Chapter 3

CONFRONTING INFORMATION OVERLOAD

There’s no getting around it: The financial markets are complicated and getting more so every day. The sheer range of financial products and services, accompanied by an expanding mass of marketing materials and messages, can lead to frustration about whether it is even possible to make sense of it all. While there are no easy, one-size-fits-all solutions in the world of investing, it is certainly possible to get a good understanding of how the financial markets work and how you can use them to your advantage. Reading this book is an essential start.

What makes financial markets so complicated? In a strong sense, the markets’ complexity is a mirror of the complex global economy and of the billions of individuals whose daily actions underlie both. If all investors had the exact same financial goals and timetables, financial markets might never have developed at all. It is because people view their financial goals with different time horizons, with different risk tolerances, from within different national and geographical boundaries, and with different aptitudes, tastes, and ambitions that the necessity of trading in financial instruments arises. Consider the following two examples:

1. The Lerner family is saving for a child’s college education, for which they will need money in five years. It might make sense for them to invest in, say, a U.S. government bond with a maturity of five years in order to deal with their expected future liability.

2. Meanwhile, the Transit family needs to buy a car to enable one of its members to commute to a new job. They need to sell a portion of their investments, perhaps withdrawing cash from a stock fund, in order to make a down payment on the car.

From these examples, we learn a basic principle that drives markets: Investors’ divergent financial needs create a demand for markets in financial instruments. At one time, it might make sense for one investor to buy stock, while his or her neighbor could be better served by investing in a mutual fund. At a later time, their situations might reverse. Markets allow investors to buy and sell a wide variety of financial products at prices that derive from the collective actions and judgments of market participants. Note that while each family may need the same amount of money, the time frame in which those funds are necessary is very different.

Despite individual differences in risk tolerance, time horizon, and other factors, there are many things that investors share in common. In general, it can be said that all investors seek the maximum return on their investment, subject to a variety of limitations, including investor constraints (what they are allowed to invest in), investor choices (what they want to invest in), and investor safety (what they believe to be a sufficiently safe investment).

Investor Constraints

Every investor, from the individual of limited means to the manager of a large pension fund, has constraints on what he or she can buy. Sometimes these constraints are financial, such as minimum income or net worth requirements that must be met for investing in so-called hedge funds and for trading in futures and options markets. Frequently, such financial constraints are coupled with a requirement that the investor have some prior experience in the financial markets so that he or she is not starting out with an inappropriately risky investment.

Sometimes there are legal constraints, for example when foreign investors are precluded from owning more than a certain percentage of a domestic company. Other constraints may result from the practice of socially responsible investing, which takes into account the moral values of the investor or investment policy committee, who may wish to avoid investing in a certain industry or country. On still other occasions, the constraint is determined by practical considerations, such as the need for a certain level of return (a so-called hurdle rate) or for a high degree of correlation with a benchmark.

benchmark

A standard used for valuation purposes.

Investor Choices

Despite all the talk about herd mentality, all investors do not think alike. Some investors avoid the financial markets entirely, choosing instead to invest their savings in real estate, family businesses, art, and so forth, while keeping an adequate supply of readily available cash on deposit with a federally insured bank. Others, while feeling comfortable with some combination of bonds (U.S. government, AAA-rated corporate, and tax-exempt), avoid investing in the stock market because they perceive it as too risky. Still others prefer to invest in stock only indirectly, through the purchase of top-performing equity mutual funds, perhaps within a tax-deferred IRA or 401(k) retirement plan. Finally, there are investors who take a passionate interest in finding the next great growth or story stock, or who painstakingly assemble and monitor a long-term portfolio of stocks chosen for their intrinsic value, perhaps according to some indicator, financial ratio, or quantitative model.

growth stock

Stock of a company with growing earnings and/or sales.

story stock

Stock of a new company without real earnings, but with an exciting idea, opportunity, or technology.

Behind all of these choices are the varied lessons that different people have taken from recent (and not-so-recent) economic history. Those old enough to remember the Great Depression may tend to view things through a different lens than those of us whose formative years were in the postwar boom era, the stagflation, gasoline lines, and gold boom of the 1970s, or the great stock market boom of the 1980s and 1990s. This makes good sense. It also makes markets, as investors chase different objectives with different views of value.

Notwithstanding the differences with which investors come to the markets, there are also common threads that affect us all. In particular, the impact of recent news—good or bad—tends to exert a powerful influence on investors’ perceptions about what to buy and sell. Many studies suggest that investors tend to give too much weight to recent events, and to forget the old adage “this too shall pass.” In consequence, many investors wind up buying overpriced securities, caught up in the enthusiasm of the moment, or on the other hand, selling undervalued securities with the mistaken belief that their price reflects the securities’ true value. We will look at the difficulties and opportunities that stem from these all-too-human tendencies in Section VI, “Summing Up Risk and Return.”

Investment Alternatives

You’ve probably seen this type of list before. No list of this type can be both comprehensive and usable. Aside from this problem, lists frequently convey the illusion that the alternatives are not only exhaustive but mutually exclusive. This, too, is usually false. There is a great deal of overlap among different kinds of investments; sometimes, the biggest difference between two investments is how they are packaged and marketed.

 

Investment Alternatives

Real estate
Family business
Art and other collectibles
Precious metals
Gems
Bank certificate of deposit
Bond
Stock
Mutual fund
Option
Future
Hedge fund
Wrap fee account
Funds of funds
Annuity
Insurance policy
Cash

Investor Safety

Many investors hold back from committing their capital to an otherwise attractive investment because of its perceived risk. People accustomed to the safety of federally guaranteed bank deposits are frequently ambivalent about investing in financial markets, particularly the stock market. They are attracted by the return potential, but are discouraged by the lack of principal guarantees. Too often, however, decisions about risk are made from a purely emotional standpoint and without a proper understanding of the relationship between risk and return. Reading this book will help you to achieve a fuller understanding of risk/return trade-offs, and you will be less likely to be swayed by appeals to the twin emotions that drive the markets: fear and greed. You will be able to make more informed, intelligent choices about your financial needs and goals.