Cost Benefits of Capital Flow Analysis: Systemic Risk and Non-Systemic Risk.

Cost Benefits of Capital Flow Analysis: Managing Systemic Risk and Non-Systemic Risk Cost Benefits of Capital Flow Analysis : continued

Capital Flows in Context

Capital Flow Analysis and Your Career

New ideas are what drive financial markets.

In the first decade of the 21st century, Capital Flow Analysis is a new idea.

As a skilled practitioner of Capital Flow Analysis, you will have insights into market behavior that are missed by most analysts who still believe in the Efficient Market Hypothesis or the idea that 'systemic risk' (sometimes called 'systematic risk') cannot be explained.

The advantage of Capital Flow Analysis is that U.S. forecasts are based on respected data from the Federal Reserve flow of funds accounts and the methods of analysis are based on commonsense.

Federal Reserve Bank: Source of National Flow of Funds AccountsCapital Flow Analysis is based on respected government statistics that are free.

There is no reliance on incomprehensible mathematics, astrological mumbo jumbo, or unproven economic 'laws'.

The product of Capital Flow Analysis can always be presented in simple language that is accessible to the ordinary person with a general knowledge of how the world works.

Of course, for Capital Flow Analysis to advance your career, you must be a good analyst.

You must be right more than you are wrong.

If you had used Capital Flow Analysis to forecast that long bond prices would be higher at the end of 2004, while market guru's like PIMCO's Bill Gross were predicting the opposite, it is likely that others will pay greater attention to your opinion in 2005. (See lesson 25)

Systemic and Non-Systemic Risk

Much of the money that is spent on professional investment analysis deals, in one way or the other, with forecasting variations in market price over three months to three years.

Although most investors hold portfolios for fifteen years or longer, most capital market institutions are oriented towards the immediate future.

Modern financial theory, aimed at the short term, divides market risk (essentially the ability to forecast market variations) into two categories: systemic risk and non-systemic risk.

Non-systemic risk is related to the correlation between fundamental data regarding the intrinsic value of specific securities to future prices. Errors in predicting changes in fundamental data may be ameliorated by portfolio diversification.

Securities Markets Have Systemic RisksSome say that market risks are unpredictable

However, whatever the fundamental data, security prices have a tendency to move in tandem, dependent on factors not related to the intrinsic value of individual securities.

Followers of Modern Portfolio Theory call this unpredictability 'systemic risk' and argue that the causes of this type of variation are unknowable.

Now, MPT says that part of the variation in price due to systemic risk may be ameliorated by diversifying portfolios according to past price changes of individual securities compared to overall market trends (the so-called beta coefficient).

However, Modern Portfolio Theory can only partially improve portfolio performance.

If, for example, the stock market falls 50%, with some stocks dropping 70% and others only 30%, Modern Portfolio Theory will help to keep investment losses to 'only' 50%.

Modern Portfolio Theory also says that market trends are unpredictable. If the portfolio manager wishes to guess as to the direction of the market, Modern Portfolio Theory will help reduce the portfolio risk based on that assumption.

However, Modern Portfolio Theory offers absolutely no help in actually forecasting the direction of market prices.

Consequently, Modern Portfolio Theory may reduce risk somewhat, but not as much as a method that would actually help to forecast market trends.

Cost-Benefits of Investment Analysis

There are essentially two categories of investment analysis: fundamental analysis which deals with non-systemic risk, and a bunch of other techniques that deal with systemic risk, including:

Table: Systemic Risk and Non-Systemic Risk

Of these techniques, MPT and Technical Analysis have the largest following and can, at least, claim partial success in reducing risk in short-term market strategies.

The most expensive type of investment research is Fundamental Analysis, requiring extensive study of tens of thousands of financial statements and supplementary data by thousands of trained analysts.

Although the cost of Fundamental Analysis is high, the return on this investment is worthwhile, especially for portfolios with relatively few securities.

Technical analysis and chart reading now can rely on modern computers to drastically reduce the cost of drawing charts and calculating relationships, but the practical results tend to be more relevant to traders and short-term speculators than to most of the investment market.

Modern Portfolio Theory is a low-cost method of reducing portfolio risk somewhat, but offers no help in predicting major market trends.


Before proceeding, check your progress:


Predictions of economic collapse are:
Choice 1 Readily accepted by the public.
Choice 3 Easily verified by historical precedent.
Choice 4 Generally supported by banks and brokers.
Choice 2 Frequently wrong.
Many investors make decisions based on:
Choice 2 Opinions of friends and colleagues.
Choice 1 Their own research of fundamentals.
Choice 3 Suggestions of brokers.
Choice 4 Articles in the financial media.
Capital flow analysts should expect:
Choice 2 Investors to know about flow of funds.
Choice 3 Respect when predictions are correct.
Choice 1 Immediate acceptance of their opinions.
Choice 4 To reach some contrarian conclusions.

Learning Module: Steps in Capital Flow Analysis  learning module : continued >

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