Chapter 27

Chapter 27 talks about using financial thinking to people's decisions in the financial market. The future value is the money in the future that would be produced today. Present value is the money available today that would be needed, using current interest rates, to produce a future amount of money. The equation X/(1+r)^N where "r" is the interest rate and "N" is the number of years that would amount to "X". Most people dislike uncertainty and are risk averse. To deal with that, in the economy, there's insurance, diversification, and risk-return trade off. Insurance suffers from problems that prevent their ability to spread risk. One problem is adverse selection, where a high risk person is more likely to desire insurance because they would benefit more from insurance protection than a low risk person. With diversification, risk can be reduced by placing a large number of small bets, rather than a small number of large bets. Even though diversification reduces the risk of holding stocks, it doesn't completely eliminate it. When people increase the percentage of their savings that they have invested in stocks, they increase the average return they can anticipate to earn. However, they also increase the risks they face, showing the trade off with risk and return. To determine the value of a company, the fundamental analysis is used. The value of an asset is determined by the efficient markets hypothesis, which implies that stock prices should follow a random walk. The efficient markets hypothesis is controversial because some economists believe that irrational psychological factors also impact asset prices and value.