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Answers to Basic Questions About Finance
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What's this "finance" thing all about?
Finance is all about deciding how people should spend their time. It's about deciding what society is going to produce. It's about directing human labor. That's the main reason that finance exists. Example:
Now, while that may be the main reason finance exists, that doesn't mean that's what everyone in finance spends their time thinking about.
Further reading:
http://en.wikipedia.org/wiki/Finance
TODO: Link to your YouTube video on this question.
Why do people in finance make so much money?
Part of the reason may be that the industry provides a lot of value relative to the number of people doing the work. An analogous example of this would be Google: a small number of employees (3 guys) created something that was of huge value to hundreds of millions of people, and as a result, they have become extremely rich. With finance you would seem to end up in a similar situation if you have 10 people running a hedge fund that manages the retirements of millions of teachers. [See the speech below by Larry Page]
Larry Page on the importance of seeking situations where a small number of people can help a large number of people at the same time
Why Is Finance So Big? - The Baseline Scenario
http://baselinescenario.com/2012/02/29/ ... #more-9912
The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence
http://pages.stern.nyu.edu/~tphilipp/papers/finsize.pdf
Has the US Finance Industry Become Less Efficient?
http://pages.stern.nyu.edu/~tphilipp/papers/FinEff.pdf
2014.05.15 - New Yorker Blog - HOW DO HEDGE FUNDS GET AWAY WITH IT? EIGHT THEORIES
http://www.newyorker.com/online/blogs/j ... th-it.html
2014.05.12 - New Yorker Blog - THE GREAT HEDGE-FUND MYSTERY: WHY DO THEY MAKE SO MUCH?
http://www.newyorker.com/online/blogs/j ... -much.html
TODO: Link to my YouTube video on this topic.
How can an investor be sure that the price of a stock that is undervalued by the market eventually will rise?
Warren Buffet's answer: "When I worked for Graham-Newman, I asked Ben Graham, who was then my boss, about that. He just shrugged and replied that the market always eventually does." [Source: '74 Forbes article]
My answer: It depends on what you mean by "sure". In one sense, it seems you can never be absolutely sure that the market will rise: a natural disaster could destroy the planet, for example.
How do we know the stock market isn't in a bubble?
Question
- It seems to me that many people in finance would agree that when some type of investment becomes thought of as "always going up", or "a sure thing", that can lead to that investment getting bid up to prices that don't make sense.
- For example, the housing bubble seems to have been caused in part by a widespread belief that housing prices would keep going up; that buying a house was "a sure thing".
- If that is true:
- What would be the effect of a widespread belief that the US stock market will always go up; that investing in it is "a sure thing"?
- What symptoms would suggest that it's being bid up to a price that doesn't make sense?
- What kind of event (or series of events) might lead to the end of such a widespread belief?
Answer
Is it true that speculators provide liquidity and thus are serving a useful purpose for society?
I've heard this a lot, and it seems plausible enough that I've found myself repeating it to others, but I've never thought about it in-depth and so it may be open to attack. I'll need to think about it carefully.
2015.09.14 - CNN - Mark Cuban says he could 'crush' Donald Trump
Cuban told CNBC that he'd like to try to simplify the tax code, address income inequality, college debt and fix stock exchanges that "investors are ceding control of [to] market hackers"
He told CNNMoney he was referring to computer-automated trading, which executes transactions faster than humans can. It's a common tool for short sellers, who bet that a stock will lose value.
Cuban said the practice is huge problem.
"They don't invest in stocks. They don't own stocks for a second," Cuban said. "They look for mistakes made by traditional investors."
What's the difference between hedge funds, private equity, venture capital, mutual funds?
It seems to me the difference is analogous to the difference between different kinds of restaurants: fundamentally they're all doing the same thing (providing food / directing capital), but they're each doing it in a separate style, catering to different customers, offering different prices, offering different levels of care / quality. One might ask the question, "Why can't one shop do it all?" And I think the answer is that if a firm/restaurant tried to do it all, they might get outcompeted by firms that specialized and were able to offer a higher level of service as a result.
Interesting read on VC:
http://blogs.hbr.org/2014/08/venture-ca ... ose-money/
http://wolfstreet.com/2014/08/28/how-to ... 0-million/
Inflating Snapchat’s valuation by $8 billion with a few million dollars rigs the entire IPO market that depends on buzz and hype and folly to rationalize these blue-sky valuations. Unnamed people “knowledgeable in the matter” who leak these valuations to the Wall Street Journal are an integral part of the hype machine: It balloons the valuations of other startups. And it creates that “healthy” IPO market where money doesn’t matter, where revenues and profits are replaced by custom-fabricated metrics.
The hope is that the IPO market remains “healthy” long enough for investors to be able to unload hundreds of these companies at crazy valuations. The hype surrounding these valuations is creating more enthusiasm about IPOs in a self-reinforcing loop. The hope is also that the broader stock market continues to soar so that potential acquirers can print more overvalued shares to acquire more overvalued startups so that the exists can come about.
https://news.ycombinator.com/item?id=8242456
One of the most depressing things I've heard in my life came from a VC type around 2007.
He basically told me straight up that working hard to build a real business with real value was a sucker's game. Every example he'd seen of people making real money was -- as he put it -- from "equity plays."
By equity plays he basically meant this kind of thing. I started calling it "hype, leverage, flip." If it were just a lot of harmless hot air that would be one thing, but what's really happening here is wealth transfer from honest and productive sectors of the economy and from the long-term savings of the population (e.g. pensions) into the chip stacks of high stakes gamblers.
Throughout history, gambling has always been one of the favored pastimes of decadent nobilities. Today's gambling is particularly clever, as it has the outward appearance of productive work.
What's the origin of the terms "long" and "short"?
Question
Why do they call it "being long" when you hold a security in the hope that its price will go up, and "being short" when you sell something you don't own in the hope that you'll be able to buy it cheaper in the future?
Answer
My guess at the moment: (based on limited research; I could be wrong about this)
the modern financial use of the phrase "sell short" came about in the early 1800s as a result of the way the phrases "to sell short of" and "of short X" were used in everyday conversation at the time. I would guess that the phrase "being long" came about in response to the financial use of the phrase "sell short", to describe someone taking the opposite side of the trade as someone who has sold a stock short.
More in-depth: If someone at that time didn't want to sell a stock for less than $100, they might say, "I won't sell short of $100." But if someone thought the stock was going to go down in value by a lot, then they could sell the stock short of (for less than) $100 and still make a profit, as long as they were borrowing the stock from someone else. So "sell short" may have become associated with guys who were more willing to sell stock for less than its current ticker value (because they were betting the price would go down even more).
Google search:
I couldn't come up with anything after looking for ~10 minutes. I did searches for the term w/ "etymology", "origin", etc.
Google Book search:
1835 - The progressive dictionary of the English language
This has the modern definition of "sell short", so the term has been around since at least then.
1827 - The World in Miniature: England, Scotland, and Ireland
Amongst others, the fradulent Baker was at one period carted through the city, with a label on his breast, amidst the shouts, hisses and groans of a deriding populace. The punishment of the pillory, too, has been awarded for selling bread adulterated, and of short weight; yet it appears that none of these penalties, added to pecuniary fines, could effect a reformation of these habits, so powerful at all times has been the temptation to cheat when men could effect it with even a probable chance of escaping detection.
As early as the time of Henry III, we find a law for the regulation of the prices of provisions, when the king issued his orders for the mayor and sheriffs of London to enforce them, and particularly against the Bakers. By this enactment, the Baker who sold short of the standard weight, for the first offence was to forfeit his bread, to suffer imprisonment for the second offence, and to stand in the pillory for the third.
1820 - The Plough boy, and Journal of the Board of Agriculture
This uses the term "sold short" in a different way than the modern financial meaning, but it gives me a clue as to how the modern meaning may have come about. Here's the quote:
The governor of Tennessee, having recently called a special session of the legislature of that state, on account of the extreme scarcity of money there, advises that treasury notes of the state be issued, to assist in forming a temporary circulating medium(?), and that the property of debtors be appraised, and then not liable to be sold short of two thirds of its appraised value. He states that in many instances the estimates of debtors have been swept away for a mere trifle compared with their value, and that many of those who have money hoard it up for the purpose of being enabled to prey on the distresses of those who are indebted. It is expected that the views of the legislature will accord with the recommendations of the governor.
What are ALL of the factors that have increased the valuation of the stock market over the past hundred years?
Question
What are ALL of the factors that have increased the valuation of ("the amount of money in") the stock market over the past hundred years?
Answer
I'll list what I can think of here until I find some journal article that spells it out in greater detail:
Pensions - People are taking some of their salaries and putting it into bonds, the stock market, etc. in order to save for retirement.
Population growth(?) -
Increased efficiency of companies(?) -
2014.08.16 - Robert Shiller Op-Ed in NYTimes - The Mystery of Lofty Stock Market Elevations
http://www.nytimes.com/2014/08/17/upsho ... 0002&abg=1
It’s possible that bond prices account for today’s stock market valuations. But that raises another question: Why are bond prices so high? There are short-term explanations: the role of central banks, for example. But is there a compelling reason for prices of stocks and bonds (and maybe houses, too) to remain high indefinitely?
I’ve looked for untraditional answers. Perhaps today’s prices have something to do with anxiety about the future. I suspect that after the financial crisis, working people are much more worried about their future pay. Many are concerned that they might lose their jobs to cost-cutting, or that they might eventually be replaced by a computer or robot or website. Such anxiety might push them to try to make up for these potential shortfalls by investing in stocks and bonds — even if they worry that these assets are overvalued.
Extrapolating from a theory of Robert E. Lucas Jr. of the University of Chicago, one might well expect lofty stock prices amid such worries: When there aren’t enough good investing opportunities, people wishing to save more for the future may succeed only in bidding up existing assets even if they think they’re overpriced. Call it the “life preserver on the Titanic” theory.
This explanation, though, is probably not the whole story. The problem, as shown in my work with Sanford Grossman, founder of QFS Asset Management, and in work by Lars Peter Hansen of the University of Chicago and Kenneth Singleton of Stanford, is that the market just moves up and down more than Professor Lucas’s theory would suggest.
So nothing I’ve come up with is a slam-dunk explanation for the continuing high level of valuations. I suspect that the real answers lie largely in the realm of sociology and social psychology — in phenomena like irrational exuberance, which, eventually, has always faded before. If the mood changes again, stock market investments may disappoint us.
What are the earliest books/writings on the stock market?
In the book "The Robber Barons" on pp16-17 the author mentions the early history of the stock exchanges in the US. I should type up that quote.
What does it mean for one country to compete against another economically?
Question
What are people talking about when they say that one country is competing against another economically? What do they mean when they say China is producing more engineers than the US and so will "beat" the US? I thought economists say that more productivity leaves everyone better off; is that wrong?
Answer
My guess at the moment: They mean that the average person in the "winning" country needs to trade fewer hours of his/her life to buy stuff on the world market. Here's my first stab at an example: If China can produce goods in a more efficient way than the US, then they can get more of our stuff for the stuff that we give them. So, for example, we'll have to give them 2 regular bananas for every 1 fancy-banana they give us; if it is as easy for them to make fancy bananas as it is for us to make regular bananas (so, say 1 person in China makes 1 fancy banana per day, and 1 person in the US makes 1 regular banana per day), and if they value 2 regular bananas more than we value 1 fancy banana, they'd seem to be getting the better end of the deal. On the other hand, though, you need to consider the hidden cost of all that time spent learning how to make fancy bananas. And you have to consider other ongoing costs: if people work 80 hour weeks in a country and therefore can buy a lot of stuff but have no free time, are they really better off than people in another country who work 20 hour weeks and don't have as much stuff but also have a lot of free time?
Here's another thought: It may be a cultural holdover from the pre-nuclear-weapons age, in which countries had to seriously prepare for war or else risk being invaded by a larger country.
Here's an answer from HBS professor Michael Porter:
9:03-11:15 - Michael Porter: What do we mean by "competitiveness"? A competitive economy is an economy that supports firms being successful in an international market while the standard of living in the nation improves. It's the ability to be productive.
When the market cap of the stock market goes down, where does all of that lost money "go"?
Question
Answer
Here's my bad-first-version answer: The value of the stock market isn't actually a measure of existing money that is being stored somewhere (like in a bank); it's just a measure of the estimated amount of money that people would be willing to pay for the stocks. When the market cap of all companies drops from $50 trillion to $40 trillion, that means that the perceived value of those companies has declined RELATIVE to the other possible uses of that money (eg buying bonds, paying off debt, buying food or luxury goods, etc.). If you Google this question you can get a lot of good information.
Why are there both stocks and bonds?
This is my understanding at the moment:
- I think a key to understanding the answer to this question is understanding that financial risk-reward-scenarios are at the heart of what the financial markets are all about. It's like what Michael Lewis said in Liar's Poker: financial risk-reward-scenarios can be cut up and canned like tomatoes, and then those cans can be sold to people who want to buy them. Here's an example of the kind of financial risk-reward-scenario you may deal with on a personal level: If you're out to eat with someone and they say they forgot their wallet and need to borrow $20 for lunch, you need to decide whether that's a smart idea or not to give them the money. The financial markets are all about making that exact same kind of financial decision, except scaled up to help huge companies instead of people. So, to repeat: financial risk-reward-scenarios are at the heart of what the financial markets are all about.
- For just about any product that is bought and sold, you can offer different variants of it to better suit the needs of the customers. When you go to the supermarket nowadays, you can often find several different kinds of tomatoes on sale: big ones and small ones, organic or not, etc. These different types of tomatoes are being made available because the customers have a desire / need / preference for them. Similarly, in the financial markets the customers (investors) have different preferences. For example, an expert on computer technology may want a financial product (stock/bond) related to computers that has more risk and more potential for a huge reward (like making 10x your money back), because he can use his expertise to better determine whether it's a good buy. On the other hand, your grandmother may want to have a product with less risk and less potential for a huge reward because she does not have the expertise to pick out the big winners from the losers. So, to repeat: when things are being bought and sold, you often see different variants start popping up to cater to different potential customers (the customers in this sense are the investors).
- And so that leads to why I think there are both stocks and bonds: they offer different levels of risk/reward to cater to different investors. When you buy a bond you're supposed to receive regular payments, and the idea is that you get your money back without taking a long-term view of the company (I think most bonds are supposed to get paid back within ~2-6 years). With a stock, however, you were originally receiving dividends that would continue forever, and so owning that kind of product inherently means that buyers are being asked to value those future dividends, which would seem to require more expertise.
Other answers given:
Sal Khan @ KhanAcademy - https://www.khanacademy.org/economics-f ... vs--stocks
Wikipedia Article on Bonds - http://en.wikipedia.org/wiki/Bond_(finance)
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e. they are investors), whereas bondholders have a creditor stake in the company (i.e. they are lenders). Being a creditor, bondholders have absolute priority and will be repaid before stockholders (who are owners) in the event of bankruptcy.[3] Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks are typically outstanding indefinitely.
Why are there bull markets and bear markets?
Question
Why are there bull markets and bear markets? Will they always exist? Is the market always in a bull or bear phase?
Answer
- Find examples of group dynamics where it's in the interest of individuals to follow what the group as a whole is doing.
- Groups fighting in combat (eg routing and rallying)
- Birds flocking together
Why does the stock market exist?
- Think about a (maybe) simpler question: "In the ancient world, why did town-square markets exist?" If you think about that question for a while, you may notice that there isn't just one reason. Markets provides a number of benefits; different people participate in a market for different reasons.
- It's a way for big entities (like a company) to raise big amounts of money.
Why do financial crises seem to happen more often in the fall?
It's probably prudent to first offer evidence that that really happens, and only then speculate about why it might happen.
A somewhat useful article: http://economix.blogs.nytimes.com/2009/ ... -the-fall/
Although I remember reading the first article in that book rec'd by Buffett to Gates and it talked about a '62(?) crash that happened in May.