Month: March 2018

Last week we learned about the efficient market theory. Yeah, yeah, yeah I know it was literally 7 days ago! I’ll save all you lazy bums some time and explain what it is again. Efficient market theory is the stock market incorporating all available and relevant information immediately into stock prices. If you religiously believe in this theory then you also believe it is impossible to beat the stock market. Therefore, you’ll just invest your money in a diversified mutual fund and take whatever return the market gives you.

However, many of are jumping up and down saying that it is not true! Not everyone invests in a diversified mutual fund to get the market return. I bet a very few people out there actually do this. Many people choose their own stocks and hope to beat the market. As a result, these rebels don’t believe in the efficient market theory.

Believe it or not, these people are also correct about the stock market. Before, all of you start yelling at me about how confusing I’m being right now. Let’s all take a deep breath and I will explain the basics behind this point.

Everyone has their own philosophy behind the efficient market theory. Individuals believe it to a certain extent. There are 3 basic levels about the efficient market theory, which can be weak, semi-strong and strong.

Weak-form efficient market theorists believe that the market is efficient in reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent. Therefore, past rates of returns should have no effect on future returns. The most popular tests executed by weak-form efficient market believers are statistical tests for independence and trading tests.

On the other hand, semi-strong form of the efficient market theory indicates the market is efficient in reflecting all publicly available information. As a result, stock prices adjust quickly to new information. Most traditional investors believe in this sort of efficient market theory. These type of theorists conduct event tests and regression series tests.

Lastly, the final form of the efficient market theory is strong form. This hypothesis implies the market is efficient at reflecting all information that is both public and private information. Interestingly enough, if this theory is true then no average investor can profit when new information is released. The typical investors who believe in this theory are insiders, exchange specialists, analysts, and institutional money managers.

I hope this clears the confusion between all the different types of efficient market theory. Whatever you believe, you should manage your risk in the stock market. Never invest too much money or a loss can lead to detrimental consequences in your life.

All in all, ride the bull or claw down the bear (just nerdy finance slang-just leave me alone).

The stock market is one of the most common place invested by ordinary people like you and me. When people invest in the stock market, they are gaining ownership of public companies. Investors are hoping for the stock market, so they can make money off capital gains and dividends.

Capital gain is the increase in the value of a capital asset that gives it a higher worth than the purchase price. For example, if you bought a stock at $100 per share and the share price goes up to $150. You just made $50 from just capital gains! On the other hand, a dividend is money paid to stockholders, normally out of the corporation’s current earnings or accumulated profits. However, not all companies give dividends to their shareholders. These companies usually reinvest the dividends into their business operations to propel growth. As a result, the expansion in business can raise stock prices and investors gain profit from capital gains.

Now coming back from the tangent. You ever wonder why stock prices move the way they do? Like why does a stock price go up or crash? The efficient market theory will explain this to you. In simplified terms, this theory says the stock market will immediately all available information into the stock price. Therefore, the stock price will instantaneously move when news is released.

This past week, Facebook has been under scrutiny with their business practices and protecting their consumer’s information. Cambridge Analytica, political consulting firm, breached Facebook’s data, which helped create data modeling and performance-optimization algorithms that were used to target boat loads of adds to different audiences. This powerful weapon helped the firm pull off one of the most dramatic political upsets in modern history with Donald Trump becoming president of the United States.

Due to this controversy, many Facebook users were concerned with Facebook’s trust with their information. As a result, many users stopped going on this social media website. Consequently, Facebook lost business from many companies as they stopped paying for advertisements on the website. This means Facebook’s expected earnings will be earnings.

With all this negative information, guess how long it took the stock market to reach? To help you with the answer, scroll up to the efficient market theory. Still don’t know the answer? If you answered immediately, you are right! Below is the stock price of Facebook when the Cambridge Analytica scandal came out.

Ultimately, the stock market is a very efficient machine. It processes all available information into stock prices. Additionally, it incorporates new information immediately. Therefore, if you have a crystal ball and know what new information is coming out then you’ll be the richest man alive. You’ll know exactly when to invest and when to short stocks. All in all, beating the market is more difficult than it seems.

 

You ever realize the price of goods and services are generally more expensive in the future? That seems really unfair! Why should I pay more for a product just because I didn’t buy it last year?

This my friend is known as inflation, which is the sustained increase in the general level of prices for goods and services in a country. For example, if the inflation rate is 2% annually, then theoretically a $100 phone will cost $102 in a year. As a result, a consumer’s purchasing power will decrease.

Purchasing power is the value of a currency expressed in terms of the amounts of goods or services that one unity of money can buy. As inflation raises, purchasing power goes down. That’s a simple correlation. However, there are many unforeseeable consequences to this. For instance, this will lead to a higher cost of living, high interest rates, and falling credit ratings.

You must be wondering what causes inflation. There are two theories that are generally accepted by economic nerds. Demand-pull inflation and cost-push inflation.

Demand-pull inflation theory simply says too much money is chasing too few goods. If the demand for a product is higher than supply, then prices will increase. This is most popular in growing economies. The graph below will give you visual understanding on the matter.

On the other hand, cost-push inflation simple says if business input costs rise then product prices will also rise. This is due to businesses’ desire to maintain their profit margins. The most common ways input costs increase are higher wages, taxes, and import costs. The image below shows you the graphical representation of cost-push inflation.

If you were following the markets this week, the Consumer Price Index (CPI) rose 0.2% last month. The CPI is an economic indicator that measures the average price of household goods and supplies. This is the most common indicator used by economists to measure inflation.

The results basically told you are paying two hundredths of a penny for all your goods. This may not seem a lot, but money adds up quickly when you make multiple purchases throughout the month.

All in all, try not to let your lowered purchasing power ruin your day.

This week we are going to take a break from the economy and discuss more technical topics in the field. We all definitely heard of bonds, stocks, derivatives, and other investment instruments. However, you ever wonder if your investment is into the debt or credit of a company?

Let’s discuss something we’re most familiar with, which is debt. Debt is typically money that is due or owed to another person or party. The most common types of debts personal households have are credit card payments, medical bills, student loans, and various utility bills.

However, businesses have different forms of debt to finance their company. Just like our personal expenditures, businesses have to pay back the principal payment plus interest at maturity when they undergo debt.

There’s a lot of advantages of debt financing for a business. For instance, the lender of the loan has no control over your company’s operations. Once a borrower pays a loan, your communication with your financier can end. Additionally, debt financing is attractive because it is tax deductible. Therefore, company’s expenses can decrease with the tax shield.

However, there’s always negatives associated with the positives in the business world. When receiving debt financing, lenders always look at the company’s future ability to pay back the loan. The lender has to analyze if the borrower can pay back the loan when the economy hits the recession stage or undergoes a terrible business year. The inability for company to pay back its debt can damage their credit rating and hinder their ability to grow.

Now let’s talk the other phase of business financing: equity financing. Equity financing is the process of raising capital through the sale of ownership in the company. For many businesses, equity financing starts with venture capitals or angel investors. These are the people you see praised at Silicon Valley and the ABC TV show “Shark Tank.” However, many of your parents and you purchase Apple, Facebook, and Google stocks on investing portfolio. Believe it or not, you are performing equity financing.

Business owners desire to use equity financing to raise capital for a variety of reasons. For instance, equity investors take risk when purchasing shares of your company. So, business owners owe no future money because they have been given small ownership of the company already.

Unfortunately, there are downfalls with equity financing. As an illustration, businesses need to give a considerable percentage of their companies to raise enough funding for projects and operations. Therefore, equity investors take their share of the profits if the company continues to grow and becomes successful.

You must wondering which is the best way for businesses to finance their companies: debt or equity? All companies do a combination of both! Business management goal is to minimize the Weighted Average Cost of Capital. Below is the formula for WACC. This is an analysis tool used by companies to decide how much their company is spending to propel growth and profitability.