Financial Markets

A financial market is a broad term describing any marketplace where buyers and sellers
participate in the trade of assets such as equities, bonds, currencies and derivatives.
Financial markets are typically defined by having transparent pricing, basic regulations
on trading, costs and fees, and market forces determining the prices of securities that
trade.
Financial markets can be found in nearly every nation in the world. Some are very small,
with only a few participants, while others - like the New York Stock Exchange (NYSE)
and the forex markets - trade trillions of dollars daily.
Investors have access to a large number of financial markets and exchanges
representing a vast array of financial products. Some of these markets have always been
open to private investors; others remained the exclusive domain of major international
banks and financial professionals until the very end of the twentieth century.
Capital Markets
A capital market is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell securities
on the capital markets in order to raise funds. Thus, this type of market is composed of
both the primary and secondary markets.
Any government or corporation requires capital (funds) to finance its operations and to
engage in its own long-term investments. To do this, a company raises money through
the sale of securities - stocks and bonds in the company's name. These are bought and
sold in the capital markets.
Stock Markets
Stock markets allow investors to buy and sell shares in publicly traded companies. They
are one of the most vital areas of a market economy as they provide companies with
access to capital and investors with a slice of ownership in the company and the
potential of gains based on the company's future performance.
This market can be split into two main sections: the primary market and the secondary
market. The primary market is where new issues are first offered, with any subsequent
trading going on in the secondary market.
Bond Markets
A bond is a debt investment in which an investor loans money to an entity (corporate or
governmental), which borrows the funds for a defined period of time at a fixed interest

rate. Bonds are used by companies, municipalities, states and U.S. and foreign
governments to finance a variety of projects and activities. Bonds can be bought and
sold by investors on credit markets around the world. This market is alternatively referred
to as the debt, credit or fixed-income market. It is much larger in nominal terms that the
world's stock markets. The main categories of bonds are corporate bonds, municipal
bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as
simply "Treasuries." (For more, see the Bond Basics Tutorial.)
Money Market
The money market is a segment of the financial market in which financial instruments
with high liquidity and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from several days to
just under a year. Money market securities consist of negotiable certificates of deposit
(CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes,
eurodollars, federal funds and repurchase agreements (repos). Money market
investments are also called cash investments because of their short maturities.
The money market is used by a wide array of participants, from a company raising
money by selling commercial paper into the market to an investor purchasing CDs as a
safe place to park money in the short term. The money market is typically seen as a safe
place to put money due the highly liquid nature of the securities and short maturities.
Because they are extremely conservative, money market securities offer significantly
lower returns than most other securities. However, there are risks in the money market
that any investor needs to be aware of, including the risk of default on securities such as
commercial paper. (To learn more, read our Money Market Tutorial.)
Cash or Spot Market
Investing in the cash or "spot" market is highly sophisticated, with opportunities for both
big losses and big gains. In the cash market, goods are sold for cash and are delivered
immediately. By the same token, contracts bought and sold on the spot market are
immediately effective. Prices are settled in cash "on the spot" at current market prices.
This is notably different from other markets, in which trades are determined at forward
prices.
The cash market is complex and delicate, and generally not suitable for inexperienced
traders. The cash markets tend to be dominated by so-called institutional market players
such as hedge funds, limited partnerships and corporate investors. The very nature of
the products traded requires access to far-reaching, detailed information and a high level
of macroeconomic analysis and trading skills.
Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or

assets. A derivative is a contract, but in this case the contract price is determined by the
market price of the core asset. If that sounds complicated, it's because it is. The
derivatives market adds yet another layer of complexity and is therefore not ideal for
inexperienced traders looking to speculate. However, it can be used quite effectively as
part of a risk management program. (To get to know derivatives, read The Barnyard
Basics Of Derivatives.)
Examples of common derivatives are forwards, futures, options, swaps and contractsfor-difference (CFDs). Not only are these instruments complex but so too are the
strategies deployed by this market's participants. There are also many derivatives,
structured products and collateralized obligations available, mainly in the over-thecounter (non-exchange) market, that professional investors, institutions and hedge fund
managers use to varying degrees but that play an insignificant role in private investing.
Forex and the Interbank Market
The interbank market is the financial system and trading of currencies among banks and
financial institutions, excluding retail investors and smaller trading parties. While some
interbank trading is performed by banks on behalf of large customers, most interbank
trading takes place from the banks' own accounts.
The forex market is where currencies are traded. The forex market is the largest, most
liquid market in the world with an average traded value that exceeds $1.9 trillion per day
and includes all of the currencies in the world. The forex is the largest market in the
world in terms of the total cash value traded, and any person, firm or country may
participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the
counter. The forex market is open 24 hours a day, five days a week and currencies are
traded worldwide among the major financial centers of London, New York, Tokyo, Zrich,
Frankfurt, Hong Kong, Singapore, Paris and Sydney.
Until recently, forex trading in the currency market had largely been the domain of large
financial institutions, corporations, central banks, hedge funds and extremely wealthy
individuals. The emergence of the internet has changed all of this, and now it is possible
for average investors to buy and sell currencies easily with the click of a mouse through
online brokerage accounts. (For further reading, see The Foreign Exchange Interbank
Market.)
Primary Markets vs. Secondary Markets
A primary market issues new securities on an exchange. Companies, governments and
other groups obtain financing through debt or equity based securities. Primary markets,
also known as "new issue markets," are facilitated by underwriting groups, which consist

of investment banks that will set a beginning price range for a given security and then
oversee its sale directly to investors.
The primary markets are where investors have their first chance to participate in a new
security issuance. The issuing company or group receives cash proceeds from the sale,
which is then used to fund operations or expand the business. (For more on the primary
market, see our IPO Basics Tutorial.)
The secondary market is where investors purchase securities or assets from other
investors, rather than from issuing companies themselves. The Securities and Exchange
Commission (SEC) registers securities prior to their primary issuance, then they start
trading in the secondary market on the New York Stock Exchange, Nasdaq or other
venue where the securities have been accepted for listing and trading. (To learn more
about the primary and secondary market, read Markets Demystified.)
The secondary market is where the bulk of exchange trading occurs each day. Primary
markets can see increased volatility over secondary markets because it is difficult to
accurately gauge investor demand for a new security until several days of trading have
occurred. In the primary market, prices are often set beforehand, whereas in the
secondary market only basic forces like supply and demand determine the price of the
security.
Secondary markets exist for other securities as well, such as when funds, investment
banks or entities such as Fannie Mae purchase mortgages from issuing lenders. In any
secondary market trade, the cash proceeds go to an investor rather than to the
underlying company/entity directly. (To learn more about primary and secondary
markets, read A Look at Primary and Secondary Markets.)
The OTC Market
The over-the-counter (OTC) market is a type of secondary market also referred to as a
dealer market. The term "over-the-counter" refers to stocks that are not trading on a
stock exchange such as the Nasdaq, NYSE or American Stock Exchange (AMEX). This
generally means that the stock trades either on the over-the-counter bulletin board
(OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they
describe themselves as providers of pricing information for securities. OTCBB and pink
sheet companies have far fewer regulations to comply with than those that trade shares
on a stock exchange. Most securities that trade this way are penny stocks or are from
very small companies.
Third and Fourth Markets
You might also hear the terms "third" and "fourth markets." These don't concern
individual investors because they involve significant volumes of shares to be transacted

per trade. These markets deal with transactions between broker-dealers and large
institutions through over-the-counter electronic networks. The third market comprises
OTC transactions between broker-dealers and large institutions. The fourth market is
made up of transactions that take place between large institutions. The main reason
these third and fourth market transactions occur is to avoid placing these orders through
the main exchange, which could greatly affect the price of the security. Because access
to the third and fourth markets is limited, their activities have little effect on the average
investor.

Financial institutions and financial markets help firms raise money. They can do this by
taking out a loan from a bank and repaying it with interest, issuing bonds to borrow
money from investors that will be repaid at a fixed interest rate, or offering investors
partial ownership in the company and a claim on its residual cash flows in the form of
stock.

What is a mutual fund?

These days you are hearing more and more about mutual funds as a means of investment. If you are like most
people, you probably have most of your money in a bank savings account and your biggest investment may be
your home. Apart from that, investing is probably something you simply do not have the time or knowledge to get
involved in. You are not the only one. This is why investing through mutual funds has become such a popular way
of investing.

What is a Mutual Fund?

A mutual fund is a pool of money from numerous investors who wish to save or make money just like you.
Investing in a mutual fund can be a lot easier than buying and selling individual stocks and bonds on your own.
Investors can sell their shares when they want.
Professional Management. Each fund's investments are chosen and monitored by qualified professionals who
use this money to create a portfolio. That portfolio could consist of stocks, bonds, money market instruments or a
combination of those.
Fund Ownership. As an investor, you own shares of the mutual fund, not the individual securities. Mutual funds
permit you to invest small amounts of money, however much you would like, but even so, you can benefit from
being involved in a large pool of cash invested by other people. All shareholders share in the fund' s gains and
losses on an equal basis, proportionately to the amount they've invested.
Mutual Funds are Diversified
By investing in mutual funds, you could diversify your portfolio across a large number of securities so as to
minimise risk. By spreading your money over numerous securities, which is what a mutual fund does, you need
not worry about the fluctuation of the individual securities in the fund's portfolio.
Mutual Fund Objectives
There are many different types of mutual funds, each with its own set of goals. The investment objective is the
goal that the fund manager sets for the mutual fund when deciding which stocks and bonds should be in the
fund's portfolio.
For example, an objective of a growth stock fund might be: This fund invests primarily in the equity markets with
the objective of providing long-term capital appreciation towards meeting your long-term financial needs such as
retirement or a child' s education.
Depending on investment objectives, funds can be broadly classified in the following 5 types:

Aggressive growth means that you will be buying into stocks which have a chance for dramatic growth
and may gain value rapidly. This type of investing carries a high element of risk with it since stocks with
dramatic price appreciation potential often lose value quickly during downturns in the economy. It is a great
option for investors who do not need their money within the next five years, but have a more long-term

perspective. Do not choose this option when you are looking to conserve capital but rather when you can
afford to potentially lose the value of your investment.

As with aggressive growth, growth seeks to achieve high returns; however, the portfolios will consist of
a mixture of large-, medium- and small-sized companies. The fund portfolio chooses to invest in stable, well
established, blue-chip companies together with a small portion in small and new businesses. The fund
manager will pick, growth stocks which will use their profits grow, rather than to pay out dividends. It is a
medium - long-term commitment, however, looking at past figures, sticking to growth funds for the long-term
will almost always benefit you. They will be relatively volatile over the years so you need to be able to
assume some risk and be patient.

A combination of growth and income funds, also known as balanced funds, are those that have a mix
of goals. They seek to provide investors with current income while still offering the potential for growth. Some
funds buy stocks and bonds so that the portfolio will generate income whilst still keeping ahead of inflation.
They are able to achieve multiple objectives which may be exactly what you are looking for. Equities provide
the growth potential, while the exposure to fixed income securities provide stability to the portfolio during
volatile times in the equity markets. Growth and income funds have a low-to-moderate stability along with a
moderate potential for current income and growth. You need to be able to assume some risk to be
comfortable with this type of fund objective.

That brings us to income funds. These funds will generally invest in a number of fixed-income
securities. This will provide you with regular income. Retired investors could benefit from this type of fund
because they would receive regular dividends. The fund manager will choose to buy debentures, company
fixed deposits etc. in order to provide you with a steady income. Even though this is a stable option, it does
not go without some risk. As interest-rates go up or down, the prices of income fund shares, particularly
bonds, will move in the opposite direction. This makes income funds interest rate sensitive. Some
conservative bond funds may not even be able to maintain your investments' buying power due to inflation.

The most cautious investor should opt for the money market mutual fund which aims at maintaining
capital preservation. The word preservation already indicates that gains will not be an option even though
the interest rates given on money market mutual funds could be higher than that of bank deposits. These
funds will pose very little risk but will also not protect your initial investments' buying power. Inflation will eat
up the buying power over the years when your money is not keeping up with inflation rates. They are,
however, highly liquid so you would always be able to alter your investment strategy.

Closed-End Funds
A closed-end fund has a fixed number of shares outstanding and operates for a fixed duration (generally ranging
from 3 to 15 years). The fund would be open for subscription only during a specified period and there is an even
balance of buyers and sellers, so someone would have to be selling in order for you to be able to buy it. Closedend funds are also listed on the stock exchange so it is traded just like other stocks on an exchange or over the
counter. Usually the redemption is also specified which means that they terminate on specified dates when the
investors can redeem their units.

Open-End Funds
An open-end fund is one that is available for subscription all through the year and is not listed on the stock
exchanges. The majority of mutual funds are open-end funds. Investors have the flexibility to buy or sell any part
of their investment at any time at a price linked to the fund's Net Asset Value.

What is a Hedge Fund?

A hedge fund is an alternative investment vehicle available only to sophisticated investors, such as
institutions and individuals with significant assets.
Like mutual funds, hedge funds are pools of underlying securities. Also like mutual funds, they can
invest in many types of securitiesbut there are a number of differences between these two investment
vehicles.

First, hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC), a
financial industry oversight entity, as mutual funds are. However, it appears that regulation for hedge
funds may be coming soon.
Second, as a result of being relatively unregulated, hedge funds can invest in a wider range of securities
than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks,
bonds, commodities and real estate, they are best known for using more sophisticated (and risky)
investments and techniques.
Hedge funds typically use long-short strategies, which invest in some balance of long positions (which
means buying stocks) and short positions (which means selling stocks with borrowed money, then
buying them back later when their price has, ideally, fallen).
Additionally, many hedge funds invest in derivatives, which are contracts to buy or sell another security
at a specified price. You may have heard of futures and options; these are considered derivatives.
Many hedge funds also use an investment technique called leverage, which is essentially investing with
borrowed moneya strategy that could significantly increase return potential, but also creates greater
risk of loss. In fact, the name hedge fund is derived from the fact that hedge funds often seek to
increase gains, and offset losses, by hedging their investments using a variety of sophisticated methods,
including leverage.
Third, hedge funds are typically not as liquid as mutual funds, meaning it is more difficult to sell your
shares. Mutual funds have a per-share price (called a net asset value) that is calculated each day, so you
could sell your shares at any time. Most hedge funds, in contrast, seek to generate returns over a
specific period of time called a lockup period, during which investors cannot sell their shares. (Private
equity funds, which are similar to hedge funds, are even more illiquid; they tend to invest in startup
companies, so investors can be locked in for years.)
Finally, hedge fund managers are typically compensated differently from mutual fund managers. Mutual
fund managers are paid fees regardless of their funds performance. Hedge fund managers, in contrast,
receive a percentage of the returns they earn for investors, in addition to earning a management fee,
typically in the range of 1% to 4% of the net asset value of the fund. That is appealing to investors who
are frustrated when they have to pay fees to a poorly performing mutual fund manager. On the down
side, this compensation structure could lead hedge fund managers to invest aggressively to achieve
higher returnsincreasing investor risk.
As a result of these factors, hedge funds are typically open only to a limited range of investors.
Specifically, U.S. laws require that hedge fund investors be accredited, which means they must earn a
minimum annual income, have a net worth of more than $1 million, and possess significant investment
knowledge.
The popularity of these alternative investment vehicleswhich were first created in 1949has waxed
and waned over the years. Hedge funds proliferated during the market boom earlier this decade, but in
the wake of the 2007 and 2008 credit crisis, many closed. One, Bernard L. Madoff Investment Securities,
turned out to be a massive fraud. As a result, they are subject to increasing due diligence.
Some of the more popular hedge fund investment strategies are Activist, Convertible Arbitrage,
Emerging Markets, Equity Long Short, Fixed Income, Fund of Funds, Options Strategy, Statistical
Arbitrage, and Macro.
Despite these recent challenges, hedge funds continue to offer investors a solid alternative to traditional
investment fundsan alternative that brings the possibility of higher returns that are uncorrelated to the
stock and bond markets. As a result, hedge funds are likely here to stay.

What Are Hedge Funds?

Definition: Hedge funds are privately-owned companies that pool investors' dollars and
reinvest them into all kinds of complicated financial instruments. Their goal is to outperform
the market -- by a lot. They are expected to be smart enough to create high returns regardless
of how the market does.
More than 8,000 hedge funds managed $2.8 trillion in 2014, according to HFR Inc.That's
triple the amount managed in 2004.
Although hedge funds have outperformed the stock market over the past 15 years, including
during the financial crisis, they've underperformed since 2009. The S&P 500 rose 137%
(including dividends) since then, compared to a 50% rise for hedge funds.
However, most of this growth goes to the super-large funds. More than $75 billion was added
to funds in 2014, but 90% went to funds that managed $1 billion or more. One reason is that
institutional investors and others who invests in hedge funds are more confident in going with
tried-and-true names. It's too risky to invest with a start-up firm. As a result, 864 firms closed
in 2014, averaging only $70 million each in assets.
Unlike mutual funds, whose owners are public corporations, hedge funds traditionally
weren't regulated by the SEC (Securities and Exchange Commission). For this reason, and
many others, hedge funds are very risky. However, it is exactly this risk that attracts many
investors who believe higher risk leads to higher return.
The term "hedge fund" was first applied in the 1940s to alternative investor Alfred Winslow
Jones. He created a fund that sold stocks short as part of his strategy.
How Do Hedge Funds Work?

Hedge funds are set up as limited partnerships or limited liability corporations that protector
the manager and investors from creditors if the fund goes bankrupt. The contract describes
how the manager is paid. It may sometimes outline what the manager can invest it, but
usually there are no limits.
Some hedge fund managers must meet a hurdle rate before getting paid. The investors receive
all profits until the hurdle rate is reached, then the manager receives a percent of profits. Most
hedge funds operate under the "2 and 20 rule." This states they earn 2% of assets in good
times and bad, that there's no hurdle rate, and they receive 20% of profits. Recently, however,
pension funds and other institutional investors have paid at least newer hedge funds less:
Hedge Funds Rewards

Hedge funds offer more financial reward because of the way their managers are paid, the
types of financial vehicles they can invest in, and their lack of financial regulation.

1. Hedge fund managers are compensated as a percent of the returns they

earn. This attracts many investors who are frustrated by the fact that
mutual funds are paid fees, regardless of fund performance. Thanks to this
compensation structure, hedge fund managers are driven to achieve
above-market returns.
2. Hedge fund managers specialize in using sophisticated derivatives, such
as futures contracts, options and collateralized debt obligations.
Derivatives allow hedge fund managers to profit even when the stock
market is going down. Hedge fund managers can use put options, or can
sell stocks short. Basically, these products all do two things: they use
small amounts of money, or leverage, to control large amounts of stocks
or commodities. Second, they pay out by a particular point in time. The
combination of leverage and timing means that managers make outsize
returns when they correctly predict the market's rise or fall.
3. Since hedge funds aren't as well regulated as the stock market, they have
free rein to invest in these high return, but speculative, financial vehicles.
For more, see SEC Bulletin on Hedge Funds.
Hedge Fund Risks

The same three characteristics that allow hedge funds to promise greater rewards also makes
them very risky.
1. Hedge funds managers are paid a percentage of their funds' returns. What
happens if the fund loses money? Do they pay the fund a percentage of
that loss? No, the managers get zero no matter how much money they
lose. This structure means hedge funds managers are very risk tolerant.
This makes the funds very risky for the investor, who can lose all the
money they invested in the fund.
2. Hedge funds invest in derivatives that are very risky because of leverage.
Options must be delivered within a certain window of time. If a "black
swan," or completely unexpected, economic event happens during that
time period, even if the manager is correct about the long-term trend, he
could lose the investment. In that sense, hedge fund managers are trying
to time the market, which some would say is very difficult if not impossible
to do.
3. The lack of regulation means that hedge fund earnings aren't reported to
the SEC or any other regulatory body. Although hedge funds are still
prohibited from fraud, this lack of oversight creates additional risk. In
addition, hedge fund investors are also part owners of the LLC. This means
they could lose their investment if the hedge fund goes bankrupt as a
business -- even if the investments do OK.

What is Private Equity?

Private equity is a source of investment capital from high net worth
individuals and institutions for the purpose of investing and acquiring equity
ownership in companies. Partners at private-equity firms raise funds and
manage these monies to yield favorable returns for their shareholder clients,
typically with an investment horizon between four and seven years.
These funds can be used in purchasing shares of private companies, or in
public companies that eventually become delisted from public stock
exchanges under go-private deals. The minimum amount of capital required
for investors can vary depending on the firm and fund raised. Some funds
have a $250,000 minimum investment requirement; others can require
millions of dollars.

Introduction to Private Equity

Private equity has successfully attracted the best and brightest in corporate
America, including top performers from Fortune 500 companies and elite
strategy and management consulting firms. Top performers at accounting
and law firms can also be recruiting grounds, as accounting and legal skills
relate to transaction support work required to complete a deal and translate
to advisory work for a portfolio company's management.
The fee structure for private-equity firms varies, but it typically consists of a
management fee and a performance fee (in some cases, a yearly
management fee of 2% of assets managed and 20% of gross profits upon
sale of the company). How firms are incentivized can vary considerably.
Given that a private-equity firm with $1 billion of assets under management
might have no more than two dozen investment professionals, and that 20%
of gross profits can generate tens of millions of dollars in fees for the firm, it
is easy to see why the private-equity industry has attracted top talent. At the
middle market level ($50 million to $500 million in deal value), associates can
earn low six figures in salary and bonuses, vice presidents can earn
approximately half a million dollars and principals can earn more than $1
million in (realized and unrealized) compensation per year.

Transaction Support and Portfolio Oversight

There are two critical functions within private-equity firms:

deal origination/transaction execution

portfolio oversight

Deal origination involves creating, maintaining and developing relationships

with mergers and acquisitions (M&A) intermediaries, investment banks and
similar transaction professionals to secure both high-quantity and highquality deal flow. Deal flow refers to prospective acquisition candidates
referred to private-equity professionals for investment review. Some firms
hire internal staff to proactively identify and reach out to company owners to
generate transaction leads. In a competitive M&A landscape, sourcing
proprietary deals can help ensure that the funds raised are successfully
deployed and invested.
Additionally, internal sourcing efforts can reduce transaction-related costs by
cutting out the investment banking middleman's fees. When financial
services professionals represent the seller, they usually run a full auction
process that can diminish the buyer's chances of successfully acquiring a
particular company. As such, deal origination professionals (typically at the
associate, vice president and director levels) attempt to establish a strong
rapport with transaction professionals to get an early introduction to a deal. It
is important to note that investment banks often raise their own funds, and
therefore may not only be a deal referral, but also a competing bidder. In
other words, some investment banks compete with private-equity firms in
buying up good companies.
Transaction execution involves assessing management, the industry,
historical financials and forecasts, and conducting valuation analyses. After
the investment committee signs off to pursue a target acquisition candidate,
the deal professionals submit an offer to the seller. If both parties decide to
move forward, the deal professionals work with various transaction advisors
to include investment bankers, accountants, lawyers and consultants to
execute the due diligence phase. Due diligence includes validating
management's stated operational and financial figures. This part of the
process is critical, as consultants can uncover deal killers, such as significant
and previously undisclosed liabilities and risks.
The second important function of private-equity professionals involves
oversight and support of the firm's various portfolio companies and their
management team. Among other support work, they can walk management
through best practices in strategic planning and financial management.
Additionally, they can help institutionalize new accounting, procurement and
IT systems to increase the value of their investment.

Types of Private-Equity Firms

A spectrum of investing preferences spans across the thousands of privateequity firms in existence. Some are strict financiers - passive investors - who

are wholly dependent on management to grow the company (and its

profitability) and supply their owners with appropriate returns. Because
sellers typically see this method as a commoditized approach, other privateequity firms consider themselves active investors. That is, they provide
operational support to management to help build and grow a better company.
These types of firms may have an extensive contact list and "C-level"
relationships, such as CEOs and CFOs within a given industry, which can help
increase revenue, or they may be experts in realizing operational efficiencies
and synergies. If an investor can bring in something special to a deal that will
enhance the company's value over time, such an investor is more likely to be
viewed favorably by sellers. It is the seller who ultimately chooses whom they
want to sell to, or partner with.
It is no surprise that the largest investment-banking entities, such as
Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM) and Citigroup
(NYSE:C), facilitate the largest deals. These banks typically focus their efforts
on deals with enterprise values worth billions of dollars. However, the vast
majority of transactions reside in the middle market ($50 million to $500
million deals) and lower-middle market ($10 million to $50 million deals).
Because the best investment banking professionals gravitate toward the
larger deals, the middle market is a significantly underserved market. That is,
there are significantly more sellers than there are highly seasoned and
positioned finance professionals with the extensive buyer networks and
resources to manage a deal (for middle-market company owners).

Investing in Upside
Middle-market companies can offer significant financial upside to their
private-equity owners. Many of these small companies fly below the radar of
large multinational corporations and often provide higher-quality customer
service. These companies provide niche products and services that are not
being offered by the large conglomerates.
Such upsides attract the interest of private -quity firms, as they possess the
insights and savvy to exploit such opportunities and take the company to the
next level. For instance, a small company selling niche products within a
particular region might significantly grow by cultivating international sales
channels. Or a highly fragmented industry can undergo consolidation (with
the private-equity firm buying up and combining these entities) to create
fewer, larger players. Larger companies typically command higher valuations
than smaller companies.
An important company metric for these investors is earnings before interest,
taxes, depreciation and amortization (EBITDA). When a private-equity firm

acquires a company, they work together with management to significantly

increase EBITDA during its investment horizon (typically between four and
seven years). A good portfolio company can typically increase its EBITDA
both organically (internal growth) and by acquisitions.
A popular exit strategy for private equity involves growing and improving a
middle-market company and selling it to a large corporation (within a related
industry) for a hefty profit. It is critical for private-equity investors to have
reliable, capable and dependable management in place. Most managers at
portfolio companies are given equity and bonus compensation structures that
reward them for hitting their financial targets. Such alignment of goals (and
appropriate compensation structuring) is typically required before a deal gets
done.

The Bottom Line

Private-equity firms have become attractive investment vehicles for wealthy
individuals and institutions. As the industry attracts the best and brightest in
corporate America, the professionals at these firms are usually successful in
deploying investment capital and in increasing the values of their portfolio
companies. However, there is also fierce competition in the M&A marketplace
for good companies to buy. As such, it is imperative that these firms develop
strong relationships with transaction and services professionals to secure
strong deal flow.

Behavioral Finance

According to conventional financial theory, the world and its participants are,
for the most part, rational "wealth maximizers". However, there are many
instances where emotion and psychology influence our decisions, causing us
to behave in unpredictable or irrational ways.
Behavioral finance is a relatively new field that seeks to combine behavioral
and cognitive psychological theory with conventional economics and finance

to provide explanations for why people make irrational financial decisions.

By the end of this tutorial, we hope that you'll have a better understanding of
some of the anomalies (i.e., irregularities) that conventional financial theories
have failed to explain. In addition, we hope you gain insight into some of the
underlying reasons and biases that cause some people to behave irrationally
(and often against their best interests). Hopefully, this newfound knowledge
will give you an edge when it comes to making financial decisions.
Behavioral Finance
What it is:
Behavioral finance combines social and psychological theory with financial theory as a means of
understanding how price movements in the securities markets occur independent of any corporate
actions.

How it works (Example):

Suppose a lawsuit is brought against a tobacco company. Investors know that when this has
happened before, the share price of the tobacco company has fallen. With this in mind, many
investors sell off their holdings in the company. This selling results in the further decline of the
security's value.
Investors in other tobacco companies may fear similar lawsuits knowing that such a lawsuit was
brought against one tobacco company. These investors may sell off their holdings for fear of loss.
The securities prices of other companies in the industry consequently decline as well.
All the while, none of these tobacco companies took any action or had a judgment against them
that intrinsically lessened their worth. This is the sort of issue that behavioral finance attempts to
explain.

Why it Matters:
Anyone knowledgeable in financial market understands that there are numerous variables that
affect prices in the securities markets. Investors decisions to buy or sell may have a more distinct
margin affect impact on market value than favorable earnings or promising products.
The role of behavioral finance is to help market analysts and investors understand price
movements in the absence of any intrinsic changes on the part of companies or sectors.

Survivorship Bias
What it is:
Survivorship bias occurs when companies that no longer exist -- due to bankruptcy, acquisition
or any other reason -- are not accounted for when calculating investment returns.

How it works (Example):

For example, suppose an investor is researching returns on Portfolio XYZ over two consecutive
years: 2006 and 2007.
In 2006, the portfolio is comprised of Stock A, Bond B and Mutual Fund C.
In 2007, Bond B was put into a seperate "loser" portfolio because of poor performance. Now
Portfolio XYZ is comprised of only Stock A and Mutual Fund C. If the 2-year portfolio returns are
calculated based on Stock A and Mutual Fund C returns without accounting for the poor returns of
Bond B in 2006, the results will have survivorship bias and will be skewed to the upside.

Why it Matters:
Survivorship bias fails to account for all variables affecting a portfolio's or investment company's
valuation. As a result, historical valuation becomes skewed, often creating the appearance of
favorable, but inaccurate, performance.

Anchoring Bias
We tend to rely too heavily on the first piece of information seen
Setting a high price for one item makes all others seem cheaper, though only when the price shown is actually
plausible (and not some silly amount!)
During decision making, anchoring occurs when individuals use an initial piece of information to make
subsequent judgments. Once an anchor is set, other judgements are made by adjusting away from that anchor, and
there is a bias toward interpreting other information around the anchor.
For example, the initial price offered for a used car sets the standard for the rest of the negotiations, so
that prices lower than the initial price seem more reasonable even if they are still higher than what the car is really
worth.
Studies have shown that anchoring is very difficult to avoid. For example, in one study students were given anchors
that were obviously wrong. They were asked whether Mahatma Gandhi died before or after age 9, or before or after
age 140. Clearly neither of these anchors are correct, but the two groups still guessed significantly differently
(choosing an average age of 50 vs. an average age of 67).
Takeaways for decision-makers
1.

If you are to use anchors, be aware of your target audience. Anchoring effects are weaker for individuals
with higher cognitive ability (Bergman et al., 2010) and those with experience buying the product youre
selling (Alevy et al., 2011).

2.

Dont set your anchor price too high, or the natural inclination to anchor other choices against this
product will greatly diminish. Keep it realistic and relatively in the realm of what else youre selling, basically.

3.

Think carefully about how you structure your product range and prices. People will anchor whether you
intend for them to do so, or not.

4. Key Concept No.2: Mental Accounting

Mental accounting refers to the tendency for people to separate their

money into separate accounts based on a variety of subjective criteria,

like the source of the money and intent for each account. According to
the theory, individuals assign different functions to each asset group,
which has an often irrational and detrimental effect on their
consumption decisions and other behaviors.
5. Although many people use mental accounting, they may not realize
how illogical this line of thinking really is. For example, people often
have a special "money jar" or fund set aside for a vacation or a new
home, while still carrying substantial credit card debt. (For more
insight, see Digging Out Of Personal Debt.)
In this example, money in the special fund is being treated differently
from the money that the same person is using to pay down his or her
debt, despite the fact that diverting funds from debt repayment
increases interest payments and reduces the person's net worth.
Simply put, it's illogical (and detrimental) to have savings in a jar
earning little to no interest while carrying credit-card debt accruing at
20% annually.
In this case, rather than saving for a holiday, the most logical course of
action would be to use the funds in the jar (and any other available
monies) to pay off the expensive debt.
This seems simple enough, but why don't people behave this way? The
answer lies with the personal value that people place on particular
assets. For instance, people may feel that money saved for a new
house or their children's college fund is too "important" to relinquish.
As a result, this "important" account may not be touched at all, even if
doing so would provide added financial benefit.
The Different Accounts Dilemma
To illustrate the importance of different accounts as it relates to mental
accounting, consider this real-life example: You have recently subjected
yourself to a weekly lunch budget and are going to purchase a $6
sandwich for lunch. As you are waiting in line, one of the following
things occurs: 1) You find that you have a hole in your pocket and have
lost $6; or 2) You buy the sandwich, but as you plan to take a bite, you
stumble and your delicious sandwich ends up on the floor. In either
case (assuming you still have enough money), would you buy another
sandwich? (To read more, see The Beauty Of Budgeting.)
6. Logically speaking, your answer in both scenarios should be the same;
the dilemma is whether you should spend $6 for a sandwich. However,
because of the mental accounting bias, this isn't so.
Because of the mental accounting bias, most people in the first
scenario wouldn't consider the lost money to be part of their lunch
budget because the money had not yet been spent or allocated to that
account. Consequently, they'd be more likely to buy another sandwich,
whereas in the second scenario, the money had already been spent.
Different Source, Different Purpose
Another aspect of mental accounting is that people also treat money

differently depending on its source. For example, people tend to spend

a lot more "found" money, such as tax returns and work bonuses and
gifts, compared to a similar amount of money that is normally
expected, such as from their paychecks. This represents another
instance of how mental accounting can cause illogical use of money.
Logically speaking, money should be interchangeable, regardless of its
origin. Treating money differently because it comes from a different
source violates that logical premise. Where the money came from
should not be a factor in how much of it you spend - regardless of the
money's source, spending it will represent a drop in your overall
wealth.
Mental Accounting In Investing
The mental accounting bias also enters into investing. For example,
some investors divide their investments between a safe investment
portfolio and a speculative portfolio in order to prevent the negative
returns that speculative investments may have from affecting the
entire portfolio. The problem with such a practice is that despite all the
work and money that the investor spends to separate the portfolio, his
net wealth will be no different than if he had held one larger portfolio.
7.
Avoiding Mental Accounting
The key point to consider for mental accounting is that money is
fungible; regardless of its origins or intended use, all money is the
same. You can cut down on frivolous spending of "found" money, by
realizing that "found" money is no different than money that you
earned by working.
As an extension of money being fungible, realize that saving money in
a low- or no-interest account is fruitless if you still have outstanding
debt. In most cases, the interest on your debt will erode any interest
that you can earn in most savings accounts. While having savings is
important, sometimes it makes more sense to forgo your savings in
order to pay off debt.

The Hindsight Bias

Judgment and decision making is one area in psychology. Bias is one
topic in judgment and decision making. There are a number of possible
types of judgment and decision bias. One important bias is the hindsight
bias. Thus, it is important to define the hindsight bias. What is the
hindsight bias?
Hindsight Bias Definition

The hindsight bias reflects a tendency to overestimate your own

ability to have predicted or foreseen an event after learning
about the outcome.
Hindsight Bias Example
There are a number of possible examples of hindsight bias. Imagine
that you receive a letter from a publisher that states that the publisher is
going to publish your short story. You tell a friend that you knew that they
would publish it. However, the friend reminds you that before you
received the letter, you had told him that you were very uncertain about
whether the publisher would accept your short story for publication. This
is one example of hindsight bias.
What Exactly Is the Hindsight Bias?

The term hindsight bias refers to the tendency people have to view
events as more predictable than they really are.

After an event, people often believe that they knew the outcome of
the event before it actually happened.

The phenomenon has been demonstrated in a number of different

situations, including politics and sporting events. In experiments,
people often recall their predictions before the event as much
stronger than they actually were.

Examples of the Hindsight Bias

For example, researchers Martin Bolt and John Brink (1991) asked college students to predict
how the U.S. Senate would vote on the confirmation of Supreme Court nominee Clarence
Thomas. Prior to the senate vote, 58-percent of the participants predicted that he would be
confirmed. When students were polled again after Thomas was confirmed, 78-percent of the
participants said that they thought Thomas would be approved.
The hindsight bias is often referred to as the "I-knew-it-all-along phenomenon." It involves
the tendency people have to assume that they knew the outcome of an event after the outcome
has already been determined. For example, after attending a baseball game, you might insist
that you knew that the winning team was going to win beforehand.
As a psychology student, you may have also experienced the hindsight bias in your own
studies. As you read your course texts, the information may seem easy. "Of course," you
might think after reading the results of a study or experiment. "I knew that all along."

This can be a dangerous habit for students to fall into, however, particularly when test time
approaches.
By assuming that you already knew the information, you might fail to adequately study the
test materials.
When it comes to test time, however, the presence of many different answers on a multiple
choice test may make you realize that you did not know the material quite as well as you
thought you did. By being aware of this problem, you can develop good study habits to
overcome the tendency to assume that you 'knew-it-all-along.'
Explanations for the Hindsight Bias
So what exactly causes this bias to happen?
Researchers suggest that three key variables interact to contribute to this tendency to see
things as more predictable than they really are.
1. First, people tend to distort or even misremember their earlier
predictions about an event. As we look back on our earlier
predictions, we tend to believe that we really did know the answer
all along.
2. Second, people have a tendency to view events as inevitable. When
assessing something that has happened, we tend to assume that it
was something that was simply bound to occur.
1. Finally, people also tend to assume that they could have foreseen
certain events.
When all three of these factors occur readily in a situation, the hindsight bias is more likely to
occur. When a movie reaches its end and we discover who the killer really was, we might
look back on our memory of the film and misremember our initial impressions of the guilty
character. We might also look at all the situations and secondary characters and believe that
given these variables, it was clear what was going to happen. You might walk away from the
film thinking that you knew it all along, but the reality is that you probably didn't.

Status Quo Bias Explained Perfectly With Apt Examples

'Status Quo Bias' reflects our inherent preferences. It comes forth through the
process of decision-making, even in everyday life. Know more about how we tend
to maintain our status quo, without actually knowing to have done so.

The Reversal TestIt is an attempt to reduce the status quo bias.Which color car
would you buy for yourself? Which color would you paint your house with? Which
is your favorite restaurant? What would you prefer for dessert? These are
probably some easy-to-handle questions. Let's get to some difficult choices now.
How do you plan to invest the surplus from your enterprise this year? What
would you prefer - a treasury bond, a low-risk mutual investment plan, a high-risk
but handsome return plan, or a moderate-risk allotment of your portfolio?
Naturally, this set of queries requires us to think more over the available options,
as compared to the choice we could have made in choosing our favorite colors!
How do you think we come to make a final decision in this second set of
questions? It is observed that we generally tend to make such difficult decisions
by our preferences, which may not always be objective enough, or rational
either. You may even remember making up your mind on an insurance plan, not
because you had carefully studied and opted for it, but rather because that was
the most-preferred choice, or the status quo. If yes, then let us find out what this
status quo bias is all about.DefinitionStatus Quo Bias is a preference given to the
present state of affairs, or a natural bias towards the current or previous
decision.A given standard is accepted to be the reference point. Any deviation
from this point is considered to be a loss or an unwanted risk. Thus, there is a
tendency to prefer the existing and default options, which is the status quo bias.
Loss aversion is understood to be a primary reason behind having a status quo
bias. When confronted with a choice, individuals go for an option that is less
likely to result into a loss.Status Quo Bias in Decision-makingWilliam Samuelson
and Richard Zeckhauser brought in the concept of 'status quo bias' through their
work 'Status Quo Bias in Decision Making', published in the 'Journal of Risk and
Uncertainty' in 1988. They presented the concept with the help of a
questionnaire. Individuals were given decision-making problems, with and
without a pre-existent status quo position (certain choices were labeled as
'status quo'). It was found that people were inclined towards the status quo
more.According to the study, 'the status quo bias is best viewed as a deeply
rooted decision-making practice, stemming partly from a mental illusion and
partly from psychological inclination'.
Why such biases occur explains that it is not something wrong, in fact, an
obvious way of thought. Transaction costs is given as an important reason. For
example, if changing my cell phone service provider takes up more dollars or
more efforts, I would prefer staying happy with the current provider, even if other
providers are better. Another cause behind a prejudice is the tendency to
procrastinate and delay decisions, leaving individuals with the status quo by
default.
The bias about status quo is believed to have either of the two attributes:
1. It is an option that a person is currently choosing,
or

2. It is the option that a person will end up with, if he or she does not actively
make a choice.
There can be, of course, a situation where both these attributes are present.
The degree of the bias that one has depends on many factors, one of them being
the number of alternatives that are present. If an individual's preference for a
particular alternative is strong, naturally, the bias is weaker. On the contrary,
with an increasing number of choices, the relative bias for status quo is
stronger.Examples of Status Quo BiasAs a Water Commissioner, one has to
choose among various probable water allocations between the farmers and
residents, during a water shortage. In this case, a status quo is introduced in
some versions of choices, by marking the water distribution option chosen by the
former Commissioner in a similar drought situation. Other details like the
agricultural demand for water are also given. The results of this decision-making
task can tell the significant impact on the actual decision made by the audience,
due to the labeling of a certain option as 'status quo'.While considering various
investment portfolios, there were several options, including a moderate-risk
company, a high-risk company, treasury bills, and municipal bonds. Few
investors or decision makers were presented portfolios with the same choice, but
with one option being marked as 'status quo'. It was a moderate-risk company;
the tax and broker commission effects arising from any changes were
insignificant. It was observed that this option was favored more after it was
marked as 'status quo'.Preferring a particular brand for various daily essentials,
like cosmetics, food and drinks, clothing, etc., also exemplifies our leanings.
Here, even though there is plenty of choice, people tend to demand a specific
product, for years long. This reluctance to change is also strong in case of
products that are equally competitive, and also similar in all attributes. The
Samuelson and Zeckhauser paper revealed such tastes of people for older
version of Coca Cola, as compared to the new Coke.People tend to use a
particular Internet browser that is already installed on their system, rather than
willfully installing another one. This can be given as a perfect example of the
'default option'. The same is also seen when an individual is facing a new
environment. While buying insurance for the first time, a person is naturally
prone to go for the 'default insurance plan', instead of purposefully choosing a
plan on his own.
Examples of the Halo Effect in the Workplace
The halo effect is a psychological phenomenon that allows a general opinion of something, or
someone, to be gathered from one element. For example, if a chef is famous for making one
particular dish, then the halo effect allows people to assume that he can cook anything with equal
proficiency. Analyzing examples of the halo effect in the workplace can help you to better
understand how it can affect productivity and morale.

Appraisals
One area where the halo effect is prevalent is in annual performance reviews. Some managers take
a relaxed approach to reviews and assume that if an employee is proficient in some elements of

the appraisal, then he is proficient in all of them. This can work the other way, as well. An
employee seen as ineffective in one or two aspects of his job can be given the general label of
incompetent.

Promotions
Movies and books may present the theme of a hero who performs one spectacular task and is
asked to rule as king of the people he saved. The problem is that the hero does not possess any of
the leadership qualities or administrative skills needed to be an effective ruler. The same thing can
happen in a corporate workplace. A sales professional is proficient at bringing in new accounts and
generating revenue, so he is promoted to the position of vice president of sales. Unfortunately, he
does not know the first thing about being a company executive.

Job Tasks
People build up a reputation in the workplace for being proficient at something when their actual
area of expertise is much different. For example, if one of the accountants from the accounting
pool becomes familiar with the accounting software, others ask for assistance in getting the
software to work properly. It is then assumed that she knows a great deal about all the software
titles in the company, and the halo effect in this situation could also get her labeled as a proficient
in hardware repair as well.

Departmental Misconception
Incompetent employees in a department can, by use of the halo effect, drag down the reputation
for the rest of the group. For example, if the payroll group in the accounting department
consistently makes mistakes on employee paychecks, then the halo effect would allow the rest of
the company to assume that no one in the accounting department can do their job properly.