Financial Markets

A financial market is a broad term describing any marketplace where buyers and sellers
participate in the trade of assets such as equities, bonds, currencies and derivatives.
Financial markets are typically defined by having transparent pricing, basic regulations
on trading, costs and fees, and market forces determining the prices of securities that
Financial markets can be found in nearly every nation in the world. Some are very small,
with only a few participants, while others - like the New York Stock Exchange (NYSE)
and the forex markets - trade trillions of dollars daily.
Investors have access to a large number of financial markets and exchanges
representing a vast array of financial products. Some of these markets have always been
open to private investors; others remained the exclusive domain of major international
banks and financial professionals until the very end of the twentieth century.
Capital Markets
A capital market is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell securities
on the capital markets in order to raise funds. Thus, this type of market is composed of
both the primary and secondary markets.
Any government or corporation requires capital (funds) to finance its operations and to
engage in its own long-term investments. To do this, a company raises money through
the sale of securities - stocks and bonds in the company's name. These are bought and
sold in the capital markets.
Stock Markets
Stock markets allow investors to buy and sell shares in publicly traded companies. They
are one of the most vital areas of a market economy as they provide companies with
access to capital and investors with a slice of ownership in the company and the
potential of gains based on the company's future performance.
This market can be split into two main sections: the primary market and the secondary
market. The primary market is where new issues are first offered, with any subsequent
trading going on in the secondary market.
Bond Markets
A bond is a debt investment in which an investor loans money to an entity (corporate or
governmental), which borrows the funds for a defined period of time at a fixed interest

rate. Bonds are used by companies, municipalities, states and U.S. and foreign
governments to finance a variety of projects and activities. Bonds can be bought and
sold by investors on credit markets around the world. This market is alternatively referred
to as the debt, credit or fixed-income market. It is much larger in nominal terms that the
world's stock markets. The main categories of bonds are corporate bonds, municipal
bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as
simply "Treasuries." (For more, see the Bond Basics Tutorial.)
Money Market
The money market is a segment of the financial market in which financial instruments
with high liquidity and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from several days to
just under a year. Money market securities consist of negotiable certificates of deposit
(CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes,
eurodollars, federal funds and repurchase agreements (repos). Money market
investments are also called cash investments because of their short maturities.
The money market is used by a wide array of participants, from a company raising
money by selling commercial paper into the market to an investor purchasing CDs as a
safe place to park money in the short term. The money market is typically seen as a safe
place to put money due the highly liquid nature of the securities and short maturities.
Because they are extremely conservative, money market securities offer significantly
lower returns than most other securities. However, there are risks in the money market
that any investor needs to be aware of, including the risk of default on securities such as
commercial paper. (To learn more, read our Money Market Tutorial.)
Cash or Spot Market
Investing in the cash or "spot" market is highly sophisticated, with opportunities for both
big losses and big gains. In the cash market, goods are sold for cash and are delivered
immediately. By the same token, contracts bought and sold on the spot market are
immediately effective. Prices are settled in cash "on the spot" at current market prices.
This is notably different from other markets, in which trades are determined at forward
The cash market is complex and delicate, and generally not suitable for inexperienced
traders. The cash markets tend to be dominated by so-called institutional market players
such as hedge funds, limited partnerships and corporate investors. The very nature of
the products traded requires access to far-reaching, detailed information and a high level
of macroeconomic analysis and trading skills.
Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or

that professional investors.9 trillion per day and includes all of the currencies in the world. Primary markets. Zürich. The forex market is the largest. institutions and hedge fund managers use to varying degrees but that play an insignificant role in private investing. (For further reading. it can be used quite effectively as part of a risk management program. but in this case the contract price is determined by the market price of the core asset. However. swaps and contractsfor-difference (CFDs).) Primary Markets vs. firm or country may participate in this market." are facilitated by underwriting groups. Singapore. excluding retail investors and smaller trading parties. structured products and collateralized obligations available. also known as "new issue markets. The forex market is open 24 hours a day. most interbank trading takes place from the banks' own accounts. corporations. Forex and the Interbank Market The interbank market is the financial system and trading of currencies among banks and financial institutions. trade is conducted over the counter. If that sounds complicated. Paris and Sydney. forex trading in the currency market had largely been the domain of large financial institutions. Hong Kong. Not only are these instruments complex but so too are the strategies deployed by this market's participants. There is no central marketplace for currency exchange. and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts. see The Foreign Exchange Interbank Market. governments and other groups obtain financing through debt or equity based securities.) Examples of common derivatives are forwards. Tokyo. Until recently. Companies. (To get to know derivatives. most liquid market in the world with an average traded value that exceeds $1. Secondary Markets A primary market issues new securities on an exchange. which consist . New York. The emergence of the internet has changed all of this. The forex market is where currencies are traded. hedge funds and extremely wealthy individuals. it's because it is. five days a week and currencies are traded worldwide among the major financial centers of London. central banks. mainly in the over-thecounter (non-exchange) market. While some interbank trading is performed by banks on behalf of large customers.assets. read The Barnyard Basics Of Derivatives. A derivative is a contract. futures. The forex is the largest market in the world in terms of the total cash value traded. There are also many derivatives. Frankfurt. options. and any person. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate.

investment banks or entities such as Fannie Mae purchase mortgages from issuing lenders. (To learn more about primary and secondary markets. in fact. (To learn more about the primary and secondary market. NYSE or American Stock Exchange (AMEX). The Securities and Exchange Commission (SEC) registers securities prior to their primary issuance. rather than from issuing companies themselves. This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. The term "over-the-counter" refers to stocks that are not trading on a stock exchange such as the Nasdaq. Secondary markets exist for other securities as well.) The secondary market is where the bulk of exchange trading occurs each day. Third and Fourth Markets You might also hear the terms "third" and "fourth markets. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred. Most securities that trade this way are penny stocks or are from very small companies. (For more on the primary market. read Markets Demystified. Nasdaq or other venue where the securities have been accepted for listing and trading." These don't concern individual investors because they involve significant volumes of shares to be transacted . Neither of these networks is an exchange.) The secondary market is where investors purchase securities or assets from other investors. such as when funds. which is then used to fund operations or expand the business. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. see our IPO Basics Tutorial. The primary markets are where investors have their first chance to participate in a new security issuance.of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. prices are often set beforehand. the cash proceeds go to an investor rather than to the underlying company/entity directly. read A Look at Primary and Secondary Markets.) The OTC Market The over-the-counter (OTC) market is a type of secondary market also referred to as a dealer market. whereas in the secondary market only basic forces like supply and demand determine the price of the security. The issuing company or group receives cash proceeds from the sale. they describe themselves as providers of pricing information for securities. then they start trading in the secondary market on the New York Stock Exchange. In the primary market. In any secondary market trade.

or offering investors partial ownership in the company and a claim on its residual cash flows in the form of stock. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The main reason these third and fourth market transactions occur is to avoid placing these orders through the main exchange. The fourth market is made up of transactions that take place between large institutions. The third market comprises OTC transactions between broker-dealers and large institutions. . issuing bonds to borrow money from investors that will be repaid at a fixed interest rate. They can do this by taking out a loan from a bank and repaying it with interest. Because access to the third and fourth markets is limited. Financial institutions and financial markets help firms raise money. which could greatly affect the price of the security. their activities have little effect on the average investor.per trade.

proportionately to the amount they've invested. Each fund's investments are chosen and monitored by qualified professionals who use this money to create a portfolio. Mutual Funds are Diversified By investing in mutual funds. not the individual securities. you own shares of the mutual fund. By spreading your money over numerous securities. Fund Ownership. however much you would like. but even so. If you are like most people. You are not the only one. It is a great option for investors who do not need their money within the next five years. each with its own set of goals. The investment objective is the goal that the fund manager sets for the mutual fund when deciding which stocks and bonds should be in the fund's portfolio. you probably have most of your money in a bank savings account and your biggest investment may be your home. funds can be broadly classified in the following 5 types:  Aggressive growth means that you will be buying into stocks which have a chance for dramatic growth and may gain value rapidly. For example. money market instruments or a combination of those. Professional Management. This type of investing carries a high element of risk with it since stocks with dramatic price appreciation potential often lose value quickly during downturns in the economy. Apart from that. an objective of a growth stock fund might be: This fund invests primarily in the equity markets with the objective of providing long-term capital appreciation towards meeting your long-term financial needs such as retirement or a child' s education. bonds. investing is probably something you simply do not have the time or knowledge to get involved in. Depending on investment objectives.What is a mutual fund? These days you are hearing more and more about mutual funds as a means of investment. but have a more long-term . As an investor. you could diversify your portfolio across a large number of securities so as to minimise risk. Investing in a mutual fund can be a lot easier than buying and selling individual stocks and bonds on your own. Mutual funds permit you to invest small amounts of money. which is what a mutual fund does. Mutual Fund Objectives There are many different types of mutual funds. What is a Mutual Fund? A mutual fund is a pool of money from numerous investors who wish to save or make money just like you. you need not worry about the fluctuation of the individual securities in the fund's portfolio. That portfolio could consist of stocks. Investors can sell their shares when they want. you can benefit from being involved in a large pool of cash invested by other people. This is why investing through mutual funds has become such a popular way of investing. All shareholders share in the fund' s gains and losses on an equal basis.

They are able to achieve multiple objectives which may be exactly what you are looking for. growth seeks to achieve high returns. The word preservation already indicates that gains will not be an option even though the interest rates given on money market mutual funds could be higher than that of bank deposits. This makes income funds interest rate sensitive. while the exposure to fixed income securities provide stability to the portfolio during volatile times in the equity markets. The fund portfolio chooses to invest in stable. well established. These funds will generally invest in a number of fixed-income securities. The fund manager will choose to buy debentures. Some conservative bond funds may not even be able to maintain your investments' buying power due to inflation. You need to be able to assume some risk to be comfortable with this type of fund objective. it does not go without some risk.  That brings us to income funds. looking at past figures. The fund manager will pick. Equities provide the growth potential. particularly bonds. so someone would have to be selling in order for you to be able to buy it.  The most cautious investor should opt for the money market mutual fund which aims at maintaining capital preservation. Even though this is a stable option. Do not choose this option when you are looking to conserve capital but rather when you can afford to potentially lose the value of your investment. Closedend funds are also listed on the stock exchange so it is traded just like other stocks on an exchange or over the counter. Some funds buy stocks and bonds so that the portfolio will generate income whilst still keeping ahead of inflation. Growth and income funds have a low-to-moderate stability along with a moderate potential for current income and growth.  As with aggressive growth. also known as balanced funds. growth stocks which will use their profits grow. Usually the redemption is also specified which means that they terminate on specified dates when the investors can redeem their units.perspective. They will be relatively volatile over the years so you need to be able to assume some risk and be patient. As interest-rates go up or down. .and small-sized companies. This will provide you with regular income. These funds will pose very little risk but will also not protect your initial investments' buying power. highly liquid so you would always be able to alter your investment strategy. rather than to pay out dividends. however. sticking to growth funds for the long-term will almost always benefit you. Retired investors could benefit from this type of fund because they would receive regular dividends. the prices of income fund shares. blue-chip companies together with a small portion in small and new businesses.  A combination of growth and income funds. The fund would be open for subscription only during a specified period and there is an even balance of buyers and sellers. in order to provide you with a steady income. however. company fixed deposits etc. however. the portfolios will consist of a mixture of large-. Closed-End Funds A closed-end fund has a fixed number of shares outstanding and operates for a fixed duration (generally ranging from 3 to 15 years). Inflation will eat up the buying power over the years when your money is not keeping up with inflation rates. will move in the opposite direction. are those that have a mix of goals. They seek to provide investors with current income while still offering the potential for growth. They are. It is a medium .long-term commitment. medium.

Investors have the flexibility to buy or sell any part of their investment at any time at a price linked to the fund's Net Asset Value. they can invest in many types of securities—but there are a number of differences between these two investment vehicles. Also like mutual funds. Like mutual funds. What is a Hedge Fund? A hedge fund is an alternative investment vehicle available only to sophisticated investors. such as institutions and individuals with significant assets. .Open-End Funds An open-end fund is one that is available for subscription all through the year and is not listed on the stock exchanges. The majority of mutual funds are open-end funds. hedge funds are pools of underlying securities.

Many hedge funds also use an investment technique called leverage. many closed. are even more illiquid. You may have heard of futures and options. Hedge fund managers. That is appealing to investors who are frustrated when they have to pay fees to a poorly performing mutual fund manager. in addition to earning a “management fee”. by hedging their investments using a variety of sophisticated methods. One. Hedge funds typically use long-short strategies. so investors can be locked in for years. hedge fund managers are typically compensated differently from mutual fund managers. which are similar to hedge funds. commodities and real estate. in contrast. . as mutual funds are. hedge funds are typically not as liquid as mutual funds. As a result. ideally. Hedge funds proliferated during the market boom earlier this decade. Options Strategy. it appears that regulation for hedge funds may be coming soon. but in the wake of the 2007 and 2008 credit crisis. in contrast. Second. As a result of these factors. On the down side. In fact. Fund of Funds. which invest in some balance of long positions (which means buying stocks) and short positions (which means selling stocks with borrowed money. Securities and Exchange Commission (SEC).) Finally.First. have a net worth of more than $1 million. including leverage. Additionally. but also creates greater risk of loss. which is essentially investing with borrowed money—a strategy that could significantly increase return potential. fallen). Convertible Arbitrage. hedge funds are not currently regulated by the U.S. Bernard L. typically in the range of 1% to 4% of the net asset value of the fund. then buying them back later when their price has. However. bonds. Fixed Income.” during which investors cannot sell their shares. such as stocks. Third. receive a percentage of the returns they earn for investors. a financial industry oversight entity. Equity Long Short. and possess significant investment knowledge.” which are contracts to buy or sell another security at a specified price. Emerging Markets. turned out to be a massive fraud. Despite these recent challenges. as a result of being relatively unregulated. Statistical Arbitrage. they are subject to increasing due diligence. many hedge funds invest in “derivatives. Specifically. hedge funds continue to offer investors a solid alternative to traditional investment funds—an alternative that brings the possibility of higher returns that are uncorrelated to the stock and bond markets. and Macro. As a result. Some of the more popular hedge fund investment strategies are Activist. seek to generate returns over a specific period of time called a “lockup period. hedge funds can invest in a wider range of securities than mutual funds can. The popularity of these alternative investment vehicles—which were first created in 1949—has waxed and waned over the years. this compensation structure could lead hedge fund managers to invest aggressively to achieve higher returns—increasing investor risk. Mutual funds have a per-share price (called a net asset value) that is calculated each day. Mutual fund managers are paid fees regardless of their funds’ performance. While many hedge funds do invest in traditional securities. these are considered derivatives. so you could sell your shares at any time.S.” which means they must earn a minimum annual income. they tend to invest in startup companies. (Private equity funds. and offset losses. hedge funds are typically open only to a limited range of investors. U. they are best known for using more sophisticated (and risky) investments and techniques. the name “hedge fund” is derived from the fact that hedge funds often seek to increase gains. hedge funds are likely here to stay. meaning it is more difficult to sell your shares. Most hedge funds. laws require that hedge fund investors be “accredited. Madoff Investment Securities.

and many others. most of this growth goes to the super-large funds. As a result. Recently. However. whose owners are public corporations.8 trillion in 2014. according to HFR Inc. Some hedge fund managers must meet a hurdle rate before getting paid. Unlike mutual funds. However. that there's no hurdle rate. The S&P 500 rose 137% (including dividends) since then. He created a fund that sold stocks short as part of his strategy. Most hedge funds operate under the "2 and 20 rule. The term "hedge fund" was first applied in the 1940s to alternative investor Alfred Winslow Jones. including during the financial crisis. How Do Hedge Funds Work? Hedge funds are set up as limited partnerships or limited liability corporations that protector the manager and investors from creditors if the fund goes bankrupt. pension funds and other institutional investors have paid at least newer hedge funds less: Hedge Funds Rewards Hedge funds offer more financial reward because of the way their managers are paid. One reason is that institutional investors and others who invests in hedge funds are more confident in going with tried-and-true names. The contract describes how the manager is paid. For this reason. compared to a 50% rise for hedge funds. it is exactly this risk that attracts many investors who believe higher risk leads to higher return. hedge funds traditionally weren't regulated by the SEC (Securities and Exchange Commission). however.That's triple the amount managed in 2004. they've underperformed since 2009. hedge funds are very risky.000 hedge funds managed $2. It's too risky to invest with a start-up firm. . More than $75 billion was added to funds in 2014. but usually there are no limits. then the manager receives a percent of profits. The investors receive all profits until the hurdle rate is reached. Although hedge funds have outperformed the stock market over the past 15 years. Their goal is to outperform the market -." This states they earn 2% of assets in good times and bad. the types of financial vehicles they can invest in. They are expected to be smart enough to create high returns regardless of how the market does. 864 firms closed in 2014. but 90% went to funds that managed $1 billion or more. averaging only $70 million each in a lot. It may sometimes outline what the manager can invest it. More than 8.What Are Hedge Funds? Definition: Hedge funds are privately-owned companies that pool investors' dollars and reinvest them into all kinds of complicated financial instruments. and their lack of financial regulation. and they receive 20% of profits.

Hedge fund managers can use put options. they pay out by a particular point in time. The combination of leverage and timing means that managers make outsize returns when they correctly predict the market's rise or fall. 1. Hedge funds managers are paid a percentage of their funds' returns. he could lose the investment. even if the manager is correct about the long-term trend. Since hedge funds aren't as well regulated as the stock market. options and collateralized debt obligations. 2. or leverage. This structure means hedge funds managers are very risk tolerant. financial vehicles. 2. Hedge fund managers are compensated as a percent of the returns they earn. This makes the funds very risky for the investor. to control large amounts of stocks or commodities. . 3. such as futures contracts.even if the investments do OK.1. see SEC Bulletin on Hedge Funds. economic event happens during that time period. which some would say is very difficult if not impossible to do. Options must be delivered within a certain window of time. hedge fund managers are trying to time the market. If a "black swan. or can sell stocks short. Hedge Fund Risks The same three characteristics that allow hedge funds to promise greater rewards also makes them very risky. Hedge funds invest in derivatives that are very risky because of leverage." or completely unexpected. For more. In that sense. Second. who can lose all the money they invested in the fund. but speculative. Thanks to this compensation structure. the managers get zero no matter how much money they lose. Basically. hedge fund investors are also part owners of the LLC. In addition. This attracts many investors who are frustrated by the fact that mutual funds are paid fees. 3. This means they could lose their investment if the hedge fund goes bankrupt as a business -. Hedge fund managers specialize in using sophisticated derivatives. What happens if the fund loses money? Do they pay the fund a percentage of that loss? No. Although hedge funds are still prohibited from fraud. they have free rein to invest in these high return. hedge fund managers are driven to achieve above-market returns. regardless of fund performance. The lack of regulation means that hedge fund earnings aren't reported to the SEC or any other regulatory body. Derivatives allow hedge fund managers to profit even when the stock market is going down. this lack of oversight creates additional risk. these products all do two things: they use small amounts of money.

Top performers at accounting and law firms can also be recruiting grounds. Transaction Support and Portfolio Oversight There are two critical functions within private-equity firms:  deal origination/transaction execution . associates can earn low six figures in salary and bonuses. and that 20% of gross profits can generate tens of millions of dollars in fees for the firm. At the middle market level ($50 million to $500 million in deal value). a yearly management fee of 2% of assets managed and 20% of gross profits upon sale of the company). including top performers from Fortune 500 companies and elite strategy and management consulting firms. it is easy to see why the private-equity industry has attracted top talent. Given that a private-equity firm with $1 billion of assets under management might have no more than two dozen investment professionals. Introduction to Private Equity Private equity has successfully attracted the best and brightest in corporate America.What is Private Equity? Private equity is a source of investment capital from high net worth individuals and institutions for the purpose of investing and acquiring equity ownership in companies. These funds can be used in purchasing shares of private companies. Some funds have a $250. Partners at private-equity firms raise funds and manage these monies to yield favorable returns for their shareholder clients. as accounting and legal skills relate to transaction support work required to complete a deal and translate to advisory work for a portfolio company's management. The minimum amount of capital required for investors can vary depending on the firm and fund raised. vice presidents can earn approximately half a million dollars and principals can earn more than $1 million in (realized and unrealized) compensation per year. others can require millions of dollars.000 minimum investment requirement. The fee structure for private-equity firms varies. typically with an investment horizon between four and seven years. or in public companies that eventually become delisted from public stock exchanges under go-private deals. How firms are incentivized can vary considerably. but it typically consists of a management fee and a performance fee (in some cases.

In other words. they usually run a full auction process that can diminish the buyer's chances of successfully acquiring a particular company. but also a competing bidder. In a competitive M&A landscape. some investment banks compete with private-equity firms in buying up good companies. accountants. and therefore may not only be a deal referral. as consultants can uncover deal killers. Transaction execution involves assessing management. historical financials and forecasts. such as significant and previously undisclosed liabilities and risks. Some firms hire internal staff to proactively identify and reach out to company owners to generate transaction leads. portfolio oversight Deal origination involves creating. This part of the process is critical. they can walk management through best practices in strategic planning and financial management.passive investors .who . deal origination professionals (typically at the associate. the deal professionals work with various transaction advisors to include investment bankers. It is important to note that investment banks often raise their own funds. maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries. the industry. they can help institutionalize new accounting. After the investment committee signs off to pursue a target acquisition candidate. Among other support work. Due diligence includes validating management's stated operational and financial figures. Deal flow refers to prospective acquisition candidates referred to private-equity professionals for investment review. vice president and director levels) attempt to establish a strong rapport with transaction professionals to get an early introduction to a deal. When financial services professionals represent the seller. the deal professionals submit an offer to the seller. Types of Private-Equity Firms A spectrum of investing preferences spans across the thousands of privateequity firms in existence. Additionally. sourcing proprietary deals can help ensure that the funds raised are successfully deployed and invested. Additionally. internal sourcing efforts can reduce transaction-related costs by cutting out the investment banking middleman's fees. lawyers and consultants to execute the due diligence phase. and conducting valuation analyses. investment banks and similar transaction professionals to secure both high-quantity and highquality deal flow. If both parties decide to move forward. The second important function of private-equity professionals involves oversight and support of the firm's various portfolio companies and their management team. Some are strict financiers . As such. procurement and IT systems to increase the value of their investment.

Because the best investment banking professionals gravitate toward the larger deals. For instance. Investing in Upside Middle-market companies can offer significant financial upside to their private-equity owners. there are significantly more sellers than there are highly seasoned and positioned finance professionals with the extensive buyer networks and resources to manage a deal (for middle-market company owners). larger players. the middle market is a significantly underserved market. they provide operational support to management to help build and grow a better company. An important company metric for these investors is earnings before interest.are wholly dependent on management to grow the company (and its profitability) and supply their owners with appropriate returns. These types of firms may have an extensive contact list and "C-level" relationships. These companies provide niche products and services that are not being offered by the large conglomerates. a small company selling niche products within a particular region might significantly grow by cultivating international sales channels. Such upsides attract the interest of private -quity firms. Or a highly fragmented industry can undergo consolidation (with the private-equity firm buying up and combining these entities) to create fewer. If an investor can bring in something special to a deal that will enhance the company's value over time. or they may be experts in realizing operational efficiencies and synergies. It is the seller who ultimately chooses whom they want to sell to. Larger companies typically command higher valuations than smaller companies. which can help increase revenue. It is no surprise that the largest investment-banking entities. These banks typically focus their efforts on deals with enterprise values worth billions of dollars. taxes. such an investor is more likely to be viewed favorably by sellers. facilitate the largest deals. Because sellers typically see this method as a commoditized approach. JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C). the vast majority of transactions reside in the middle market ($50 million to $500 million deals) and lower-middle market ($10 million to $50 million deals). or partner with. Many of these small companies fly below the radar of large multinational corporations and often provide higher-quality customer service. That is. as they possess the insights and savvy to exploit such opportunities and take the company to the next level. depreciation and amortization (EBITDA). However. such as Goldman Sachs (NYSE:GS). That is. such as CEOs and CFOs within a given industry. other privateequity firms consider themselves active investors. When a private-equity firm .

the professionals at these firms are usually successful in deploying investment capital and in increasing the values of their portfolio companies. for the most part. As the industry attracts the best and brightest in corporate America. Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance . Behavioral Finance According to conventional financial theory. As such. A popular exit strategy for private equity involves growing and improving a middle-market company and selling it to a large corporation (within a related industry) for a hefty profit. they work together with management to significantly increase EBITDA during its investment horizon (typically between four and seven years). rational "wealth maximizers". A good portfolio company can typically increase its EBITDA both organically (internal growth) and by acquisitions. causing us to behave in unpredictable or irrational ways. Most managers at portfolio companies are given equity and bonus compensation structures that reward them for hitting their financial targets. However. Such alignment of goals (and appropriate compensation structuring) is typically required before a deal gets done. there is also fierce competition in the M&A marketplace for good companies to buy.acquires a company. capable and dependable management in place. there are many instances where emotion and psychology influence our decisions. However. The Bottom Line Private-equity firms have become attractive investment vehicles for wealthy individuals and institutions. the world and its participants are. it is imperative that these firms develop strong relationships with transaction and services professionals to secure strong deal flow. It is critical for private-equity investors to have reliable.

All the while. acquisition or any other reason -. The role of behavioral finance is to help market analysts and investors understand price movements in the absence of any intrinsic changes on the part of companies or sectors.due to bankruptcy.e. Behavioral Finance What it is: Behavioral finance combines social and psychological theory with financial theory as a means of understanding how price movements in the securities markets occur independent of any corporate actions. This is the sort of issue that behavioral finance attempts to explain. By the end of this tutorial. Investors’ decisions to buy or sell may have a more distinct margin affect impact on market value than favorable earnings or promising products. we hope that you'll have a better understanding of some of the anomalies (i. irregularities) that conventional financial theories have failed to explain. Survivorship Bias What it is: Survivorship bias occurs when companies that no longer exist -. The securities prices of other companies in the industry consequently decline as well. Hopefully. These investors may sell off their holdings for fear of loss. In addition. Investors know that when this has happened before.. the share price of the tobacco company has fallen. How it works (Example): Suppose a lawsuit is brought against a tobacco company. none of these tobacco companies took any action or had a judgment against them that intrinsically lessened their worth. this newfound knowledge will give you an edge when it comes to making financial provide explanations for why people make irrational financial decisions. Why it Matters: Anyone knowledgeable in financial market understands that there are numerous variables that affect prices in the securities markets. This selling results in the further decline of the security's value. many investors sell off their holdings in the company.are not accounted for when calculating investment returns. With this in mind. we hope you gain insight into some of the underlying reasons and biases that cause some people to behave irrationally (and often against their best interests). . Investors in other tobacco companies may fear similar lawsuits knowing that such a lawsuit was brought against one tobacco company.

In 2007. the initial price offered for a used car sets the standard for the rest of the negotiations. For example. 2011). anchoring occurs when individuals use an initial piece of information to make subsequent judgments. and there is a bias toward interpreting other information around the anchor. Studies have shown that anchoring is very difficult to avoid. 2010) and those with experience buying the product you’re selling (Alevy et al. other judgements are made by adjusting away from that anchor. Anchoring Bias We tend to rely too heavily on the first piece of information seen Setting a high price for one item makes all others seem cheaper. Don’t set your anchor price too high. 4. Clearly neither of these anchors are correct..How it works (Example): For example. Key Concept No. Once an anchor is set. If the 2-year portfolio returns are calculated based on Stock A and Mutual Fund C returns without accounting for the poor returns of Bond B in 2006. but the two groups still guessed significantly differently (choosing an average age of 50 vs. but inaccurate. so that prices lower than the initial price seem more reasonable even if they are still higher than what the car is really worth. Takeaways for decision-makers 1. basically. performance.2: Mental Accounting Mental accounting refers to the tendency for people to separate their . Anchoring effects are weaker for individuals with higher cognitive ability (Bergman et al. though only when the price shown is actually plausible (and not some silly amount!) During decision making. Keep it realistic and relatively in the realm of what else you’re selling. They were asked whether Mahatma Gandhi died before or after age 9. If you are to use anchors. in one study students were given anchors that were obviously wrong. Now Portfolio XYZ is comprised of only Stock A and Mutual Fund C. an average age of 67).. Why it Matters: Survivorship bias fails to account for all variables affecting a portfolio's or investment company's valuation. be aware of your target audience. or the natural inclination to anchor other choices against this product will greatly diminish. suppose an investor is researching returns on Portfolio XYZ over two consecutive years: 2006 and 2007. Bond B and Mutual Fund C. the portfolio is comprised of Stock A. historical valuation becomes skewed. 2. the results will have survivorship bias and will be skewed to the upside. or before or after age 140. 3. As a result. In 2006. or not. often creating the appearance of favorable. For example. Think carefully about how you structure your product range and prices. Bond B was put into a seperate "loser" portfolio because of poor performance. People will anchor whether you intend for them to do so.

while still carrying substantial credit card debt. For example. the dilemma is whether you should spend $6 for a sandwich. This seems simple enough. (For more insight. people may feel that money saved for a new house or their children's college fund is too "important" to relinquish. Logically speaking. this isn't so.) 6. The Different Accounts Dilemma To illustrate the importance of different accounts as it relates to mental accounting. In this case. However. whereas in the second scenario. but as you plan to take a bite. According to the theory. Although many people use mental accounting. would you buy another sandwich? (To read more. even if doing so would provide added financial benefit. they'd be more likely to buy another sandwich. see The Beauty Of Budgeting. but why don't people behave this way? The answer lies with the personal value that people place on particular assets. or 2) You buy the sandwich. Different Source. rather than saving for a holiday. Because of the mental accounting bias. they may not realize how illogical this line of thinking really is. As you are waiting in line. this "important" account may not be touched at all.) In this example. the most logical course of action would be to use the funds in the jar (and any other available monies) to pay off the expensive debt. like the source of the money and intent for each account. which has an often irrational and detrimental effect on their consumption decisions and other behaviors. In either case (assuming you still have enough money). you stumble and your delicious sandwich ends up on the floor. see Digging Out Of Personal Debt. it's illogical (and detrimental) to have savings in a jar earning little to no interest while carrying credit-card debt accruing at 20% annually. money in the special fund is being treated differently from the money that the same person is using to pay down his or her debt. individuals assign different functions to each asset group. Consequently. the money had already been spent. 5. people often have a special "money jar" or fund set aside for a vacation or a new home. despite the fact that diverting funds from debt repayment increases interest payments and reduces the person's net into separate accounts based on a variety of subjective criteria. Different Purpose Another aspect of mental accounting is that people also treat money . because of the mental accounting bias. most people in the first scenario wouldn't consider the lost money to be part of their lunch budget because the money had not yet been spent or allocated to that account. For instance. your answer in both scenarios should be the same. consider this real-life example: You have recently subjected yourself to a weekly lunch budget and are going to purchase a $6 sandwich for lunch. As a result. one of the following things occurs: 1) You find that you have a hole in your pocket and have lost $6. Simply put.

In most cases. money should be interchangeable. Mental Accounting In Investing The mental accounting bias also enters into investing. Thus. The Hindsight Bias Judgment and decision making is one area in psychology. What is the hindsight bias? Hindsight Bias Definition .regardless of the money's source. The problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio. As an extension of money being fungible. all money is the same. You can cut down on frivolous spending of "found" money. This represents another instance of how mental accounting can cause illogical use of money.or no-interest account is fruitless if you still have outstanding debt. Bias is one topic in judgment and decision making.differently depending on its source. such as from their paychecks. realize that saving money in a low. One important bias is the hindsight bias. some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. There are a number of possible types of judgment and decision bias. sometimes it makes more sense to forgo your savings in order to pay off debt. Logically speaking. his net wealth will be no different than if he had held one larger portfolio. Where the money came from should not be a factor in how much of it you spend . Avoiding Mental Accounting The key point to consider for mental accounting is that money is fungible. For example. people tend to spend a lot more "found" money. spending it will represent a drop in your overall wealth. Treating money differently because it comes from a different source violates that logical premise. by realizing that "found" money is no different than money that you earned by working. the interest on your debt will erode any interest that you can earn in most savings accounts. regardless of its origin. compared to a similar amount of money that is normally expected. such as tax returns and work bonuses and gifts. it is important to define the hindsight bias. For example. regardless of its origins or intended use. While having savings is important. 7.

As a psychology student.  The phenomenon has been demonstrated in a number of different situations. When students were polled again after Thomas was confirmed. For example. 58-percent of the participants predicted that he would be confirmed. including politics and sporting events. Imagine that you receive a letter from a publisher that states that the publisher is going to publish your short story. Hindsight Bias Example There are a number of possible examples of hindsight bias. the friend reminds you that before you received the letter.The hindsight bias reflects a tendency to overestimate your own ability to have predicted or foreseen an event after learning about the outcome. Prior to the senate vote. Examples of the Hindsight Bias For example. This is one example of hindsight bias. people often believe that they knew the outcome of the event before it actually happened. The hindsight bias is often referred to as the "I-knew-it-all-along phenomenon. researchers Martin Bolt and John Brink (1991) asked college students to predict how the U. You tell a friend that you knew that they would publish it. people often recall their predictions before the event as much stronger than they actually were. As you read your course texts." It involves the tendency people have to assume that they knew the outcome of an event after the outcome has already been determined. the information may seem easy." you might think after reading the results of a study or experiment." . In experiments. However. "Of course. 78-percent of the participants said that they thought Thomas would be approved. you may have also experienced the hindsight bias in your own studies.  After an event.S. after attending a baseball game. you had told him that you were very uncertain about whether the publisher would accept your short story for publication. you might insist that you knew that the winning team was going to win beforehand. What Exactly Is the Hindsight Bias?  The term hindsight bias refers to the tendency people have to view events as more predictable than they really are. Senate would vote on the confirmation of Supreme Court nominee Clarence Thomas. "I knew that all along.

2. people also tend to assume that they could have foreseen certain events. even in everyday life.' Explanations for the Hindsight Bias So what exactly causes this bias to happen? Researchers suggest that three key variables interact to contribute to this tendency to see things as more predictable than they really are. We might also look at all the situations and secondary characters and believe that given these variables. it was clear what was going to happen. When assessing something that has happened. By assuming that you already knew the information. 1. Know more about how we tend to maintain our status quo. the hindsight bias is more likely to occur. When a movie reaches its end and we discover who the killer really was. When it comes to test time. Second. we tend to assume that it was something that was simply bound to occur. however. . It comes forth through the process of decision-making. You might walk away from the film thinking that you knew it all along. but the reality is that you probably didn't. without actually knowing to have done so. 1. particularly when test time approaches. When all three of these factors occur readily in a situation. Status Quo Bias Explained Perfectly With Apt Examples 'Status Quo Bias' reflects our inherent preferences.This can be a dangerous habit for students to fall into. you can develop good study habits to overcome the tendency to assume that you 'knew-it-all-along. By being aware of this problem. people have a tendency to view events as inevitable. Finally. however. As we look back on our earlier predictions. First. we might look back on our memory of the film and misremember our initial impressions of the guilty character. the presence of many different answers on a multiple choice test may make you realize that you did not know the material quite as well as you thought you did. people tend to distort or even misremember their earlier predictions about an event. we tend to believe that we really did know the answer all along. you might fail to adequately study the test materials.

but rather because that was the most-preferred choice.a treasury bond. not because you had carefully studied and opted for it. If yes.The Reversal TestIt is an attempt to reduce the status quo bias. or the status quo. Transaction costs is given as an important reason. then let us find out what this status quo bias is all about. a low-risk mutual investment plan. in fact. It was found that people were inclined towards the status quo more. Another cause behind a prejudice is the tendency to procrastinate and delay decisions. Any deviation from this point is considered to be a loss or an unwanted risk. a high-risk but handsome return plan. Loss aversion is understood to be a primary reason behind having a status quo bias.A given standard is accepted to be the reference point. When confronted with a choice. or . It is an option that a person is currently choosing. The bias about status quo is believed to have either of the two attributes: 1. there is a tendency to prefer the existing and default options. an obvious way of thought. 'the status quo bias is best viewed as a deeply rooted decision-making practice. Individuals were given decision-making problems.According to the study. with and without a pre-existent status quo position (certain choices were labeled as 'status quo'). I would prefer staying happy with the current provider. Let's get to some difficult choices now. You may even remember making up your mind on an insurance plan.DefinitionStatus Quo Bias is a preference given to the present state of affairs. stemming partly from a mental illusion and partly from psychological inclination'. individuals go for an option that is less likely to result into a loss. or rational either. this set of queries requires us to think more over the available options. even if other providers are better. leaving individuals with the status quo by default. Why such biases occur explains that it is not something wrong.Which color car would you buy for yourself? Which color would you paint your house with? Which is your favorite restaurant? What would you prefer for dessert? These are probably some easy-to-handle questions. or a moderate-risk allotment of your portfolio? Naturally. How do you plan to invest the surplus from your enterprise this year? What would you prefer . as compared to the choice we could have made in choosing our favorite colors! How do you think we come to make a final decision in this second set of questions? It is observed that we generally tend to make such difficult decisions by our preferences. They presented the concept with the help of a questionnaire. which may not always be objective enough. or a natural bias towards the current or previous decision.Status Quo Bias in Decision-makingWilliam Samuelson and Richard Zeckhauser brought in the concept of 'status quo bias' through their work 'Status Quo Bias in Decision Making'. which is the status quo bias. published in the 'Journal of Risk and Uncertainty' in 1988. if changing my cell phone service provider takes up more dollars or more efforts. Thus. For example.

If an individual's preference for a particular alternative is strong. the tax and broker commission effects arising from any changes were insignificant. for years long. naturally. the relative bias for status quo is stronger. if a chef is famous for making one particular dish. While buying insurance for the first time. also exemplifies our leanings. It is the option that a person will end up with. the bias is weaker. For example. due to the labeling of a certain option as 'status quo'. treasury bills. etc. to be gathered from one element. a high-risk company. with an increasing number of choices. It was observed that this option was favored more after it was marked as 'status quo'.Preferring a particular brand for various daily essentials. people tend to demand a specific product.Examples of Status Quo BiasAs a Water Commissioner. On the contrary. food and drinks.People tend to use a particular Internet browser that is already installed on their system. a situation where both these attributes are present. one of them being the number of alternatives that are present. as compared to the new Coke. a status quo is introduced in some versions of choices. of course. clothing. if he or she does not actively make a choice. Analyzing examples of the halo effect in the workplace can help you to better understand how it can affect productivity and morale.While considering various investment portfolios. instead of purposefully choosing a plan on his own. by marking the water distribution option chosen by the former Commissioner in a similar drought situation. Appraisals One area where the halo effect is prevalent is in annual performance reviews. even though there is plenty of choice. There can be. Examples of the Halo Effect in the Workplace The halo effect is a psychological phenomenon that allows a general opinion of something. The results of this decision-making task can tell the significant impact on the actual decision made by the audience. one has to choose among various probable water allocations between the farmers and residents. In this case. Other details like the agricultural demand for water are also given. Some managers take a relaxed approach to reviews and assume that if an employee is proficient in some elements of . The same is also seen when an individual is facing a new environment. The degree of the bias that one has depends on many factors. and also similar in all attributes. there were several options. Here. or someone. and municipal bonds.2. like cosmetics. then the halo effect allows people to assume that he can cook anything with equal proficiency. The Samuelson and Zeckhauser paper revealed such tastes of people for older version of Coca Cola. It was a moderate-risk company. including a moderate-risk company. This reluctance to change is also strong in case of products that are equally competitive. This can be given as a perfect example of the 'default option'.. but with one option being marked as 'status quo'. rather than willfully installing another one. during a water shortage. Few investors or decision makers were presented portfolios with the same choice. a person is naturally prone to go for the 'default insurance plan'.

the appraisal. For example. so he is promoted to the position of vice president of sales. by use of the halo effect. This can work the other way. Departmental Misconception Incompetent employees in a department can. if the payroll group in the accounting department consistently makes mistakes on employee paychecks. It is then assumed that she knows a great deal about all the software titles in the company. . Job Tasks People build up a reputation in the workplace for being proficient at something when their actual area of expertise is much different. The same thing can happen in a corporate workplace. The problem is that the hero does not possess any of the leadership qualities or administrative skills needed to be an effective ruler. An employee seen as ineffective in one or two aspects of his job can be given the general label of incompetent. as well. Unfortunately. if one of the accountants from the accounting pool becomes familiar with the accounting software. then he is proficient in all of them. and the halo effect in this situation could also get her labeled as a proficient in hardware repair as well. Promotions Movies and books may present the theme of a hero who performs one spectacular task and is asked to rule as king of the people he saved. For example. A sales professional is proficient at bringing in new accounts and generating revenue. then the halo effect would allow the rest of the company to assume that no one in the accounting department can do their job properly. drag down the reputation for the rest of the group. others ask for assistance in getting the software to work properly. he does not know the first thing about being a company executive.