What Is Risk Tolerance & Why Is It Important?

April 2022

Each investor should have an understanding of their level of risk tolerance before investing. Simply put, risk tolerance is the amount of variability in investment returns an investor is comfortable with. The level of risk varies across asset classes, such as bonds, stocks, commodities, or even cryptocurrencies. Furthermore, there are highs and lows in the financial markets that can be associated with macroeconomic and microeconomics trends. Because of this volatility, there can be panic sell offs.

Being able to stick to a strategy, understand time horizons, and tolerate risk are important skills each investor should possess before and while investing in the financial markets.

Some things to consider when understanding risk tolerance are the following:

• Desired time horizon
• Age
• Financial situation and obligations
• Investment goals
• Income

Age is often a large factor in determining risk tolerance. For example, a young investor in their 20s, who is saving for retirement, may be able to take on greater risk, compared to older investors who have a shorter-time horizon. As the time horizon increases, the risk can be further minimized.

Qualitative Classifications of Risk Tolerance

Aggressive

Aggressive investors are aiming for maximum returns with a much higher risk, compared to other investors. Aggressive investors tend to have a deeper understanding of the financial markets which allow them to be more comfortable investing in growth stocks, derivatives, and other volatile financial instruments.

Moderate

The moderate investor is willing to accept some risk but takes a more balanced approach to their investment portfolio. In order to balance the risk, the moderate investor might invest in bonds and large ETFs to balance for the more risky assets.

Conservative

The conservative investor will try to avoid any volatility in their portfolio. This investor prefers assets that are highly liquid or traditionally safe, such as bank certificates of deposit and money market funds.

Key Takeaways

• An investor’s risk tolerance is determined by factors such as age, income, and time horizon
• Aggressive investors are aiming for high returns with the expense of higher risk and volatility
• Moderative investors try to balance risky and non-risky assets. They are often comfortable with a little volatility but not as much as the aggressive investor
• Conservative investors aim for no volatility and target investments that are highly liquid or traditionally safe, such as the U.S. Treasury bills

Understanding Inflation & Time Value of Money

April 2022

Inflation is an integral factor in economics, government policies, personal savings and investments. Inflation is the increase in prices and fall in purchasing power of a currency. Often expressed as a percentage, inflation reflects the change in price level for goods and services.

When a currency, like the U.S. dollar, inflates in value, the currency’s purchasing power decreases. Consumers can notice the prices for goods, such as cereal or bread, have slightly increased over time.

Inflation arises from more money flowing into the markets (cheap capital), higher than expected demand by buyers, or limited supply all else equals. For excess money supply, this can either mean that more foreign banks are investing money into the U.S., or it could be that the U.S. Federal Banks are printing more money. Sometimes, the Federal Bank, or Fed, will print more money in order to stimulate the economy. The hope is that people will take that extra money to buy clothes, goods, invest, etc. However, as a result of the increased money supply, the currency inflates.

A common saying in finance is “a dollar today is worth more than a dollar tomorrow.” Imagine you have $100 and the inflation rate is 3%. You then keep that $100 until next year. That $100 is now worth 3% less. You only have $97 worth of goods and services in terms of last year’s dollars.

Another way inflation affects money is with investments and savings. Imagine you have $10,000 in a savings account that earns you 1% interest per year. If inflation is at 3%, you are actually losing money. Although your money is earning 1% every year, inflation is depreciating your money 3% per year. Overall, your savings are losing 2% per year in value. The nominal return is 1% but the inflation-adjusted return or real return is -2%. This logic can also be applied to stock market returns. This is why inflation is sometimes referred to as a "hidden tax".

Types of Inflation

There are generally two types of inflation, cost-push inflation and demand-pull inflation.

Cost-push inflation is caused when wages and the cost of raw materials increase. This causes goods and services to inflate in price. Since the cost of raw materials is higher, the aggregate supply produced is reduced. When demand is constant but the supply decreases, the prices of goods increase.

Demand-pull inflation is when the demand for goods outpaces the supply. This can happen when unemployment is low. More people have disposable income and have the ability to purchase more goods. If companies cannot keep up with the higher demand for goods, the prices of those goods increase.

How to measure inflation?

Inflation is typically measured by two indexes, the Consumer Price Index (CPI) and Personal Consumption Expenditure Price Index (PCE).

The U.S. Bureau of Labor Statistics calculates the CPI by tracking the spending data of tens of thousands of Americans. They track goods and services, such as gas, food, college tuition, and mortgage payments, to see how they change over time. Inflation can be calculated by comparing the total cost of those goods and services within the recent months to the total costs of previous months.

The U.S. Bureau of Economic Analysis calculates the PCE inflation rate. Similar to the CPI, the PCE is calculated by tracking the price changes of goods and services. The main difference between the PCE and CPI is that the PCE tracks the prices businesses report selling goods and services for. This is important, especially for healthcare costs.

CPI usually has a fixed set of types of goods and services it tracks. The PCE is less fixed and is able to track different goods and services over time if a large majority of people switch to a substitute good, for example.

Hyperinflation and Deflation

The value of money and its purchasing power is a spectrum with general inflation being one segment of that spectrum. Hyperinflation and deflation are also two other types of changes in currency value.

Hyperinflation is the rapid, uncontrollable increase in prices. Typically, an economy is in hyperinflation when the currency inflates by more than 50% per month. Although rare, hyperinflation has occurred in economies throughout history, such as in China and Germany, but never in the United States. Hyperinflation can become extremely dangerous for a country because it can make a currency virtually worthless. General goods and services can change in price from day-to-day, making life incredibly difficult.

Deflation is the opposite inflation. Deflation is when prices for goods and services decline, and the purchasing power of the currency increases over time. Deflation can occur when there is a decrease in the money supply. Although lower prices seem great, deflation can be harmful for an economy in the long run. For borrowers such as mortgage owners, it becomes more difficult to pay off debts. Periods of deflation are also associated with slower economic growth. Assets decrease in value, and there is less borrowing.

How to combat inflation?

When inflation becomes too high, the Fed will increase interest rates to reduce money supply as this means that it costs more to borrow money. It also means that if you loan money, you are making higher earnings.

Many money lenders will also increase interest rates on previous loans they made. It is common to notice this with mortgage and car loans. If there is an increase in interest rates, it costs more over time to pay back the loan. Consumers lower their expenditures and the lower demand, typically leads to a drop in price of goods and services (i.e.less inflation).

Time Value of Money (TVM)

Time value of money is a concept that states the sum of money now is worth more than the sum of money in the future. This theorem is built on two principles, inflation and opportunity cost. First, inflation is the silent killer of the value of money. $100 today does not have the same purchasing power as $100 of next year. Second, there is an opportunity cost from not investing or growing your money. If that $100 is not invested or put into a savings account to earn interest, you will lose additional money that could have been earned if you did invest.

The formula for the TVM is the following:

• FV = PV x [ 1 + (i / n) ] ^{(n x t)}

The variables are:

• FV = future value of money
• PV = present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years

Key Takeaways

Tracking inflation over time is important to understand the value of money and investments over the long run. Inflation devalues the currency and reduces the purchasing power. In order to combat inflation, it is important to earn more interest than the current inflation rate. However, it is important to note that inflation is not a bad thing, unless it is uncontrollable. An increase in the money supply may result in a greater wages and incomes for workers and helps stimulate economic activity.

Analyzing a Stock: A Fundamental Approach

April 2022

Fundamental analysis is a method to determine the intrinsic or “real” value of a stock. This analysis is often used by long-term and value investors who are looking for discounts or fairly priced companies.

The goal of any analysis, including fundamental, is to determine the value of the stock. Based on this value, the stock can be compared to other stocks to best determine an investment strategy.

Fundamental analysis helps analysts and investors determine if a stock price is undervalued or overvalued. If the “real” intrinsic price of the stock is higher than the market price, the stock may be considered undervalued.

Although fundamental analysis is not the complete and only method to analyze a stock, it is still a critical component of portfolio management.

Macro vs Micro

When analyzing a stock using fundamental analysis, it is typical to start with a top-down approach. Macroeconomic factors, such as interest rates, inflation, and the unemployment rate, are components that may impact the fundamentals of the stock and its industry. Microeconomic factors, such as a company’s balance sheet, management team, and brand name recognition, are components to further understand the present and future health of a stock.

Three Pillars of Fundamental Analysis

There are many layers to fundamental analysis; however, the three pillars to understand the financial performance of a company are the income statement, balance sheet, and cash flow statement.

Income Statement

An income statement shows both the operating and non-operating revenue. Operating revenue is the money a company receives from their primary business activities, such as a T-shirt company selling shirts. Non-operating revenue is the money a company receives from non-core business activities, such as the T-shirt company receiving rental income. In an income statement, the company must report any expenses or losses. Cost of goods sold (COGS) are the expenses from selling the product of service. Selling, general, and administrative expenses (SG&A) are the expenses in running the business.

There are many other metrics that are reported in an income statement, but at the end, the goal is to determine the net income by using the following formula:

REVENUE - EXPENSES - TAXES = NET INCOME

Balance Sheet

The balance sheet is another financial statement that reports the company’s assets, liabilities, and shareholder equity. Balance sheets are great to understand the capital structure of a company.

The reason why this statement is called a balance sheet is because assets and liabilities should be equal or “balanced.”

ASSETS = LIABILITIES + SHAREHOLDER EQUITY

Cash Flow Statement

Cash flow is similar to the net income statement in that it shows the movement of cash in and out of the business. In general, cash flow can summarize the cash from three sources: operating activities, investing activities, and financing activities.

Cash from operating activities shows how much is coming in and out from selling a good or service. Cash from investing activities shows how much cash is coming out from investing in equipment and other assets. In financing, it can be cash-in, such as raising funds from venture capital, or cash-out for paying off a loan from the bank.

Key Takeaways

• Fundamental analysis tries to find the fair market value of a company
• Fundamental analysis can help an analyst or investor determine if a company is undervalued, overvalued, or fairly priced
• Income statements, balance sheets, and cash flow statements are three pillars of understanding the fundamentals
• Fundamental analysis is NOT the only way to determine the value of a company, nor is it always correct

Analyzing a Stock: A Technical Approach

April 2022

Technical analysis is a method to analyze stocks based on examining historical price data in order to predict the future price. There are many strategies and variations to technical analysis, but at the core, it is based on two principles, the stock’s price and the stock’s volume.

Investors and traders who take a technical approach to the stock market analyze charts and graphs that show specific signals and price patterns of a stock of interest. Because of this, technical analysis may be a more difficult method of analyzing potential investments or traders.

There are two main approaches to technical analysis: the top-down and bottom-up approach. Top-down is first analyzing the economy, then the sector or industry, then a small list of companies, then a specific company’s stock and its price patterns. Bottom-up is finding first a stock of interest from other means, such as fundamental analysis, then analyzing up toward the macroeconomic factors.

Technical analysis is often used by traders who buy and sell equities in a short period of time, but investors also use technical analysis in order to determine buying and sell points of their investment. Technical analysts believe that the past trading activity and price changes can be indicative of future price movements. Because of this, technical analysts try to find these patterns and make a decision on when to buy and sell.

There are hundreds of indicators and patterns that technical analysts are searching for, but the main are price trends, chart patterns, volume, oscillators, moving averages, and support and resistance levels.

Price Trends

Price trends is simply understanding if a stock is mainly moving up or down. If a stock is primarily moving upward with only small, inconsistent downward price changes, it can be said that the price is in an upward price trend. This is helpful in determining when to buy or sell a stock.

Chart Patterns

Chart patterns are specific patterns that are indicators of future price movements. Some common chart patterns are the double top, double bottom, and descending and ascending triangle. Analysts try to recognize these patterns and find points of entry and exit using the patterns in order to make quick returns.

Volume

Volume measures the number of shares that are traded for that stock. Volume is an indicator of liquidity, or the ability to enter and exit positions quickly. Technical analysts would track sudden increases in volume as they can be indicative of big swings in the price movement of a stock.

Oscillators

Oscillators are indicators that show when a stock is overbought or oversold under certain conditions. A popular oscillator is the relative strength index or RSI. The RSI measures recent price changes to determine if a stock is overbought or oversold.

Moving Averages

Moving averages create a constantly updated average price of a stock over time. Since technical analysts are trading on shorter time frames, the price is constantly changing, even if it is between a small range of values. Moving averages are used to calculate the support and resistance lines.

Support and Resistance Levels

Support and resistance levels are price levels that act as barriers for the stock price. Technical analysts try to calculate these levels in order to act when the stock price breaks those price level barriers. The support level is where a downtrend is expected to pause while the resistance level is where the upward trend is expected to pause.

Key Takeaways

Technical analysis is one tool that analysts use to determine trades and investments. Technical analysis is often used by traders and is based on the movement of price, while its counterpart, fundamental analysis, is based on the company’s financial statements and intrinsic value. There are hundreds of indicators, price chart patterns, and analysis tools to determine the price movements of a stock.