The Ascent of Money - Part 6
In this episode, titled Chimerica, we take a look at the globalization of finance and learn a bit about both the good and bad parts of options, hedge funds, and diversification.
The episode is called Chimerica because Ferguson envisions the relationship between China and America like they are combined into one big country, where one part of the country (China) is extraordinarily good at saving their money and funds the consumption habits of the other part (America), who is extraordinarily bad at saving their money and has a seemingly insatiable appetite for purchasing more things than they need.
The Ascent of Money (Part 6): Chimerica
Aside from the obvious importance of globalization and the role it has played in the business, finance, and investing arenas, there are a few other important topics mentioned in this episode which we feel deserve some additional attention.
Very Brief Explanation of Options
First off, we’d like to briefly explain the basics of how options work. Options are part of the derivatives market that we touched on in the previous post, The Ascent of Money (Part 4): Risky Business. As mentioned in that post, you shouldn’t invest in derivatives unless you’ve thoroughly done your homework on them and have a firm understanding of how to value them.
As mentioned in the video, an option is a financial instrument that gives you the right to either buy or sell a security at some time in the future for a fixed price agreed upon on the day you buy the option.
An instrument that gives you the option to buy is a call option.
An instrument that gives you the option to sell is called a put option.
The basic idea behind having the option to buy or sell something is as follows. You are betting that the price of something will be higher or lower than some price at a specific date in the future.
If the underlying security is not worth what you bet it would be, you would not exercise your option and you would only lose the amount you paid for the option, which is a relatively small amount in comparison to the value of the security you had bought the option for.
You can also sell options (whether you actually own them or not), but that opens up a whole new level of complexity, where you make money as long as the underlying scenario is such that it is not worth it for the people who bought the options from you to exercise their options to buy or sell whatever it is underlying the option.
If you remember from the video, this is what Ferguson said Long Term Capital Management did. Observing how their situation turned out, it bears repeating that you can both make and lose a significant amount of money by dealing in options.
Math and Finance Don’t Always Mix
Another point Ferguson touched on in the video was how the world’s leading economists and mathematicians can get together and try to fit reality into a neat (or sometimes not so neat) mathematical formula.
Sadly, this doesn’t always work as expected, as we saw with Long Term Capital Management. As we mentioned in our previous post, The Ascent of Money (Part 4): Blowing Bubbles, financial markets are driven by supply and demand, which are driven by human emotions.
As we all know, human emotions are complicated and unpredictable, which means that incorporating them into a mathematical formula is very difficult to do.
The Ups and Downs of Diversification
Another example of mathematical theory being applied to finance is the concept of diversification. As with most financial innovations, there are upsides and downsides to the theories behind diversification.
Diversification is the name given to the practice of splitting up the money you have to invest into several different investments. Diversification is essentially an attempt to reduce risk by spreading your eggs among many baskets so that when something happens to one basket, it’s only a small portion of your money that is lost.
Diversification relies on the mathematical concept of correlation. Two investments are positively correlated when their prices move up and down together. Investments are negatively correlated when one normally goes up in value as the other goes down. Investments are uncorrelated when the price movement of one has no impact on the other.
The great thing about diversification is that it spreads your risk out and statistically reduces the chances that you will experience a financial catastrophe because you are not committing a significant amount of money to any one investment.
What we don’t like are people’s misunderstanding of the concept and the blind faith in it that some people have.
What we mean by misunderstanding is that some people believe they are properly diversified when, in fact, they are not. For example, when someone says something like, “I have a diversified portfolio of technology stocks,” they really aren’t diversified. They are overlooking the requirement that in order to be properly diversified, the assets they invest in must be uncorrelated. Otherwise, when the technology sector tanks, so will the portfolio they thought was diversified.
What we mean by blind faith is the faith people have that just because they have invested in a diversified portfolio of uncorrelated assets, that they will not lose money. These people are overlooking the fact that just because assets are uncorrelated, doesn’t necessarily mean that they can’t go down in value at the same time.
This concludes our series based on Niall Ferguson’s book. We hope the videos and explanations were helpful and that you’ll take some of these concepts into consideration when making financial decisions.
Learn more about Niall Ferguson at his website - NiallFerguson.com.
Buy Niall Ferguson’s book - The Ascent of Money: A Financial History of the World.
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