Ok – so what are the assumptions of Capital Market Theory (CMT)?

The assumptions of Capital Market theory are primarily eightfold and I will attempt to explain them below.

1. Everyone is an Efficient Investor – It goes without saying that everyone wants to be a efficient investor. No investor wants economic loss and all investors attempt to invest with a relative return correlated to their risk portfolio. The exact location of an investor on the efficient frontier is relative to this specific risk-return utility function and this is what return primary depends on.
2. Same Probability of Return - We must assume that all investors have the same probability distribution for future rates of return. That is, all investors want homogeneity – the same or similar future rates of return which again must be correlated to the risk-return profile.
3. Risk-Free RFR - An important assumption for the purpose of pure capital market theory is that all investors can lend or borrow money at the risk-free rate of return.
4. No Taxes or Transaction Costs - Importantly, CMT assumes that there are no transaction costs or taxes associated with the purchasing or selling of assets. The model cannot incorporate these features because they are essential dynamic measurements.
5. Fractional Components - CMT assumes that all investments can be purchased as fractional elements. That is, any investment can be purchased as a fractional component which allows the model to be illustrated graphically on a curve. Evidently, this is not possible in real life (1/4 of a share for example) but for the purposes of CMT it is assumed that it is possible otherwise exponential graphing wouldn’t occur.
6. No Inflation - There is not any inflation or changes in underlying interest rates in the pure world of CMT assumptions – there is only a reasonable initial assumption which can be modified later. Future changes cannot be modelled or rather – are not encompassed within the model.
7. Investments are purely risk-efficient - That is, that investments have a perfect risk correlation which infers that all capital markets are in equilibrium as each investment has a respective risk ratio which perfectly matches it.
8. Time Line - All investments in the CMT have a similar time-line across which they are measured. This infers that all investments are modeled within a relative time-space continuum. If investments were not measured across a similar time period then evidently other variables would change such as the measurements of risk and so forth.

Evidently, this is a whole bunch of assumptions which really begin to make one laugh at how well a model can really encompass the real world environment when so many variables are isolated. The idea of the theory is to merely measure some variables and allow us to explain asset pricing and the rates of return on assets. The entire foundation (well almost) of capital market theory is the concept that a risk-free asset exists – without this fundamental assumption there could not be a measurable comparison between risky and non-risky assets – that is, without a risk-free asset as a basis how could one formulate what is a risky asset? There would no compatible base indicator and this why it’s such a critical assumption.

What is a Risk-Free Asset exactly? That is for a future post!

• Trade-off Theory – The Trade-off Theory is a theory which suggests that companies have an optimal capital structure based on a trade-off between the benefits and the costs of using debt. 
• Pecking Order Theory – The Pecking Order Theory – or the ‘Capital Shuffle’ as I call it – suggests that companies always follow a hierarchical pattern in financing sources such that internal funds are always preferred to external ones and borrowing is preferred to issuing risky securities. This theory is based on information asymmetry whereby all relevant information is not known by all parties interested in knowing it. Information asymmetry is the battle ground for most fundamental investors as it is involves the discrepancy between what insiders of a company know (managers) versus what those external to the company do (such as shareholders and lenders).

Trade-off Theory

The trade-off theory really emphasis the effects of taxes and the costs of financial distress in engaging in high leverage finance. This theory suggests that companies should borrow until the marginal tax advantage of additional debt is offset by the increase in present value of the expect costs of financial distress. Many opponents to the trade-off theory question how the theory actually explains capital structure decisions because there are many cases where corporate leveraging is much lower than what the trade-off theory suggests. Such opponents argue that many multi-national companies with high profit margins have operated for an extended period of time with low debt ratios and achieved solid credit ratings. Trade-off theory would suggest that these same companies could achieve significant interest tax savings by increasing their debt ratios without any remote possibility of financial distress becoming an issue.

Evidently, there are large bodies of evidence to suggest the opposite is also true and that trade-off theory is entirely useful. Trade-off theory can explain most of the differences in capital structure that exist between competing industries in stances where leveraging is low when business risk is high and when most of companies assets are intangible in nature. However, while trade-off theory does really take a common sense approach to capital structure there are many things it cannot explain. Some of these include:

• the conservative nature of companies when utilising debt finance
• why leverage is negatively related to profitability
• why leverage is so consistent across most countries despite huge variances in their taxation systems

Pecking Order Theory

The Pecking Order Theory is a popular capital structure theory which usually explains why internal finance is much more popular than external finance and why debt is classified as the most attractive external finance option. The theory basically suggests that companies with high profitability may use less debt than other companies because they have less need to raise funds externally and because debt is the ‘cheapest’ and most ‘attractive’ external option when compared to other methods of capital raising.

Conclusion

Both of these methods have there advantages and their disadvantages when examining the structures of capital financing. There are an abundant number of issues which must be explored and there are numerous texts available on this branch of finance. The most important aspect is to understand the different structures of capital financing so that it is possible to estimate the future profitability of a company and also the managements strategies in raising differing forms of finance. Information asymmetry does imply that ‘insiders’ will always have a greater knowledge bucket in comparison to external investors of a company, and therefore examining the different methods of capital structure does help to strike abalance in the vicinity of par towards those external to a company.

The public debt market

It’s firstly very important to realise that the public debt market has a number of different segments depending on the length of the debt obligation. That is,

1. Bonds will short term maturities of less than one year – this is coined as the money market by investors.
2. Medium length maturities of more than one year but less than 10 years and is typically coined the note market.
3. Long-term maturities with a maturity that typically extends for more than 10 years and are subsequently called bonds.

The live of the debt obligation can change towards the maturity date such that debt obligations can be traded in a secondary market. This is a very important point to understand in debt obligations because when pricing bonds we look at the volatility of the bond and a big factor in determining this volatility is the remaining maturity life of the bond.

So what are bonds ?

Public Bonds are typically long-term, fixed debt obligation securities packaged into affordable denominations for sale to individual investors or to large financial institutions. They are substantially different to other debt securities such as mortgages since they are sold entirely to the public rather than to private  lenders. Bond issues are fixed-income because they have fixed requirements on issuers of them. The issuer usually agrees to pay a fixed amount of interest over a period of time to the holder of the bond and t repay a fixed amount of principal at a specific date of maturity.

A standard interest term is usually every six months for bonds, but this can change depending on the issuers requirements to as long as 1 year or as short as 1 month. The principal amount is that required to be repayed is due at the agreed maturity date to the holder and this is termed the par value of the bond.

Bond Characteristics

There are a bunch of unique bond characteristics that we must explore to really understand what bonds are. A bond is typically based on its instrinsic features, its type and any relevant features which affect its cash flows and/or its maturity which subsequently would influence its volatility.

The coupon, maturity, value and ownership characteristics all fall within the intrinsic features of a bond. A coupon is basically the income buckets that will be received by the bond holder over the life of the bond also termed the coupon income or nominal yield. The term to maturity is the amount of time before the bond matures or expires and can be split into both a single term bond or a serial bond. Evidently, the name suggests the inherent differences such that a single term bond has only one maturity date whereas a serial bond has a series of maturity dates.

The par value of a bond, as suggested earlier, represents the original value of the obligation. Don’t get confused with par value as the market value of the bond since it is not. The market price of a bond can rise and fall above or below the bonds principal value because of differences between the bonds coupon payments and the current market interest rates.

Finally some ownership differences can effect a bonds characteristics such that a bearer bond is the owner, and the issuer has no ownership rights while a registered bond has a record of ownership and interest must be paid to the registered owner.

What affects a Bonds Maturity?

This is perhaps one of the more trickier areas when understanding bonds. There are usually three core things which will affected the maturity of a bond and they range in complexity. For example, a noncallable provision of a bond is where the issuer cannot retire the bond prior to its maturity date while a freely callable provision is one which allows the issuer to retire the bond at any time. This is similar to logic of European and American call options. The ‘middle man’ provision is called the deferred call which infers that a bond cannot be called for a certain period of time after the date of the bond issue.

One other feature which can affect a bond is coined the sinking-fund – which infers that a bond must be paid off over the life of the bond rather than as a lump sum at the maturity date. The size of the sinking fund is typically calculated as a percantage of a bond issue or as a total percentage of the debt outstanding.

Conclusion

So you can see that bonds are complex instruments but clearly a very important aspect of the debt market around the world. The more information that you can get on bonds, the better since they are a very important tool for large scale financial institutions around the world as well as for Governments. If you feel I have missed anything (this is only a brief overview) or that I should do another post on a particular section then please let me know and I’ll try and get something up.

By slashing the interest by a full percentage point – the RBA is hoping to reduce pressure pressure on banks and ensure that they remain profitable throughout this period of market turmoil. The ASX was down in morning trading today but shot up very quickly after the news was released and now is again in the black. As I stated in my last post:

Of course, the risk in all of this is that the Big Banks are not going to pass on any associated interest rate cut in order to sooth the pain of the huge losses from the USA market collapse, and the still very high funding costs. Unfortunately, this is not something that the market can directly control – other than to pressure the Federal Government to in turn, pressure the banks to fully pass on the cut.

This is still true of course, and despite their mega billion dollar profits – the banks should still pass on at least 50 basis points, or 0.50% cut, to their lending rates in order to free up some consumer dollars and assist big business in their interest costs. The focus now, of course, is going to be on the Australia Dollar and its plummeting value – something I think the RBA is not really looking at, at the moment – but will have to be in the coming months and importers feel the pain and exporters get rich (although maybe not if they have locked in their contracts until March 2009). While the free up in interest repayments is good for consumers, the cost of living may be on the increase as importers start hiking the cost of their goods up in order to match any associated losses with higher import costs.

I would watch this area closely. The Aussie dollar has taken a dive of more than 10 US cents in the past couple of trading days, was recently at 70.37 US cents, down from 71.97 just prior to the RBA’s shock move. Unless something changes in the market, I would think it’s going to go lower as other Asian countries start selling off the AUD because of future interest rate decreases.

Typically, you see “marked to market” referring to a derivatives position or a margin lending facility. At the end of each trading day, each counter party exchanges the change in the market value of their position in cash. That is, each counter party is required to settle their obligations to ensure a “zero-net-game” exists. So “marking to market” typically occurs at the end of the trading day where an account has fallen below a given threshold and a broker requests from the client, via a margin call, that the client deposits more funds (or at worst, liquidates the account) in order to get the account back within the predefined “ratio limit”. i.e. the ratio limit is the amount a broker will allow for “fluctuations” in the market before instigating a margin call. Typically most brokers set this rate between 5% – 10% of the trade amount. So if you had a $10,000 margin loan set up, and the ratio limit before a margin call was instigated was at 10% – a value drop of more than $1000 would instigate a margin call and you would be required to top up the account.

So really ‘marked-to-market’ means ensuring that the position you are in is “converted to the current market prices” and is a full reflection of the market on any given day at closing.

Learning to Invest

If you break down learning, the most fundamental aspect to it starts at the absorption of information – whether it be through visual or audio means. Yes, it’s true that some people learn better by practically experiencing things but I would argue that fundamentally, most people truly learn through reading. Undoubtedly, reading is the single most important factor in investing. Forget the complex maths, the structured finance products, the thousands of videos I get sent on ‘how to beat the market’ and ‘earn $1 million in 24 hours’ – they are just trash. They only demonstrate someone elses learning (& a lot of false promises). No, the truth behind learning to invest is straight forward and simple – reading.

Warren Buffet once famously said that when he first started investing he

“read everything. Every magazine and newspaper that had financial commentary in it, I would read and question and jot down notes. The more I read about the market, the more I understood it – and the more I understood it, the more I began to understand where to put my money.”

In my mind, I have no question that this is true. The best way to get interested in investing and proactively engage in ways to make your money grow, is to target an area of the market that you are interested in – and read a whole lot about it. The more you read about a particular sector, the more you will begin to understand the niche areas of this sector. ‘Big Gain’ investing is ALWAYS centered around niche areas and information dissemination. It’s a measure of what you know that someone else doesn’t and how quickly you can act on that information before the market does. Of course, I am not suggesting that you start engaging in ‘insider trading’ – rather, I am suggesting the complete opposite – by researching and reading as much information as you can find on a particular market sector that you are interested in, you will begin to understand the market trends and niche areas to target. This will then allow you to ‘cherry pick’ investments that will return great, if not, outstanding results.

But Tim, I don’t have the time to read!

This brings me to the second point that really frustrates me and is what I actually intended to focus the majority of this post on. People are always complaining to me that they have made “bad investments” or that the market “is against” them. I respond by suggesting – “why did you choose that investment in the first place?” And they typically say to me, “well such and such said this” or “I read a report which said that” – and my response is then “so what you are really telling me is that you didn’t really research the investment“. The most common defense to this is then “well I have a financial planner who looks after my affairs”, and then I respond “well perhaps you really didn’t research the financial planner well enough?”. I am by no means trying to be smug with responses such as these – I am merely trying to make these people aware of what they are really saying and take some accountability for their actions. Ultimately, it’s their money that’s being lost and I often find it’s me trying to convince them to be more proactive in the management of it.

I think sometimes people get dissociated from the fact that they are paying financial planners to work for them. That’s right – the market is awash with financial planning companies, and if your planner is not returning you what you expect them to be returning, or more importantly, what they have allegedly ‘promised based on past returns’ – there is absolutely nothing stopping you moving to another one. You should be consistently maintaining contact with anyone that manages your affairs to ensure they are not ignoring your portfolio – not matter how small – in favour of higher net worth clients. And in truth, if they are any good – they should be maintaining regular contact with you. If they aren’t – question them as to why they aren’t! (Perhaps this topic needs another post as I again digress from the main point of this post.)

Realistically, what happens to most mum and dad investors (who don’t have a financial planner) is that they trust their money to blue chip stocks which are always market indicators – that is, these stocks market value (market capitalization) is so large that they are always in line with business cycles. This means that mum and dads investments will also always rise and fall with the market, and they will complain that their portfolio has little or average growth.

The key to making strong profits from investing, and the strategy that stock brokers and fund managers take, is to trade stocks that are always increasing (duh!). This seems like such a stupid statement to make, yet I find that not many mum and dad investors truly understand it. This again, comes back to the principle I am attempting to focus this post on – time. I think it may not be such a case as them not understanding it, as much as it is a case of them not having the time to understand it and therefore not bothering to actively manage their money. Most people become completely ‘daffed’ with anything to do with investing and are often confused by the financial lingo. I absolutely empathize with these people because life gets busy and one more thing to add into the mix is often just too hard. But at the same time I argue – if you never make an effort to learn about it, then how are you every going to understand it and why are you risking your hard earned money in it ?

Call me a cynic, but I have always been of the belief that if you are going to trust someone else with your money without understanding the core principles behind what they are doing with it – then you are gambling. This is what has lead to some many problems in the financial planning sector – a core misunderstanding between client instruction and financial planning representation. Have a basic understanding about where your money is going to be invested, and question why it is going there. If you don’t feel comfortable with a recommendation, suggest another one. Ask questions, and then ask some more.

They key to it all of course is to make time to read.

Let’s break it down very simply and easily again. Make time to read.

There are 168 hours in a week. Subtract 56 of these for sleep at 8 hours a day, and you are now at 16 hour days or a 112 hour weeks. Lets now also assume that each day it takes 2 hours in the morning to get up and get to work and the same to leave work and get home – a total of 4 hours. That’s another 20 hours gone for the average 5 day working week. You now have 92 hours left in the week. Lets also subtract 45 hours for weekday work, and you arrive at the magic number of 47 hours of free time for the average person.

47 Hours!

You cannot honestly tell me that you cannot find 2-3 hours (or even 30 minutes) a week out of this 47 hours to read some information about the stock market or investing or a market sector that you are personally interested in. This free time doesn’t even include the 5 hour weekly lunch break period or the Internet “breaks” when you are at work. Extrapolate this figure across an entire year without any holidays and it’s 2,444 hours of free time! This is such a huge amount of time that you currently spend doing other activities or watching TV! 30 less minutes of television a week will not only improve your health, it may improve your wallet!

I am not suggesting that you become a professor of finance, or that you need to be the next Warren Buffet. I am simply suggesting that you have so much free time available when you break it down, that to really allocate a tiny portion of it each week to reading something about investing is not much to ask. It’s only going to improve your knowledge and help you manage both your money and your investments better throughout your life and those of your future generations.

Hopefully in the time it took you to read this post, you are already better off

Buffet has always had a keen eye for killer investments when they are at rock bottom prices. His view of the world, from what I have read, is that now is the time to buy and to buy up big – this is true if you have a spare $47 Billion in cash on your balance sheet such as Berkshire Hathaway has. Funnily enough, Buffets investment strategy has always been to investment in rock solid “moat surrounding the castle” businesses who have a sustainable business model that he can clearly understand and comprehend. His view is that “businesses who can extend the moat, and build the castle bigger are where you want your money to sit.” He once famously said that “The World loves Coke. It always has and always will, so that’s why I bought into the business – it’s not exactly rocket science”.

However, the move into the investment and financial banking world does go against some of his ideologies. Buffet has always attempted to steer clear of financial derivatives suggesting they are a “financial train wreck” primarily due to his past experience from the acquisition of General Re, an insurance company, which was completely ruined because of complex derivative instruments which were taken out by the company – unclear to Buffet at the time.

The newest investment into Goldman Sachs will give Buffet approximately a 10% annual dividend which is around $500 million in cash per year. The dividends are attached to preference shares and take precedence over common stock holders. It will also get $5 Billion in warrants over common stock struck at $115 a share which can be exercised at any time in the next five years. It would seem according to Goldman Sachs closing price yesterday of $125.05 USD – this is a very good buy (they made it to $134.75 USD in after hours trading – *cha ching*). Goldman’s shares this time last year where riding around $247 USD – more than 40% higher than what they are now.

Is this a safe investment? Well, as a federally regulated bank holding company – Goldman Sachs cannot take the risks that some of the other investment banks on Wall St have taken which lead to the huge and spectacular bonuses seen in recent years. After the current market nightmare, you would perceive this as a good thing and probably one of the strongest reasons as to why Buffet purchased such a large stake in the company.

Buy low, sell high? Buffet certainly hopes so.

As part of the Small Stocks redesign – we want you to let us know what sort of education you want to read about. We have plenty of content that we can post about but we thought that it would be much easier to simply ask you, as the readers of Small Stocks what content you want to read about. Also, if there is a particular area of the market you want to read about – such as Mining or Tech stocks – then let us know and we can put up a few posts around this.

I’ve got a pretty extensive knowledge database that I have compiled over the years and I am happy to share any of this information as people request it. The more stuff you want to know about, the faster I can post it. At this stage, I am happy to post a lot more technical analysis education – since I get a lot of emails regarding this – but if there is something else you are keen to see let me know.

Growth Period (Age 20 - 35)

• You are attempting to accumulate assets in order to achieve immediate needs or long term goals
• Your acceptance of risk is fairly high because you realize that you have a long investment horizon in which you can accumulate more assets.

Consolidation Period (Age 35 – 55)

• You are now well into your career and are paying off the majority of your long-term debt such as your mortgage and other associated debts.
• Your earning should exceed you debt and you should be investing this for future retirement in medium-risk investments for your retirement
• You no longer are willing to accept a high level of risk you earning capacity is decreasing as you get older.

Retirement and Spending Period (Age 55 - 75+)

• You have usually accumulated all your life-time earnings and you are at the peak to your net worth
• Your assets and income should more than cover any expenses and you should be able to satisfy any future goals
• You are no longer willing to invest in medium to high risk investments because you have enough equity capital to sustain your expenses
• You now have the ability to spend your lifetime earnings and enjoy the remaining time of your life.

It is important to remember that this is just an established and widely accepted guideline but is by no means definitive or perfect. You may differ from this structure because of a hugely differing number of reasons that are specific to you and these should be discussed with your financial planner or adviser. The purpose of including them in this educational section is not to get you overly worried about their importance but to ensure you are conscious of the underlying purpose of these periods and the reasoning behind why they exist.

This is generally because you are approaching the later stage of your life and wish to spend the money that you have accumulated during it and not risk it for the purposes of accumulating more money. Conversely, if you are at a young age you have a longer investment horizon (time available to invest) available to you and therefore can choose to take higher levels of risk, provide more capital (money) for your investments and not be as concerned about the investment liquidity because you are able to continue to gain wealth, because of your age, even if your investment has not returned what you wanted it to.

While these two different situations may not always be true, most people will not choose to adopt a lot of risk at an older age because they have spent the majority of their life earning money, and choose not to take unnecessary risks later in life that may lose them their earnings. Young people don’t have this concern as they have a longer time horizon in which to re-invest should an investment turn sour.

Therefore, it is important to understand that this means that age is positively correlated to the amount of risk that will be adopted (see Risk Section) and it is sensible to parallel this relationship to your own investment strategy.

The correlation of age in comparison to risk, and age in comparison to net value (value of all your assets) can be modeled graphically.