High Yield Spread and VIX
Investors can use the high yield spread and VIX to assess investor sentiment and stock market expectations. Both have proven to be reliable indicators, but no indicator is 100% accurate so investors could use these indicators as part of their overall investment analysis and strategy.
Funding a Company and Capital Structure
Investors need to understand not only how a company funds its operations but also the makeup of its capital structure, since both are critical to successful companies and investment returns. Borrowing from banks is just one way a company can fund its operations and investments, and several different classes of capital are available to firms throughout their corporate life cycle.
The Federal Reserve and Monetary Policy
Central banks, including the Federal Reserve, are responsible for monetary policy, which refers to the actions taken by central banks to manage the money supply, and, consequently, interest rates. These activities work toward achieving macroeconomic goals like stable prices, low unemployment, and economic growth. In contrast, fiscal policy is under the purview of the government, which uses taxation and government spending to influence a country’s economy, with the objective of promoting sustainable economic growth, manage inflation and stabilize business cycles. In a free market economy, interest rates along the entire yield curve are a function of market factors, and the Federal Reserve uses monetary policy tools to influence interest rates.
Tariff Considerations for Investors
Tariffs are taxes, sometimes called duties, to be paid on a specific class of imports, and function like a tax on imported goods. Historically their purpose was to protect domestic producers, and often are compared to value-added-taxes (VAT). However, whereas a tariff is applied only to specific imports, a VAT is a broad consumption tax on both domestic and imported goods, and for imported goods you could have both. For example, tariffs are applied to the customs value of goods, and then a VAT is applied to the total value. What tariffs and taxes have in common is the government receives the proceeds, but where they differ is who pays.
Financial Account Framework
Investment objective, liquidity, and time horizon are three variables that can be used as a basis for a financial account framework. Financial accounts are considered those that comprise financial assets and includes bank, brokerage, retirement, education accounts, and others based on personal circumstances.
Personal Financial Statements
Investors use financial statements to assess the financial condition and performance of companies. However, equally important is for investors to assess their own financial position through the use of personal financial statements, in particular a Balance Sheet and Income Statement.
Financial Theory and Investment Decisions
There are many definitions of risk, but the definition I’ve found that most closely aligns with investing and risk management is that risk is the potential for deviation from an expected result, whether the deviation is a positive or negative result. Managing investment risks, by extension, is the analytical process that measures the potential for deviation to better enable decision-making on what risk to pursue, mitigate or avoid. Risk and return go together, and every investment decision carries an element of risk, which is why a practical understanding of financial theory can assist investment decision-making.
Market Risk
There are many risk factors that could give rise to market risk, including: geopolitical risk, monetary and fiscal policy, changes in interest rates and foreign exchange rates, terrorist events, and natural disasters. The need to understand market risk has grown as the operating environment has become more volatile and this volatility has increased the potential for large, frequent and unexpected asset price swings, consequently regulators have increased expectations for banks to develop extreme but plausible scenarios for their modeling framework, but investors also need to consider how volatility catalysts could impact their portfolios, and many brokerage firms have built capabilities that enable investors to stress test their portfolios.
Financial Markets Primer
Asking what the market did today is a common question, but in this case the market is really referencing a single equity index, which is usually the S&P 500. While the S&P 500 is a significant index it is only a single index within an economy that has multiple markets, and each market operates in different ways. A market, by definition, is a trading place where a buyer and seller exchange goods and services, and it could be a physical market or an online market. Because the definition is so broad, the balance of this article addresses financial markets: equity markets, debt markets, derivative markets and money markets.
Investment Objectives
Perhaps the single most important question an investor can ask himself or herself is “what is my investment objective”. The answer to that question serves as the basis underpinning investment decisions and investment objectives can change over time. Let’s take a look at investment objectives for a specific individual’s 401K and over time.
Accounting and Financial Statements
Accounting is the language of business, and financial statements summarize the various underlying accounting entries. Accounting, especially through financial statements, allows us to understand a business and make better investment decisions, but it also allows us to improve our personal financial lives.
Liquidity, Cash Flow and Capital
Liquidity, cash flow and capital play critical roles in ensuring firm solvency, especially during stress scenarios like the 2008 recession, and supporting the growth and performance of a firm. The three terms are often used interchangeably, but they are distinct and serve different purposes for firms. Firms have become insolvent because of inadequate capital, liquidity and/or cash flow, not only causing loss of shareholder value but also shaking confidence in the stability of the financial system.
Cognitive Biases and Emotions
Cognitive biases and emotions work in concert to influence our decisions, thus we need to be aware of both and deploy mechanisms to mitigate negative influences. Similarly, investors need to be aware of how firms also deploy mechanisms that mitigate biases and emotions within firms when making decisions, because it is the sum of these decisions that determines if firms, and our investments, succeed or potentially fail.