Note: I never actually made proper notes for third-year pre-honours… ironically because I spent my time writing notes for second-year pre-honours in preparation for third year pre-honours. Lol. Anyway, here are the notes I uploaded as a facebook note.
Originally posted: Saturday April 12, 10:16am
This note is mainly for my own purposes, as I find it highly likely I will lose my notes I made on finance (I think I’ve already lost them, so I might as well jot them down now). Also, I don’t feel like starting my law assignment or my mooting just yet. In a kingdom of blind men, procrastination rules supreme.
Now, I’ve just finished reading up on the Finance second year Pre-Honours course (which I didn’t do, but have to know since I’m doing third year pre-honours this semester). I have come to the conclusion that it is actually remarkably simple.
Before the emergence of sophisticated capital markets, investors were restricted to simple choices which limited their freedom to choose. Fortunately, Adam Smith came away, blew away all the communists and established efficient capital markets which increased freedom of choice considerably. However, the question remains, what financial asset will a sophisticated investor choose?
Fortunately, financial economic provides an answer by limiting the choice set considerably, and providing a few simple choices in this complicated, and most sophisticated financial system- regardless of an individual investor’s preferences.
We call this the Fisher Separation Theorem. You have an absolute freedom to like whichever assets you like, and the absolute freedom to choose whatever assets you wish to buy within the range of your initial monetary endowment. This is strictly separated from how you will actually exercise your choice, which, if you are smart, you will exercise in exactly the way we say.
But look, we’re not elitist. We think everyone is smart, or as we like to say “rational”. But there are problems, for example people who both gamble (a sign of risk-loving) and buy insurance (a sign of risk-aversion). How could this be?
Fortunately, Milton Friedman in his infinite majesty proposed a solution: maybe some investors are both risk-averse and risk-loving? Some other guy (Friedman’s blinding light blocked all light from reaching his name) disagreed, at his own peril. One does not simply disagree with Milton fucking Friedman. I admire his guts – one for standing up to Milton Friedman, and two for abandoning everything for a guaranteed place in the unemployment queue. But back to his actual disagreement. He thought that risk-loving was always irrational, and that’s fair enough. We have an absolute say over what people believe in America, I mean look at our mega-churches. Instead he proposed an alternate solution entirely consistent with being rational- maybe people are stupid, and can’t calculate simple probabilities. What if they thought they had a 1/5 chance of winning instead of a 1/10 chance? If we do a few calculations, we see buying into this 1/5 lottery is the same as buying into insurance (if he similarly stupidly believes he can get a payout without going to court for a few years against the monopolistic industry gods). It’s mathemagic!
But hey, let’s get back to being rational. You can believe whatever you want, but here’s a few rules for what you need to do to be smart.
(1) cowardice: you must be risk-averse. You can’t argue with me on this point, because I’ve just defined you to be a coward, and cowards don’t fight back remember?
(2) You are absolutely self-serving and would sell out your own grandmother if you got an extra cent. This is a logical conclusion from the fact that you are a coward and unable to stand up for any principles except the ones propounded in this article.
and there’s a few others, which I won’t list because I’m rational. It would take effort, and that’s a definite no-no without adequate payment. It’s about 5c/60 mins for hard manual labour, and $60m/5mins for sitting at a desk and pretending to be a CEO.
So in conclusion, we have financial theory to thank for making us so very sophisticated (and above all, incredibly rich). It removed the barriers choice, freeing us of those few simple choices and maximising our utilities. But to deal with the complexities of the financial markets, financial economics developed many restrictive assumptions to simplify everything down to a few simple choices. Isn’t it wonderful?
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