Economics: Basic Tools of Finance

Difficulty: 1/3 (Much easier compared to earlier chapters)
Review: 5/5 (short and sweet)

Alright so last blog post was longer than intended so I'm going to make this one shorter, like a crash course.

If interest rate is r, then value of money of the present until future is (1+r)^n * P where P = principal amount of money put in and n = number of years. The money compounds in the bank. Thus, an X amount of money n years from now is equivalent to X/(1+r)^n dollars in the present. This method is called discounting.

People are risk averse, they tend to not like risk. The utility curve describes this, comparing utility with respect to wealth; the utility of each additional dollar of wealth grows less from diminishing marginal utility. Thus when bad things happen it's usually worse than good things happen, so people play it safe. There are 3 types of risk aversion: insurance, diversification, and risk-return trade-off.

There's the insurance market. It's like gambling. They reduce risk of individuals and spread it out. There's risk of living too long and a type of insurance pays you annuity for every year you live for an initial fee. There are problems: adverse selection (high risk people like buying insurance), moral hazard (once I have insurance I can be risky). Insurance companies can't discriminate these people well, so they raise prices if risk is high.

There's diversification of firm specific risk. Don't put all your eggs in one basket. The more variety you have the less standard deviation of risk there is, as shown in portfolios. There is firm-specific risk from different companies depending on the company, but there is always market risk, like risk of recession that affects all.

There's the trade off between risk and return. You can have more risk for more return with stocks or play it cool with government bonds or banks.

Asset Valuation: what determines the price of stock? Well, use fundamental analysis of the company to determine its value. Buy stocks when undervalued and sell when overvalued.

Efficient Market Hypothesis states that everyone manages closely so that there is equilibrium of those who think undervalued and overvalued. It makes the market informationally efficient, it uses all information, and thus shows how current value of stock is pretty heckin' accurate based off of what's given and is fairly valued. The random walk is an implication, shows the wobble in stocks.

The EM hypothesis is not completely true, but largely is. Index funds that automatically buy and sell at certain indices do better than active managers generally. You can't beat the market.

Market irrationality debate continues, the market fluctuates and isn't very predictable. Still, it can't be fully irrational or else someone would have taken advantage of it. Wow, so controversial.