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PHOTO: CHRISTIAN SCHIRM
Ahead Education, 10 Aug 2016
You will not find it in financial statements nor in accounting ledgers. Yet, it’s a central idea in sound business decision-making, which should not be taken lightly. The opportunity cost is a virtual construct that could and should be applied in management as well as in finance, if not in daily life as well.
What is an opportunity cost?
In simple terms, when facing two choices, the opportunity cost is the ... READ MORE
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The dangers of ignoring opportunity costs
Ahead Education, 3 Aug 2016
They say education is the great equalizer. Equal educational opportunities have repeatedly proven successful for socio-economic equity in countries with high wealth inequalities, racial equity in multi-ethnic countries, and gender equity in a vast part of the world. While the subject mostly refers to developing countries, there are still biases, with varying degrees of severity, present in some modernized countries. Not only do women acquire more knowledge and skills through education, thus bringing an ... READ MORE
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Can the market be truly predicted?
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Why Apple sits on so much cash
Is it possible to predict a certain stock? Can past price movements predict the future? The debate over the efficiency of the financial markets is as old as the markets themselves. The battle between bulls and bears takes another dimension between those who claim that the markets are as efficient as a WYSIWYG (what you see is what you get), and those who assume them to be areas of overly sentimental mobs, mildly chaotic, but sometimes dangerously in unison.
The Efficient Markets Hypothesis (EMH) assumes that the markets include all the relevant information into a security’s current price. It bases itself on the assumption that investors are rational and value securities based on their expected future cash flows. It also assumes that irrational investors cancel each other’s decisions. Accordingly, the price of a security will only change when there is new relevant information in the market, and thus comes the term “random walk”.
EMH has three forms indicating the degree of information incorporated:
1. The weak form: prices from the past do not predict the future. We know from a global perspective, and over (very long) periods of time, securities grow in value. This is only true if we are looking at decades, but in between, there is no price-driven predictor of how a certain stock or bond will do tomorrow based on its history.
2. Semi-strong form: publicly available information cannot help you predict the future prices. This form assumes that all public information is already incorporated in today’s price. Whatever news you may find is therefore redundant, and investors have already, through trading, adjusted the price to reflect all the public information.
3. Strong form: all information (public and private) cannot help you predict the future prices. In this scenario, even inside traders are facing a complete random outcome. Everything there is to be possibly known, public or private, is already reflected in today’s price. The price will only change, up or down, if new information comes up.
So how is this supposed to happen? Since this hypothesis considers investors to be making rational decisions, a phenomenon called arbitrage is taking place. Simply put, arbitrage is the profitable trade of securities based on discrepancies between the actual price of a security and its intrinsic value. Such trades will bring the price closer to the “real” value, thus eliminating any deviation.
Rational arbitrageurs will ensure that any fluctuation beyond the real value is eliminated. This behavior is far more common in algorithmic high frequency trading -computers supposedly being the most rational-, which today constitute the majority of the transaction volumes, nibbling small profits per trade from any price discrepancy, and thus maximizing the market efficiency. (High frequency trading has its own set of problems and disasters, beyond the scope of this article).
So if the markets are truly as random as flipping a coin, why even bother invest and trade? Enter behavioral finance.
Even as rational human beings, we often place our judgements based on the perceptions that may not be entirely real. Even worse, we sometimes do not process accurate information correctly. Why? Because we’re human.
Take politics for example, we have witnessed throughout history that large populations may drift out of the reasonably rational when times are rough, especially in poverty or war.
In the financial markets, the most remarkable cases when this happens are bubbles. Bubbles are the result when the prices of tradable securities outrageously, and consistently, diverge from their intrinsic values, only to suddenly collapse after market information reveals that said market cannot truly deliver to the hopes of the security issuers and investors alike. These are the most memorable moments on the financial news: watching traders switch from mania to panic.
While most noticeable, bubbles may only be proofs that irrational and perception-driven decisions are made on a daily basis, but unlike bubbles, we cannot see them.
Some of the errors in processing information are overconfidence in abilities to forecast, conservatism and resistance to change beliefs in face of new information, wrong sample sizing, and faulty forecasting. Other forms of irrationalities come in the form of behavioral biases. Even when the information has been correctly processed, investors may still misplace their judgements from past successes or bitter experiences. They may also be willing to take higher risks with gains than with their principal, something which mathematically does not make any sense, but is more common in the psychological behavior in gambling (Lookup the dictionary entry for “greed”.)
While diametrically opposite, both hypotheses have their merits; the truth may be somewhere in between, or it simply may depend on which kind of investor you are. For the majority of investors who deal with trading without looking at the much larger political and socio-economical contexts, EMH is the more accepted reality. However, for some, such as Warren Buffett, to truly “beat” the market, to be able to simultaneously see the divergence of wind and ship directions –and more importantly their later convergence-, a strong understanding of behavioral finance becomes a must.
Ahead Education, 27 Jul 2016
In the middle of a public debate concerning Apple’s overseas cash stockpile of $216 billion, there is a similar discussion whether Apple truly holds that amount in cash. Some claim that the money is stockpiling because Apple is not able to bring it back to the United States for fear of being subjected to corporate taxes. There are, however, other more fundamental reasons, why a company basing itself on innovation chooses to save as much money as possible.
Ahead Education, 17 Aug 2016