Adverse selection is created by asymmetric infromation before a transaction occurs.  Adverse selection is usually found in insurance and credit markets, but can be found in other markets as well.  Adverse selection is a part of agency theory.

For instance in the credit market those who have bad credit and are therefore bigger risks are more likely to seek out a loan.  They are bigger risks because they are more likely to take chances with the money and use it poorly, this is why they have bad credit to begin with, and this is why they are in need of money.  Creditors will thus be less likely to lend anyone because they can assume that if someone wants a loan from that they most likely have bad credit, even though they may not.

Adverse selection is also obersvable in the used car market and is referred to as the “lemon problem.”  When you look to buy a used car from the newspaper you may not be able to tell right away that the transmission is on its last leg, even though the person who is selling the car, trying to dump it before it becomes cheaper to just buy a new one, knows that the transmission is on its last leg you do not, and there is an asymmetry of information.  Because everyone knows that there is this asymmetry of information a car automatically uses a large portion of its value as soon as it drives off the new car lot, as now the market can not be sure on whether or not it is a lemon.  Due to this lemon problem caused by adverse selection owners of non-lemons, referred to as peaches, may be unwilling to sell their car because they would receive less than its value in the market as its price would be lowered to compensate for the risk that it could be a lemon.

The market has found ways to combat adverse selection.  In the credit markets creditors are able to assign people credit scores that show their history of paying back loans and are an indictation of their likelihood to pay back future loans.  For people who do not yet have a credit score there usually need to be another signer with a favorable credit score on the loan, or the interest rate on the loan will be very high to compensate for the possibility of not being paid back.  In markets like the used car markets dealers have stepped up to combat the lemon problem.  They have expertise and methods to evaluate whether or not a car is a lemon before they buy it, eliminating the asymmetry of information, and then when they sell they can sell the car with their reputation and a warranty.  Because of the dealer the used car buyer should not have to worry on whether or not the used car they bought is a lemon because they are aware of the dealer’s reputation or they have a warranty on the car.

Most people tend to think it is scary to buy a $60 stock. In reality, it is no different then buying a $2 stock. It is more of a gamble to buy a $2 stock than a $60 stock. Many big institutions that really drive the stock price up do not back $2 stocks, for the most part. They want a company they know is secure and will continue to rise in price. In a study conducted by William O’neil, the stocks that rose 200%+ in a short time all started out on average at $28.  You need to think of the stock market like eBay. If a stock is selling at $2 there is a reason it only sells for $2. This stock is not in huge dmand. The $28+ stocks as mentioned beofre are high because of demand. This means they have more of a chance to go up.  I am not saying that a $2 stock can’t go to $200 but the chances of this happening are slim to none. Make sure to buy into companies with good financials and improving earnings and revenue. These stocks are where you can make the most with the least amount of risk.

Moral hazard is created by an asymmetry of information after a transaction has been completed.   In the financial markets this is usually in the form of a loan.  There is a risk, a hazard, that the borrower may engage in poor, immoral, decision making, from the lender’s perception, because these actions increase the likelihood that they will not get paid back.  Moral hazard is a part of agency theory.

Here is an example:  You decided to lend $500 to your cousin Jeb because he says he can double that $500 by buying an undervalued guitar for $500 and then selling it on eBay for $1,000, which is still below its value.  Your cousin Jeb knows guitars really well, you know enough about him from his renditions of “Stairway to Heaven” at the family reunions to not have an asymmetry of information there.  So you make the loan to cousin Jeb.  However, you did not know your cousin quite well enough, Jeb also loves to place bets at the dog track.  Once Jeb has the money he may be more tempted to place the $500 you loaned him on the dog Might-Win-This-Time for the 20 to 1 shot down at the track.  The bet has a greater risk and with it a greater reward.  If Jeb wins he gets $10,000 dollars and is able to pay you back your $500 and still get to go buy that dirt bike he has always wanted with the $9,500 he has left.  However, if Jeb loses the $500 on Might-Win-This-Time, which will probably happen (it usually isn’t Might-Win-This-Time’s time), then you will not get paid back and Jeb simply loses your faith in him.  Jeb was probably OK with that considering to him you’re just his turd litle cousin, Jeb isn’t very nice.  If you could’ve followed Jeb around you could’ve discouraged him from betting on Might-Win-This-Time and instead watched him buy the guitar and complete the transaction on eBay.  But, you don’t live near Jeb, and you can not always know what he is doing, you had an asymmetry of information of Jeb’s actions.  That asymmetry of information on Jeb’s whereabouts led to the moral hazard of Jeb betting your loaned money at the dog track.  Because of this moral hazard, even if you really, really believed Jeb would use that money to flip the guitar on eBay, you still may not make him the loan.

Moral hazard can be eliminated by the market and the law.  Financial intermediaries, institutions such as banks, have greater means and expertise to be able to monitor people that they lend to in the market.  You and a financial intermediary could write provisions, restrictive covenants, into your loan contract that restrict the borrower.  The covenants could say the loan can only be used for a certain thing, or that a minimum asset balance be maintained by the borrower, or that information be provided about activities periodically.  The covenant could also require collateral, also known as secured debt, so that if the loan is not paid back then you keep the collateral as payment.  This is like a morgatage on your home, if you don’t pay your morgatge to the bank that gave you the morgatge then they can seize the title to your home and auction it off to pay for what is owed to them.  However, legal fees may be too costly to purse a breaking of these covenants, which is why loans are usually done between financial intermediaries, because they can make use of economics of scale, and in larger denominations.  All of these tools help to make the moral in moral hazard not so hazardous and thus encourage people to make loans and fuel the economy.

What is Growth Investing?

Growth investing is when someone invests in a company whose earnings are 20% year after year. Examples of this would be Cisco, Microsoft, and Paychex. They each had huge earning reports that beat the previous year. These stocks usually have a product that users want and has a superior profit margin.

What is a Value Investor?

A value investor is one who tries to find stocks that are priced low but have a great balance sheet and assets in their company. Basically - a company who someone thinks is undervalued. The value investor tends to like finding stocks with a  low P/E ratio or a low price to book value.

Hmm…

Now you might think that P/E ratios are everything a stock is about and that value investing is the best idea on the planet…this isn’t true.  The stocks mentioned above in growth investing had P/E ratios of over 31; that is 31 times earnings! If you were a value investor you would have not made the critical buys of the great companies, such as Microsoft in its prime years. Also, you must remember, unless you are Warren Buffet, you will not get special information on investing. Warren Buffet has teams and teams of auditors who can go through companies’ books. Just beacuase he can do it and be successful does not mean that you will be as successful. Mr. Buffet has many more tools than you will ever have, unless you plan to one day be the oracle of your town.

Exotic currency is currency that is not well established and used in the world.  Exotic currency is called that because it is unusual in the trading market, it is difficult to exchange due to its low demand which is due to its higher than average volatility and risk.  Examples of exotics currency are the Iraqi Dinari, Ethiopian Birr, Korean Won, Turkish Lira, Brazilian Cruzeiro and others.  These are expensive to trade due to their illiquidty, which ups their bid-ask spread, and risky because these countries’ economic future is usually very uncertain.