The Most Important Thing About Contemporary Finance, part 1
The most important thing about finance, if one had to elevate a single concept to the top of the scale, would be the relationship between risks and returns. All financial models that have come into ascendancy – original academic models that are now used in the professional world, as well – deal in terms of the relationship between risks and returns.
However, when financial analysts speak of risks and returns, they often forget about entry and exit mechanisms. People sometimes buy securities and go into other forms of businesses with respect to physical assets without a real understanding of how they’ll get out or the costs of doing so. High-level professionals certainly consider that. But sometimes in the euphoria of understanding a prospective business deal, or even equities in emerging markets, people forget about exit mechanisms. With respect to financial assets, these are things that can significantly affect risks and returns.
Particularly if we’re speaking of comparing stocks (or even bonds), we usually don’t think in terms of buying and selling costs – economists would call these items transaction costs. In effect, entry and exit mechanisms should be added to the risk- return equation. Many financial markets are very, very thin, especially in so-called emerging markets. And so, particularly with respect to institutional investing in these emerging markets, the very buying and selling action of investors can sometimes drive stock prices through their own activities. So while risks and returns are probably the two most important aspects in contemporary finance, and all models deal with these two elements, many of these models forget to explicitly include entry and exit mechanisms in the equations; it is often assumed that entry and exit costs are negligible.
It is also assumed that transaction costs will remain constant throughout, and that is not the case. Particularly in times of crises, even in mature and well developed large capital markets – our capital markets, for example – these entry and exit costs (usually now we’re speaking exclusively of exit costs) – rise precipitously. There was a time during the market crisis of 1987 when NASDAQ dealer-market-makers were reputed to have backed away from investors wishing to liquidate their positions – they simply wouldn’t answer their phones. Dealer-market-makers were required to deal once they picked up their phones, according to NASDAQ rules, so they just wouldn’t answer their phones.
And so these things are not factored into the models, and that makes it difficult to rely on just a notion of risks and returns. It’s actually far more complex than just saying risks and returns are the sole significant aspects of financial concern because there are many aspects of consequence. For example, past volatility, which we usually take as a measure of risk, and some computation of past returns or even a projection of future returns, are normally considered the elements of primary consequence. However, because markets often do not remain constant over time, the risk and return parameters of the past are frequently not accurate predictors of the future.
Valuation is, of course, the key to financial analysis. One could well have said that valuation is the most important aspect of contemporary finance, and valuation is best approached through an effective understanding of risks and returns. Further, valuation can be comprehended from many perspectives. The most common method now employed is the Capital Asset Pricing Model (or CAPM) and other related models. This approach understands the value of a capital asset as a function of the “riskless” return, the market return on financial assets in general, and the degree of risk inherent in any particular financial commitment in relation to the risk of financial assets in general.
Yet, one of the cardinal aspects about finance is that there are no rules, or practically none. There are some mathematical relationships that will always hold true. If you were to, say, compute rates of return from looking at cash inflows and outflows and you find a 5 percent or 10 percent figure, that’s a reasonably hard and fast mathematical relationship that will almost never change. We say “almost” because even here you can have some gimmickry and tricks and complexities. But other than this, basically there are no rules. And probably the single most important rule in finance is that there are no rules that can be relied upon at all times and under all circumstances.
If you look for simplistic answers, you frequently get fooled. It is often rather easy to get fooled if you are uninitiated and unsophisticated in financial matters and look to solve this problem through simplistic answers. Accounting earnings are a very good example of this, and people are finally coming to understand the qualitative nature of accounting earnings.
Tags: Finance