The Financial Environment

Principles of Finance

There are six foundational principles that can be used to study finance: money has a time value; the higher the reward, the greater the risk; diversification of investments can reduce overall risk; financial markets are efficient in pricing securities; a manager's and stockholders' objectives may differ; and reputation matters.

The first principle of finance is that money has a time value. In other words, a dollar earned today will be more valuable than a dollar earned in the future. Therefore, money can be invested in order to make more money. Inflation is the continual increase in the average price levels of goods and services. For example, Jim Smith buys a loaf of bread every week for $3.50, but if the price of the same bread increases by $0.30 due to inflation, it is possible Jim may no longer be able to afford the bread in the future.

The second principle of finance explains the relationship between risk and reward. The higher the reward, the greater the risk. This principle suggests that making a high-risk investment is a waste of resources if the return is small. For example, if Jim has the choice to invest in a fully backed government bond or a junk bond that is not secured, the risk will be low for the government bond and high for the unsecured bond. A junk bond is a bond that is not rated highly, which means that there is a high chance that there will be a default on the investment. If Jim invests in the junk bond, he may not be paid. On the other hand, the government guarantees that the holder of a government bond will get their money back. Secured bonds are also considered low risk because they are backed by an asset, such as a car or house, that a lender can claim ownership of should the borrower default on the loan. This is important, since it reduces the risk of the investor losing their gains.

High Risk/High Reward

The relationship between risk and reward demonstrates that low risk offers low return while higher risk offers the potential for higher return.
The third principle of finance states that diversification of investments, or distributing investments and risk over many different businesses, can reduce the investor's overall risk. This is important because lack of investment diversity can increase the investor's market risk. For example, if Jim only invests in oil stocks and there is a shortage of oil in the marketplace, all of his holdings will be affected. However, if Jim diversifies his portfolio to include grocery stores and music recording companies, he can expect more stability because his risk is distributed across the marketplace and not concentrated in one type of business.

The fourth principle of finance states that financial markets are efficient in pricing securities. The market follows news on a company, future forecasts, supply and demand, and other factors. Depending on historical information, this principle may not be the best strategy for investors, since financial markets are efficient in themselves and the financial environment is always changing.

The fifth principle of finance is that a manager's and stockholders' objectives may differ. The manager is doing what they believe is best for the business. On the other hand, the stockholder wants the value of the stock to go up so that the stockholder can sell the stock at a higher price to maximize their wealth.

The sixth principle of finance states that reputation matters. Reputation has a significant influence on an investor's decision whether or not to invest in a financial instrument. A financial instrument is a legal document representing the right to receive an asset such as cash, a contractual right to deliver or receive cash, or another form of owned equity that can be traded. Companies with good reputations will inspire more people to buy their stocks. Companies with bad reputations may have difficulty convincing people to buy stocks. For example, investors would rather buy shares in Microsoft than Enron. In the past, Enron's lack of ethical behavior called its reputation into question. Ethical behavior is behavior that is consistent with what society, businesses, and individuals typically think are good values. Investors are wary of companies such as Enron, which manipulated its financial statements to make its position appear better than it was. This kind of unethical behavior costs investors a large amount of money in a short period. Consequently, Enron went out of business when its fraudulent activities were discovered.

Six Principles of Finance

There are six main principles of finance. Among other things, these principles state that greater risk offers higher returns, diversification reduces risk, and financial markets price securities efficiently.