Economics Of Investing

There are several concepts in economics that are important to become at least reasonably familiar with as investors, especially those that affect the pricing of securities. Without a reasonably sufficient grasp of these concepts, we may not be able to properly make many of the decisions that arise when looking to invest.

One of the more obvious concepts that are in play here is the relationship between supply and demand. Financial markets rely on this to conduct all financial transactions, and it is only when supply and demand meet at an equilibrium price point that a financial transaction can even take place.

This isn’t so important in the present, when is entering a trade, but it’s very important as far as looking to predict the future price movements of a security. It’s even very important to know as far as being able to even engaging in trading, because you have to know what moves markets to even understand whether a trade will be a good one or not.

Liquidity is another important concept to understand if one is seeking to understand trading, and more or less liquidity can really effect trades. Liquidity means how easy or difficult it is to trace certain securities, and this also determines things like spreads, with more liquid issues having tighter spreads, which is in everyone’s interest.

Opportunity cost is another concept from economics that certainly applies to investing. What opportunity cost entails is that one must compare opportunities to decide what the best option is, and taking advantage of one opportunity means that other opportunities must be foregone, and this is what is known as the cost of opportunity cost.

Opportunity cost not only involves deciding between investment opportunities at the individual level, it also can be used to understand markets better, which are affected by this concept as well.

The relationship between money and time is another significant economic factor in investing, as the value of money declines over time to certain degrees, both on an individual level and in the aggregate. This also relates to things like interest rates and inflation, to give us a complete picture of the future value of an investment.

Supply and Demand

How big a deal is supply and demand in determining the price of a security?  It’s not part of the deal, or most of the deal, it’s the entire deal. Now there are other factors involved of course, earnings expectations for example, or other fundamental data, but it’s only to the extent that this data is acted upon that it drives prices.

If there is more demand than supply for something, the price goes up, and if there’s more supply than demand, the price goes down. The best way to think of this is if you were looking to buy a large order, and at any given time, there are people who are willing to sell to you at a certain price, some who would sell to you at a price a little higher, and so on.

So the larger your order, the higher your average price will be, and the higher you will drive the price up with it, providing that it is large enough to move the market, in other words to exhaust the supply at the current ask price and require it be filled with higher ask prices.

The same thing happens if you are trying to sell something, if your order is large enough it will drive the price down. This all happens in the aggregate, and these upward or downward pressures are what drives security prices.

We also use this to predict movements in supply and demand, which is called technical analysis. This type of analysis just uses price and volume data over time and employs a wide range of charting techniques and indicators to predict future price movements, with some accuracy.

The other major form of analysis, called technical analysis, deals with business data, that of the underlying security, and while this can be quite predictive as well, it applies to longer term holdings, where technical analysis specializes in shorter timeframes, even though it can be applied to any period of time.

While the past does not always predict the future, it can do so to a reliable degree overall, and what we’re shooting for is better results than random, so that one can make a profit after transactional costs are deducted.

Liquidity

Liquidity is very important to financial trading, and this is the reason why financial markets exist, to provide liquidity to securities. In a privately held company for instance, one may own shares, but they can be extremely difficult to sell because they are so illiquid, there just isn’t much demand for them and no easy place to sell them.

When a stock goes public though, this brings together those who are looking to buy and sell stocks, and it then becomes an easy affair to sell your shares, and they can even be sold in as little as seconds rather than perhaps not at all if they aren’t listed and offered in the market.

If something is publicly traded, it always has some liquidity, in almost all cases that is, although if a company has failed for instance, it may be very difficult if not impossible to do so. Sometimes trading is halted on issues temporarily, in which case the issue has become completely illiquid for a time, and this interrupts the free flow of the market and can result in both uncertainty and an abrupt price movement when it opens up.

We want to take into account the amount of liquidity that a security has when considering trading it, and while this is just one factor, it’s a significant one. Less liquid issues have wider spreads, which generally involve one having to make the spread before a profit can be realized on the excess.

So if you bought and sold an issue with a wide spread immediately, the spread would represent your losses, providing you were trading on the bid and ask that is. So bigger spreads mean less profit and more risk, which must be accounted for.

Liquidity also involves the ease that you can move in and out of a position, and there are some issues that only trade infrequently, and therefore you may not be able to trade it when you want to or perhaps not even that day if it’s illiquid enough.

Opportunity Cost

When deciding between investments, it is always wise to not just look at the investment as an opportunity in itself, but instead look at other comparable and viable opportunities alongside it. Among these alternatives is doing nothing, just holding the funds in cash for now, and this is a strategy that’s actually used pretty often in investing, especially in areas of uncertainty, or with funds that cannot go short the market and want to have some of their money not being exposed to the current risks.

An example of how opportunity cost can affect an individual investor is the situation where one can purchase a certain security, which by all accounts looks like a good trade, and then the investor realizes a profit. However, there may have been another security which looked even better and performed even better, and if one had been aware of this, more success could have been achieved.

In this case, while we have made money on the initial trade, selecting it over the better performing trade has cost us, and the cost here is the opportunity that was missed by perhaps not being diligent enough.

While this is a simple example, and it’s often not so easy to measure or decide among competing uses of our funds, especially given that the risks involved may differ quite a bit, we always want to be aware that our resources are limited, and we generally give something up by taking one course of action over another, and we need to be aware of all of this and its potential impact.

Time Value of Money

Money in your hand now is worth more than a similar amount of money in your hand in the future, for several reasons. First of all, it’s just better to have the money now, as we could spend it on something, where if we have to wait for it we can’t.

Even more significant to investing is that money in our hand now can be invested, where money that we have to wait for cannot, right now anyway. Since this is all the case, if we are going to pass on the ability to use money now, we’re going to need to be compensated for it, and ideally we get at least as much more as we discount its value in the future.

If you lent money interest free for example, for a year, there’s the risk you won’t get paid back, there’s the risk you might not be still around to collect it, there’s money lost to inflation. There’s also the lost opportunity of spending it now if you wanted to, or investing it into something, that must also be accounted for.

So money declines in value dollar for dollar in the future, and how much less becomes the future discount that we will need to apply. People generally don’t work this out of course, and it’s very difficult to do anyway if you wanted to, but one still needs to be aware of the concept and the general idea behind it, and what things go into this equation, to make decisions about money that are properly informed.

With these basic principles in hand, individual investors can better equip themselves to make decisions about their future, as well as the future of what they invest in, which is what investing properly is really all about.