates of the efficiency markets theory suggest diversification and “pick a line and stand in it”. The index funds are a sensible and conservative financial tool to put such advice into practice (e.g.: index to S&P 500, IBEX35 etc...Index to the biggest firms in a country. There should be a national catastrophe for all these major business massively under perform and probably the consequences would be worse than the mere loss of a bunch of Euro). Even though some other funds based on riskier stocks can over perform in the short/medium term, the index fund is more profitable in the long term and might be a retirement plan logical option.
On the other hand, behavioral economics is gaining ground based on individual´s irrationality when making some investment decisions and the flaws it entails. “We are prone to herd-like behavior, we have too much confidence in our own abilities, we place too much weight on past trends when predicting the future, and so on”. So the theory of a market “informationally efficient" is coming to a dead end: a) markets may do irrational things” and b) the average investor probably can´t beat the market and shouldn´t try.
Anyhow, Wheelan doesn´t try to provide an investing guide although he gathers a “basic set of rules” any investment advice “must conform”:
- “Save, invest and repeat”. Save for your future, invest for your future.
- “Take risk, earn reward” - the riskier a stock is, the higher turnover may be. “The investor is compensated for taking more risk”.
- “Diversify” - It lowers the probability of a massive stock underperforming and therefore the risk of the investment.
- “Invest for the long run” - “buying a stock in hopes of selling it several hours later at a profit incurs all the costs of trading stocks (commissions and taxes) without any of the benefits that come from holding equities for the long run" (equities usually outperform in the long run).
Now a couple of clips of Seinfield that illustrates the chapter. One about the "information" efficient market theory, “The stock tip”, and another about how “financial intermediation typically facilitates the channeling of funds between lenders and borrowers”, “The blood”.
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