(This post is a part of the series Basics of Finance and Investing.)

It did not surprise anyone when Warren Buffett, while recently hosting a group of business students from the University of Pennsylvania’s Wharton School (his alma mater) for a two-hour question-answer session, began by pointing out the folly of the efficient market theory (EMT). After all, his objection to EMT is as legendary as his support for fundamental analysis (FA), as the foundation for smart investing.

But first thing first: what is EMT, and what indeed is FA? (These are my short-hands, by the way.)

Efficient Market Theory (EMT)

EMT holds that the (stock) market is so efficient in absorbing the latest developments in the industry (company merger, major product launch, corporate scandal etc.) that the stock prices almost instantly reflect these developments. Thus, there is very little time available to an average investor to act on such “inside information”, before it becomes common knowledge so everyone does the same (thereby quickly driving stock prices up or down). In other words, because such developments are unpredictable, stock prices in turn cannot be predicted and they execute a random walk down Wall Street.

The investing strategy based on EMT is known as portfolio diversification, where the investors buy and hold a range of stock (and bond) funds indexed to broad segments of the financial market (also called index mutual funds). Because the prices of individual securities in a fund do not move in lockstep with each other, the portfolio achieves “diversification” by spreading the risk of asset downturns (dip in one security is compensated by rise in another).

Fundamental Analysis (FA)

FA holds the contrasting view that although unpredictable market events drive the stock prices over short times (as in EMT), there is a fundamental (or intrinsic) value of every stock that can be determined by analyzing the company papers (financial statements, annual reports etc.) and other available information on its management policy, competitive edge and so on. The stock price eventually catches up with its value (which is predictable), and the investor can benefit by trading the mispriced stock and waiting till it is “corrected” by the market.

The investing strategy based on FA is known as value investing, where the investor looks to buy undervalued stocks of otherwise healthy companies. Such a portfolio is expected to grow with time despite short-term fluctuations (so no need for diversification). But, because a company does not generally stay healthy forever (management changes, economy takes a hit, and so on), a value investor must tune his portfolio time to time by selling old overvalued stocks and buying new undervalued ones.

Go on to “Part II - Which one of them is correct?”

(This post is a part of the series Basics of Finance and Investing.)

Unlike a debt type security such as a money market or a bond, a stock is an equity or ownership type security, which entitles its buyer one share in the ownership of the issuing corporation. Because the risk of investing in a stock is significant (you may lose your entire invested asset if the corporation faces bankruptcy), stocks are examples of a variable income type security.

There are two classes of stocks: common stock and preferred stock.

Common Stock

If you buy a common stock, your ownership stake in the company comes in two flavors: you have a claim on the company’s earning, and you also get to cast one vote per stock on the company’s management decision in its yearly meetings. (Stockholders often vote by proxy, instead of attending these meetings.)

The company may either directly pay your share of income as cash dividend, or may reinvest it for business growth to earn you a capital gain (increasing the value of your stock). You have a residual claim on the company’s assets and finances in the event of a bankruptcy, because you are the last in line after others, including tax authorities, employees, bondholders and such creditors, are paid off.

Most common stocks are traded in stock exchanges such as NYSE. The most important feature of a publicly traded stock is its P/E ratio (price-to-earning ratio), which is the current stock price divided by last year’s earning per share. This value tells the investor how much to pay for each dollar the company earns. A low P/E makes a stock “undervalued” (a good buy unless the firm is facing problems), and a high P/E makes it “overvalued” (a good sell).

Preferred Stock

A preferred stock is a stock that retains some features of a bond, because the issuing company pays the investor a fixed amount each year (like a bond that never matures). Also, like a bondholder, owners of a preferred stock does not have a voting right in company management.

But, for tax purposes this payment is treated as a dividend and not an interest, which makes a preferred stock an equity type security. Also, unlike a bond, the company is not obliged to make a regular payment to the investors. In case of a bankruptcy, the preferred stock owners have a right to claim the company’s assets after the bondholders and before the holders of common stocks.

(This post is a part of the series on Basics of Finance and Investing.)

An interest rate is the monthly rate you pay as a borrower, or receive as a creditor/lender. If you save money in bank, or invest in a money market, you are indirectly lending money to a borrowing corporation (or the government). If the interest rate goes up, the borrower must pay you more, which makes them unhappy but you happy (your bank balance soars). The mood swings the other way when interest rate goes down.

Here we are talking about a real interest rate, which is the rate after adjusting for inflation. So, for the purpose of this topic, just assume inflation does not exist (hard, I know, given the reality, but it simplifies our discussion).

Demand and supply influence the real interest rate

There are almost as many different types of interest rates as the investing and borrowing choices available to us (your bank pays you one rate, and you pay another rate to your credit card company). But they all respond to three fundamental market forces: supply of funds, demand for funds, and occasional government interventions.

Households supply funds via their invested assets, whereas corporations and the government borrow these funds to finance their needs (see this post on the interaction between investors and borrowers). This dynamics of supply and demand determine how all these different rates arise. It is easy to think in terms of a single abstract rate, as the picture below illustrates, which plots real interest rate against available fund.

The supply curve (solid blue graph) goes up from left to right, because with increasing interest rate the households save and invest more. By contrast, the demand curve (solid red graph) falls as more fund is available. The intersection of these two curves, point A, determines the equilibrium real interest rate.

Now suppose there is an increase in the budget deficit, which will raise the government’s borrowing demand. This pushes the demand curve to the right (dashed red graph), and lifts the interest rate to point B, which in turn may discourage businesses from further borrowing and slow the economy down. The government may then intervene by releasing more fund from the central bank (Federal Reserve). This action pushes the supply curve to right (dashed blue graph), and brings the interest rate down (to point C).

So, again, the fundamental market forces that set the interest rate, and run the investing world, are the demand and supply of funds.

(This post is a part of the series on Basics of Finance and Investing.)

You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 - a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 - 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R - i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R - i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

(This post is a part of the series on Basics of Finance and Investing.)

Like money market, a bond market is a debt instrument issued by both the US government and corporations to borrow fund from public. But there are two differences: a bond market has longer term maturity, and bond returns are not always fixed (and so it is not totally correct to categorize them as fixed-income securities).

Following are the common bond market instruments.

Treasury Notes and Bonds

“T-note” and “T-bond” in short, these are government debt securities (like T-bill in money market) sold in denominations of $1000 or more. Maturity of a T-note is up to 10 years, and T-bonds mature between 10 and 30 years. Interests are paid semi-annually based on the specified annual rate. For example, at 4.5% annual rate, a $1000 T-note will pay you $22.5 every 6 months. Because they are backed by the government, these securities are safe investments.

Municipal Bonds

These are issued by the state and local governments, and the interest earned is exempt from the federal income tax and state tax in the issuing state. This makes them an attractive investment choice for people in high income category (they pay higher tax). But you must pay tax on any capital gain (increase in the bond value) at maturity.

To see the tax advantage of municipal bonds, suppose the interest of a taxable security is i, and your income tax bracket is t. Your after-tax earning is then i(1-t). So, if you pay 35% tax on your income, then 4.5% interest of a T-note (which is taxable) reduces to a little over 2.9% after tax. Compared to this, a municipal bond that pays 3.5% tax-free interest is quite attractive. This is also why someone coming into lot of money suddenly (like winning a lottery) finds investing in municipal bonds a good choice.

Corporate Bonds

Corporate bonds are a mean by which corporations borrow fund directly from investors. As in T-notes and T-bonds, these too pay interest in semi-annual installments and return the principal at maturity. The important difference is that a corporate bond has relatively higher risk of defaulting (in the event of the issuing firm facing bankruptcy).

Callable bonds are those that can be bought back by the issuing firm at a stipulated call price. Convertible bonds allow the bondholder to exchange each bond for a specific number company stocks.

Mortgage-backed securities

These securities, as the name suggests, are built on a pool of mortgage loans that are securitized and sold in secondary markets. Investors earn from the cash inflow as more and more loans are paid off. Because the mortgage lender collects the interest and principal payments from borrowers (home-owners) and pass them to the investors, these securities are also known as pass-throughs.

They are issued by the Government National Mortgage Association (GNMA, or Ginnie Mae), which is owned by the US government, and also by federally sponsored organizations such as the Federal National Mortgage Association (FNMA, or Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) and Federal Home Loan Bank (FHLB).

We will discuss “Stock Market” in a later post.