Asset Valuation in Finance

There are nine theories and ten methods for valuation. The valuation of any asset is a highly subjective one and depends on hosts of factors, some beyond the control of buyer or seller. This picture captures some of the essence of valuation.

The nine theories are

1. Fernandez (2007) assumes that the company will have a constant debt-to-equity ratio in book value terms. In this scenario, the risk of the increases of debt is equal to the risk of the free cash flow.
2. Miles and Ezzell (1980) assume that the company will have a constant D/E ratio in market value terms: the correct discount rate for the tax shield (D Kd T) is Kd for the first year, and Ku for the following years.
3. Modigliani and Miller (1963) assume that the amount of debt of every future year is known today and discount the tax savings due to interest payments at the risk-free rate (RF).
4. Myers (1974) makes assumptions similar to those of Modigliani and Miller (1963) and discounts the tax savings due to interest payments at the required return to debt (Kd).
5. Miller (1977) concludes that the leverage-driven value creation or value of the tax shields is zero.
6. Harris and Pringle (1985) and Ruback (1995) discount the tax shields at the required return to the unlevered equity (Ku). According to them, the value of tax shields (VTS) is VTS = PV[D Kd T ; Ku].
7. Damodaran (1994). To introduce leverage costs, Damodaran assumes that the relationship between the levered and unlevered beta is:  βL = βu + D (1-T) βu / E (Instead of the relationship obtained in Fernandez (2007), βL = βu + D (1-T) (βu - βd) / E).
8. Practitioners method. To introduce higher leverage costs, this method assumes that the relationship between the levered and unlevered beta is: βL = βu + D βu / E.
9. With-cost-of leverage. This theory assumes that the cost of leverage is the present value of the interest differential that the company pays over the risk-free rate.

The ten methods are

1. equity cash flows discounted at the required return to equity;
2. free cash flow discounted at the WACC;
3. capital cash flows discounted at the WACC before tax;
4. APV (Adjusted Present Value);
5. the business’s risk-adjusted free cash flows discounted at the required return to assets;
6. the business’s risk-adjusted equity cash flows discounted at the required return to assets;
7. economic profit discounted at the required return to equity;
8. EVA discounted at the WACC;
9. the risk-free rate-adjusted free cash flows discounted at the risk-free rate; and
10. the risk-free rate-adjusted equity cash flows discounted at the required return to assets.

But valuation of asset is a highly subjective. There can never be generalizations. Value depends on the

1. Demand and supply
2. Urgency to buy or sell
3. Behavior of seller and buyer
4. One’s forecast of future events
5. One’s future planning
6. Cash flows and discount rates

Another Inside Story

Two films apart from the recently celebrated “Inside Job” show some glimpses how money is made in the Wall Street and these carry the same name Wall Street (1987) and Wall Street:Money Never Sleeps (2010).

Mario Puzo has rightly quoted at the start of his famous novel “The Godfather” that Behind every great fortune there is a crime. Great fortunes or huge wealth can not be achieved without usurpation.

Here is an excerpt from another such story

The vast investigation into insider trading on Wall Street that culminated this week in Raj Rajaratnam going on trial in New York accused of securities fraud was always likely to ensnare a large institution – perhaps a big hedge fund or a Wall Street bank. No one, however, expected the institution in question to be McKinsey & Co.

It was bad enough for the blue-chip management consultancy when Anil Kumar, one of its partners, admitted to supplying Mr Rajaratnam with inside information in return for bribes (Mr Rajaratnam denies all charges). But the Securities and Exchange Commission’s claim last week that Rajat Gupta, who was the head of McKinsey between 1994 and 2003, passed on tips as a board member of Goldman Sachs and Procter & Gamble, is a heavy blow.

It is hard to believe that trading on price-sensitive inside information from clients is rife inside the puritan, strait-laced firm – if evidence of that emerged, it would soon collapse, as Arthur Andersen did after Enron. But the accumulation and sharing of privileged knowledge is integral to how it works and it cannot afford its corporate and government clients to pull the shutters down.

Thomas Watson Jr, the former president of IBM, wrote in his autobiography Father, Son & Co of being asked by a company executive in 1956 whether he should share sensitive internal pricing information with a Booz Allen Hamilton consultant. “‘Sure,’ I said, ‘It’s like your doctor. You have to tell them everything.’”

The calculation every client makes is, in the words of Christopher McKenna, a professor at the Oxford university’s Saïd Business School who studies professional services firms, that “consultants will carry information in and information out. The client has to decide which of those flows is worth more.”

Indeed, one of the main reasons companies hire consultants is to make sure they do not fall behind what their competitors are doing – in return for parting with their own secrets, they gain access to their rivals’ suitably disguised “best practices”. The consultant is a broker who attempts to amass so much knowledge that each company has to hire him, no matter how uncomfortable that feels.

Can we predict future?

Ragu Rajan of University of Chicago Booth School of Business tries to explain who is responsible for not forewarning about the financial crisis that has engulfed the entire financial world.

At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis? There have been several responses to that query. One is that economists simply lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong. Finally, an answer that is gaining ground is that the system bribed economists to stay silent. In my view, the truth lies elsewhere. I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

He reluctantly accepted that forecasting future events is difficult, if not impossible. Here is another study that shows, why it is so difficult.

Stossel cited a study in the journal Economics and Portfolio Strategy that tracked 452 managed funds from 1990 to 2009, finding that only 13 beat the market average. Equating managed fund directors to “snake-oil salesmen,” Malkiel said that Wall Street is selling Main Street on the belief that experts can consistently time the market and make accurate predictions of when to buy and sell. They can’t. No one can. Not even professional economists and not even for large-scale market indicators. As economics Nobel laureate Paul Samuelson long ago noted in a 1966 Newsweek Column:  “Commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions!”

Even in a given tech area, where you might expect a greater level of specific expertise, economic forecasters fumble. On December 22, 2010, for example, the Wall Street Journal ran a piece on how the great hedge fund financier T. Boone Pickens (chair of BP Capital Management) just abandoned his “Pickens Plan” of investing in wind energy. Pickens invested $2 billion based on his prediction that the price of natural gas would stay high. It didn’t, plummeting as the drilling industry’s ability to unlock methane from shale beds improved, a turn of events even an expert such as Pickens failed to see.

Why are experts (along with us non-experts) so bad at making predictions? The world is a messy, complex and contingent place with countless intervening variables and confounding factors, which our brains are not equipped to evaluate. We evolved the capacity to make snap decisions based on short-term predictions, not rational analysis about long-term investments, and so we deceive ourselves into thinking that experts can foresee the future. This self-deception among professional prognosticators was investigated by University of California, Berkeley, professor Philip E. Tetlock, as reported in his 2005 book Expert Political Judgment. After testing 284 experts in political science, economics, history and journalism in a staggering 82,361 predictions about the future, Tetlock concluded that they did little better than “a dart-throwing chimpanzee.”

The said study concluded that expertise in one area of study leads to narrowed focus and increases confidence but also blurs the value of dissenting views and transforms data collection into belief confirmation. One way to avoid being wrong is to be skeptical whenever you catch yourself making predictions based on reducing complex phenomena into one overarching scheme.

Having said so leads us to nowhere. Since the world is a very complex phenomena and there are many intervening variables, we shall never be able to predict future whatsoever may be at our help. There will always be surprises.

A Hadith of Prophet (PBUH) - Narrated Abdullah Ibn Umar (RAA)

Allah's Apostle said, "The keys of the Unseen are five:

1. Verily with Allah (Alone) is the knowledge of the Hour,
2. He sends down the rain and
3. knows what is in the wombs.
4. No soul knows what it will earn tomorrow, and
5. no soul knows in what land it will die.

Verily, Allah is All-Knower, All-Aware." (31.34) 

Sahih Al-Bukhari  6.151

Humans As Rational Beings

Neoclassical economics is built on very strong assumptions that, over time, have become “established facts.” Most famous among these are that all economic agents (consumers, companies, etc., are fully rational, and that the so-called in- visible hand works to create market efficiency). To rational economists, these assumptions seem so basic, logical, and self-evident that they do not need any empirical scrutiny.

But how rational is human? Only one entity in this entire universe can answer this question with certainty – the One who created all things in this universe.

To Him is due the primal origin of the heavens and the earth; when He decreeth a matter He saith to it: "Be"; and it is. (Aya 117 of Sura Al-Baqara)

Allah (SWT) says in Ayat 19 –21 of Sura Al-Ma’arij

Truly man was created very impatient,

Fretful when evil touches him;

And niggardly when good reaches him

So there are bounds to rationality of human beings. The demands of classically defined rationality, according to Albin, simply go far beyond the capabilities of human actors to deal with the world’s complexities. These are the ‘barriers and bounds to rationality.’

Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating.  The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so.  This is a beautiful idea, but the question of course is how closely it represents reality.

That’s Harvard economist Greg Mankiw’s advice to students of all ages:

Economists like me often pretend that people are rational. That is, with mathematical precision, people are assumed to do the best they can to achieve their goals.

For many purposes, this approach is useful. But it is only one way to view human behavior. A bit of psychology is a useful antidote to an excess of classical economics. It reveals flaws in human rationality, including your own.

The main stumbling-block with traditional approaches to development, Sendhil Mullainathan said in a talk this year, is “this little three-pound machine that’s behind your eyes and between your ears” — the human brain. “This machine is really strange, and one of the consequences is that people are weird. They do lots of inconsistent things.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”

Why did Mr. Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? We think their mistake was to neglect the role of human nature. To prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioral economics: bounded rationality and limited self-control.The standard (non-behavioral) econ­omic model has greatly influenced regulators. In that model, economic agents (econs for short) choose optimally, no matter how hard a problem they face. They play chess as well as they play tic-tac-toe. The problem with this approach is that the world is populated by humans, not econs. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality.

سچی خوشی

ہماری زندگیوں میں جو باتیں اہم ہیں وہ ہیں ایک دوسرے کےساتھ وقت گزرانا، قریبی دوستوں کے ساتھ گپ شپ اور خوبصورت کتابیں پڑھنا اور ہم خوش قسمت ہیں کہ ہمارے پاس رہنے کے لیے جگہ ہے اور ارد گرد اتنی ثقافتی سرگرمیاں جاری رہتی ہیں جو ہمیں متحرک رکھتی ہیں۔ اس سب کچھ کے بعد آپ کیا کسی اور چیز کا مطالبہ کریں گے۔

'

یہ ہیں خیالات متوسط طبقے سے تعلق رکھنے والے ایک برطانوی نوجوان ٹوبی اورد کے جنہوں نے اپنی زندگی بھر کی کمائی ان لوگوں کے لیے

وقف کر دی ہے جن کے پاس ان کی ضرورت سے کم ہے۔

اکتیس سالہ اورد نےجو آکسفورڈ یونیورسٹی میں محقق ہیں اپنی زندگی میں دس لاکھ پاؤنڈ ضرورت مند افراد کو دینے کا عہد کیا ہے۔ اس مشن کی تکمیل کے لیے اورد نے فیصلہ کیا ہے کہ وہ سالانہ بیس ہزار پاؤنڈ سے زیادہ جتنا کمائیں گے ضرورت مندوں میں تقسیم کر دیں گے اور ان کی اہلیہ ڈاکٹر بیرنادیت ینگ نے اپنے لیے پچیس ہزار ہاؤنڈ کا ہدف رکھا ہے۔

وہ کرائے کے ایک کمرے کے خوبصورت فلیٹ میں رہتے ہیں جس میں صرف ضرورت کی بنیادی چیزیں رکھی ہیں۔ ان کے پاس ٹی وی نہیں لیکن اس کی وجہ پیسے کی کمی نہیں بلکہ ان کی خواہش ہے۔ وہ دو ہفتے میں ایک بار باہر کھانا کھاتے ہیں، ہفتے میں ایک بار کافی پیتے ہیں۔

اورد نے بی بی سی سے بات کرتے ہوئے کہا کہ جب وہ طالب علم تھے اور سالانہ چودہ ہزار پاؤنڈ کماتے تھے اس وقت وہ دنیا کے امیر ترین چار فیصد لوگوں میں سے ایک تھے۔ 'میں نے سوچا کہ اگر میں اس آمدن کا دس فیصد کسی کودے دوں تو میں پھر بھی دنیا کے امیرترین پانچ فیصد لوگوں میں شامل ہوںگا۔'

اب اورد تنہا نہیں۔ ان کی دیکھا دیکھی چونسٹھ لوگ ان کی تحریک

'Giving What We Can'(اپنی حیثیت کے مطابق دے دینا) میں شامل ہو چکے ہیں۔

Fallacies of Research

Researchers tend to generalize theories based on their observations and experiments. Sometimes these generalisations are too general, seeing things from the very high and assuming a dream world to be of any help in solving the real world phenomena and sometimes these generalisations are based on limited data that make these research meaningless in our day to day life. Take the case of Capital Structure theories in Finance, there is no link to real world and interaction of human beings who are not so rational and the markets are not so efficient.

Behavioural Finance has come to rectify this anomaly. But it also have its limitations. Here is an excerpt from an article that shows what these are

The behavioural revolution in economics and psychology has successfully identified and named close to three dozen biases (my favourite behavioural folk song defines them in verse).  I had thought that these biases transcended issues of culture.  Indeed, both neoclassical and behavioural economists were united in a belief that cultural variables were of secondary importance when it came to the deep drivers of behaviour.  But a series of experiments now has me thinking that the underlying heuristics are less universal.

The article, “The Weirdest People in the World” (ungated working paper), has the startling thesis that social scientists in trying to investigate basic psychology may have erred by oversampling outlier populations.  The “Weirdest People” of the title are Western, Educated, Industrialized, Rich, and Democratic.  (The cuteness of the title is not one of the article’s strengths.)  But the idea that “we” are the exotics usefully jars one from complacency.

The heart of the review is a catalogue of experiments where the results differ markedly across different societies.

Take, for example, the Müller-Lyer illusion, which I would have bet dollars to doughnuts would be a universal trick of the eye:

Turns out not only that different societies display different degrees of illusion bias, but the U.S. subjects (represented here by subjects in Evanston, Illinois) are outliers when researchers tested for the prevalence of the illusion across more than a dozen societies throughout the world.  The WEIRD subjects, as expected, require “segment a” to be on average 20 percent longer than “segment b” before they subjectively assess the two to be the same length.  But other cultures exhibit markedly less bias.  Indeed, the “San foragers of the Kalahari seem to be virtually unaffected by the illusion”:

Markets can be manipulated

Here is an excerpt from an article which throws some light on the causes of bubbles in finance. Clever people take advantage of human brain flaw and succeed in creating bubbles and bubble are destined to burst, which is as sure as daylight.

Why are bubbles such a persistent feature of financial history? Economists argue that these speculative frenzies are caused in part by market failures like too much liquidity or lax regulation. Cognitive psychologists, meanwhile, see bubbles as a case of pattern recognition gone awry, as people extrapolate the past into the future. In recent years, neuroscientists also have become interested in bubbles, if only because the financial manias seem to take advantage of deep-seated human flaws; the market fails only because the brain fails first. Read Montague, at Baylor College of Medicine, has spent the last few years trying to decipher the bits of brain behind our irrational exuberance. It’s microeconomics at its most microscopic.

At first, Montague’s data confirmed the obvious: our brains crave reward. He watched as a cluster of neurons acted like greedy information processors, firing rapidly as the subjects tried to maximize their profits during the early phases of the bubble. When share prices kept going up, these brain cells poured dopamine into the caudate nucleus, which increased the subjects’ excitement and led them to pour more money into the market. The bubble was building.

But then Montague discovered something strange. As the market continued to rise, these same neurons significantly reduced their rate of firing. “It’s as if the cells were getting anxious,” Montague says. “They knew something wasn’t right.” And then, just before the bubble burst, these neurons typically stopped firing altogether. In many respects, these dopamine neurons seem to be acting like an internal thermostat, shutting off when the market starts to overheat. Unfortunately, the rest of the brain is too captivated by the profits to care: instead of heeding the warning, the brain obeys the urges of so-called higher regions, like the prefrontal cortex, which are busy coming up with all sorts of reasons that the market will never decline. In other words, our primal emotions are acting rationally, while those rational circuits are contributing to the mass irrationality.

Unfortunately this tendency is exacerbated by other people. Montague has also found, for instance, that subjects in the investment game are extremely vulnerable to what he calls “the country-club effect,” which occurs when we try to make more money than someone else. “This is what happens when you’re sitting around with your friends at the country club or watching cable TV, and everybody is talking about their huge profits,” he says. “Those conversations are going to change the way you think about risk.” Men seem especially vulnerable to this foible: When they competed against strangers, they were much more likely to get swept away by the financial speculation.

Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) - An hypothesis which states that the price of a security is a reflection of all available information about it and thus represents its true value. It states also that the current price of a security is the most appropriate measure of future returns. 


But in real world there is no such thing. Investment bankers, brokers, vested interests all use all the weapons including academia to ensure that people believe in the EMH. Here is an excerpt from an article that makes the point clear.


" We already know that Lehman and other firms used fake accounting to hide liabilities and inflate assets; that lenders and securitizers frequently knew that the loans they sold and packaged were fraudulent or defective; and, of course, we also now know that Goldman Sachs and other investment banks sold securities they knew to be defective (they were often sold to pension funds for low-paid government employees, by the way) -- and that they designed many of these securities so that they could profit by betting against them after they were sold."

BCG Growth - Share Matrix

An excerpt from Nudge Blog

How would a behavioral economist look at the BCG growth-share matrix? She might start by redrawing the axes and isolating the analysis to business units (or business unit workforce, perhaps). And what axes could be most appropriate? Procrastination and status quo bias.

The dog and star boxes should make sense to readers. In the cash cow category are high status quo bias and low procrastination. In other words, the business unit is working diligently and productively on its key product, while remaining oblivious to forward-thinking innovations. As long as the status quo is working in the marketplace, the unit will survive just fine. Then there is the unit that is not wedded to any status quo, but is stuck in a cycle of “tomorrow we’ll deliver.” Will that delivery ever arrive? Indeed, that’s a question mark.

Balancing Task-Focus with Goal-Focus

"So establish weight with justice and fall not short in the balance." Aya 9 of Sura Ar-Rahman


Recent psychological research suggests one of the keys to getting big projects done is balancing up individual tasks against the grand vision. It's all about knowing when to flip the frame of reference from looking closely at the details of individual components of a project, and when to look up and see the project's grand sweep.


How we react to failure along the way is a clear predictor of ultimate success (or otherwise). That's why Houser-Marko & Sheldon (2008) set up an experiment to see how people reacted to failure depending on whether they were thinking about the individual task or their overall goal.


What they found was that being told they were doing badly made participants feel bad and lowered their motivation. No surprise there. But what they were really interested in was whether their level of focus - either on the individual task or the overall goal - affected their motivation. They found that it did: those told they were doing badly but only on the specific task didn't feel as bad, and didn't expect to do so badly in the future, as those who were focusing on their primary goal. So it seems that when doing badly on a task it's better to keep focusing on the individual task rather than start contemplating the ultimate goal.

Here's what the research means in practical terms:

• To stick to a task, while carrying it out, keep the ultimate goal in mind. Self-control is increased by global processing, abstract thinking and high-level categorisation. Taking the first step on the long road to your goal may require a greater focus on the destination.
• When evaluating progress on hard tasks when the chance of failure is high, stay task-focused. At the start of your journey, when evaluating progress, it's often better to focus on the individual steps. Comparing recent failure with the ultimate goal destroys motivation - instead narrow focus to succeeding on the individual task.
• Once tasks are easier or the end is in sight, a goal focus is once again the psychological approach to choose. It increases positive emotion, decreases negative emotion and increases perceived performance.

Think of it like a 100 hundred metres runner. Moments before the race they look off into the distance, in the general direction of the finish line. Moments after the starting gun fires they stare down at the ground and their feet. Smoothly the head comes up, then, towards the end of the race, they have just one focus: the line.

Only most projects take a little longer than 9.69 seconds.

Behavioral Traps

Behavior means actions or reactions of a person or animal in response to external or internal stimuli. It is the mind that sends signal to different parts of the body to act or react to any exteral or internal reason for such an action. Normatively speaking everybody is rational unless otherwise proved. By being rational, we tend to behave rationally, means behaving logically, based on reason. That is where the danger lies.

Our minds set up many traps for us. Unless we're aware of them, these traps can seriously hinder our ability to think rationally, leading us to bad reasoning and making stupid decisions. Features of our minds that are meant to help us may, eventually, get us into trouble.

Here is a list of 10 such traps.

1. The Anchoring Trap: Over-Relying on First Thoughts - Your starting point can heavily bias your thinking: initial impressions, ideas, estimates or data "anchor" subsequent thoughts.
2. The Status Quo Trap: Keeping on Keeping On - We tend to repeat established behaviors, unless we are given the right incentives to entice us to change them. The status quo automatically has an advantage over every other alternative.
3. The Sunk Cost Trap: Protecting Earlier Choices - You pre-ordered a non-refundable ticket to a basketball game. On the night of the game, you're tired and there's a blizzard raging outside. You regret the fact that you bought the ticket because, frankly, you would prefer to stay at home, light up your fireplace and comfortably watch the game on TV. What would you do?

It may be hard to admit, but staying at home is the best choice here. The money for the ticket is already gone regardless of the alternative you choose: it's a sunk cost, and it shouldn't influence your decision.

4. The Confirmation Trap: Seeing What You Want to See - You feel the stock market will be going down and that now may be a good time to sell your stock. Just to be reassured of your hunch, you call a friend that has just sold all her stock to find out her reasons.

Congratulations, you have just fallen into the Confirmation Trap: looking for information that will most likely support your initial point of view - while conveniently avoiding information that challenges it.

This confirmation bias affects not only where you go to collect evidence, but also how you interpret the data: we are much less critical of arguments that support our initial ideas and much more resistant to arguments against them.

No matter how neutral we think we are when first tackling a decision, our brains always decide - intuitively - on an alternative right away, making us subject to this trap virtually at all times.

5. The Incomplete Information Trap: Review Your Assumptions - We keep mental images - simplifications of reality - that make we jump to conclusions before questioning assumptions or checking whether we have enough information.
6. The Conformity Trap: Everybody Else is Doing It - This "herd instinct" exists - to different degrees - in all of us. Even if we hate to admit it, other people's actions do heavily influence ours. We fear looking dumb: failing along with many people is frequently not considered a big deal, but when we fail alone we must take all the heat ourselves. There's always peer pressure to adopt the behaviors of the groups we're in.

7. The Illusion of Control Trap: Shooting in the Dark - Even in situations we clearly can't control, we still tend to irrationally believe that we can somehow influence results. We just love to feel in control.

8. The Coincidence Trap: We Suck at Probabilities - This means that the "miracle" is not only possible but - given enough attempts - its likelihood increases to a point of becoming almost inevitable.

9. The Recall Trap: Not All Memories Are Created Equal - What happens is we analyze information based on experience, on what we can remember from it. Because of that, we're overly influenced by events that stand out from others, such as those with highly dramatic impact or very recent ones. The more "special" an event is, the greater the potential to distort our thinking.

10. The Superiority Trap: The Average is Above Average - With few exceptions, people have much inflated views of themselves. They overestimate their skills and capabilities, leading to many errors in judgment.

One way to keep your debt down is to bring a loss frame to your loan statement

Here is a reproduction of a very useful technique to remind oneself to keep the debt figure down. The description is in the context of credit card statement but can be applied to credit facility statement as well.


"Nudge blog reader and Booth School grad Fakhr Mokadem thinks there is a way to reframe credit card statements to keep people from overspending. Instead listing the balance as a positive amount, Mokadem wants to list it as a negative.

For instance, say I have a credit limit of $10,000 and I have spent $8,500 throughout the month. Usually a credit card statement would read: – Credit $8,500. Available balance $1,500. This lets people feel that they have room to spend…

What if I had the following statement: You are -$8,500 and you can go down to -$10,000.

Framing the statement this way makes feel that you should move up to zero, rather than trying to stay below $10,000.

Mokadem says he tries to read his statements this way in order to motivate himself to keep his debt down. “Instead of feeling that I have a right to spend up to my available balance, I feel that I am under water or really in debt,” he says."

Nudge blog · Trying to keep your debt down? Bring a loss frame to your credit card statement

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Computerized Controlled Free Market

Here is an excerpt from an interesting article about free market

While the SEC is busy investigating Goldman Sachs, it might want to look into another Goldman-dominated fraud: computerized front running using high-frequency trading programs.

Market commentators are fond of talking about “free market capitalism,” but according to Wall Street commentator Max Keiser, it is no more. It has morphed into what his TV co-host Stacy Herbert calls “rigged market capitalism”: all markets today are subject to manipulation for private gain.

Keiser isn’t just speculating about this. He claims to have invented one of the most widely used programs for doing the rigging. Not that that’s what he meant to invent. His patented program was designed to take the manipulation out of markets. It would do this by matching buyers with sellers automatically, eliminating “front running” – brokers buying or selling ahead of large orders coming in from their clients. The computer program was intended to remove the conflict of interest that exists when brokers who match buyers with sellers are also selling from their own accounts. But the program fell into the wrong hands and became the prototype for automated trading programs that actually facilitate front running.

Also called High Frequency Trading (HFT) or “black box trading,” automated program trading uses high-speed computers governed by complex algorithms (instructions to the computer) to analyze data and transact orders in massive quantities at very high speeds. Like the poker player peeking in a mirror to see his opponent’s cards, HFT allows the program trader to peek at major incoming orders and jump in front of them to skim profits off the top. And these large institutional orders are our money -- our pension funds, mutual funds, and 401Ks.

When “market making” (matching buyers with sellers) was done strictly by human brokers on the floor of the stock exchange, manipulations and front running were considered an acceptable (if morally dubious) price to pay for continuously “liquid” markets. But front running by computer, using complex trading programs, is an entirely different species of fraud. A minor flaw in the system has morphed into a monster. Keiser maintains that computerized front running with HFT has become the principal business of Wall Street and the primary force driving most of the volume on exchanges, contributing not only to a large portion of trading profits but to the manipulation of markets for economic and political ends.

Web of Debt - COMPUTERIZED FRONT RUNNING: HOW A COMPUTER PROGRAM DESIGNED TO SAVE THE FREE MARKET TURNED INTO A MONSTER

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The origins of economics

“Adam could deal with apples — as long as there were no serpents and women,” Mr. Thaler added. “When you add serpents and women, you get self-control problems that the model cannot deal with.”

Most people on the panel accepted that the mainstream model of rational human beings who maximize utility within budget constraints, expertly making cost-benefit analyses by comparing the net present value of their options, no longer works.

The origins of economics « Nudge blog

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Free Market is an Illusion

"There is much to be said for markets. When working efficiently they engender competition thus forcing producers to pass on value to consumers. A good illustration is the Pakistani mobile phone market, perhaps one of the most competitive in the world. Despite the many virtues of markets, however, it is not necessary that they serve everyone all the time.

The reasoning is simple. Markets are blind and allocate on the basis of effective demand, i.e. demand backed up by purchasing power. Thus, if Demi Moore, say, wishes to take a milk bath every day, the market will ensure delivery of sufficient milk to her, even if it means that 100 African children, who cannot afford the price, go without a drop.

Amartya Sen who won a Nobel Prize in economics pointed out how many of the world’s worst famines were actually caused by unfettered market forces."

DAWN.COM | Business | Sugar crisis and free markets

The Capital Structure Decisions of New Firms

"Outside debt (financing through credit cards, credit lines, bank loans, etc.) was the most important type of financing for new firms, followed closely by owner equity. These two sources accounted for about 75 percent of startup capital."


Why so? May be because the owner does not want to share his profits or may be that he could not find a partner.

The Capital Structure Decisions of New Firms


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There are no free lunches in this world

"The hypothesis that actual prices reflect fundamental values is the Efficient Markets Hypothesis (EMH). Put simply, under this hypothesis, “prices are right,” in that they are set by agents who understand Bayes’s law and have sensible preferences. In an efficient market, there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk."

The "no free lunch" slogan is not restricted to the EMH as above. It is omnipresent. Here is an excerpt from an interesting article.

"My father used to tell me, "There's no such thing as a free lunch, son." One day, when I was feeling clever, I thanked my dad for the "free" lunch he had just bought me. He replied, "This lunch isn't free, son … you have to sit here and listen to me while you eat it, don't you?" Point taken."

The Hidden Costs of Free Software - Small Business Software - Entrepreneur.com


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Intel’s Bet on Future

Future is an uncertain entity, anything can happen. Future projections are at best probabilities. Here is an excerpt from an article about Intel's bet on future. The future is what you think and have faith in.

"With the global economy reeling, businesses and consumers had pulled way back on their typical technology spending, and sales of personal computers had started to decline at their steepest rates in history. The major two-year investment was a matter of faith — in an economic recovery and in the Internet continuing to drive a long-term increase in demand for computers, smartphones and other devices with chips inside."

Intel’s Bet on Innovation Pays Off in Faster Chips - NYTimes.com

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Investment in Stock Market and Gambling is Identical

Here is an excerpt from an interesting article "How Poker can Make You a Better Investor".

Ever watch professional poker players calculating the odds, then coolly dissecting their opponents? Many of the same skills the top players use can help you be a better investor. Success at both investing and gambling, it turns out, has much to do with controlling emotions. And playing a little poker can help you recognize, and avoid, emotional traps that endanger your most important stack of chips -- your portfolio. But you need to know what to look for.

The psychological issues that drive investing and gambling decisions aren’t merely similar. They are “identical,” says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for Financial Engineering and one of the leaders in the field of behavioral finance. It’s easy to find investment professionals and professional poker players who agree. Says poker pro Daniel Negreanu, who holds four World Series of Poker bracelets and two World Poker Tour Championship titles: “Having emotional stability and emotional control is key to both investing and poker.”

Can you gain that control at a poker table? Aaron Brown is among many who think so. Brown is a onetime finance professor and former portfolio manager for Prudential Securities who is now a risk manager for hedge funds. He’s also the author of The Poker Face of Wall Street(Wiley, $17). Says Brown: “People tell me playing poker is risky. Investing for a financial lifetime without playing poker is risky. I’d much rather make these mistakes at the table.”

And by mistakes, Brown means the common emotional errors that plague investors. The burgeoning fields of investor psychology and behavioral finance are uncovering more about these errors all the time, and they are the subject of a year-long series co-produced byKiplinger’s and Nightly Business Report on PBS.

By playing some poker, “you can find out your tendencies to make emotional mistakes, and then you can guard against them,” says Frank Murtha, a behavioral-finance consultant with a PhD in counseling psychology (his dissertation explored the effect of psychological errors in gambling). Murtha helps clients from investment banks, financial-services companies and trading firms to avoid making psychological errors.

He’s also co-founder of MarketPsych, which offers psychological-training services to traders and money managers and which offers a number of online tests that any investor can take to better understand his or her own psychological makeup.

Most investors make few investment decisions over a year, or even over a lifetime. But experts agree that just a few hours of playing poker will take you through literally dozens of financial decisions -- potentially a lifetime’s worth if you were making those decisions about your portfolio. By playing poker while keeping in mind the psychological errors that are also common to investing, you can get a lifetime’s worth of training in one evening.

What are these errors? We’ve picked five of the most common, and all can be found both in investing and in gambling. Click on each one below to learn how they appear in poker and investing and to find out how you can use poker to help train yourself not to make these errors.

Greed
Overconfidence
Regret
Seeing patterns
Holding on to losers

Interview with Eugene Fama: Rational Irrationality : The New Yorker

Eugene Fama theorized "efficient markets hypothesis" that says prices of financial assets accurately reflect all of the available information about economic fundamentals. When asked about solution to present financial crisis, he reluctantly said that solution lies in equity financing. Here is an excerpt from his interview.

"So what is the solution that problem?

The simple solution is to make sure these firms have a lot more equity capital—not a little more, but a lot more, so they are not playing with other people’s money. There are other people here who think that leverage is an important part of they system. I am not sure I agree with them. You talk to Doug Diamond or Raghu Rajan, and they have theories for why leverage in financial institutions has real uses. I just don’t think that those effects are as important as they think they are."

Interview with Eugene Fama: Rational Irrationality : The New Yorker

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