​Investment -  Financial Statements Analysis 
Financial statement analysis is the use of information provided by financial statements, as well as information from other sources, to find key links. These relationships may not be evident by reading the financial accounts alone.

The use of ratios allows analysts to standardise financial information and offers a context for making meaningful comparisons between years (time series) and between firms (cross-sectional). Specifically, ratios let investors evaluate companies of different sizes as well as help assess the performance of one company at different points in time. 

They also enable managers of the company or outside creditors and investors answer crucial questions relevant to predicting a company’s likely future performance, such as the following: 

How liquid is the company?
Is the corporation earning enough returns from its assets?
Does the corporation have too much debt?
Is the corporation delivering sufficient return for its shareholders?  

How Liquid Is the Company?
In accounting, liquidity refers to a company’s capacity to fulfill its existing commitments in the short term, often within the next year. Two ratios typically used to assess liquidity are the current ratio and the quick ratio.

CURRENT RATIO
The current ratio assesses the current assets available to meet current liabilities:

If the current ratio is larger than 1, current assets are more than current liabilities and the company appears to be able to cover its debts in the short term.

But not every current asset is easily or rapidly convertible into cash, hence a current ratio of 2 is usually employed as a minimum desired requirement.

Current ratio = Current assets/Current liabilities

QUICK RATIO
Some consider the quick ratio to be a stronger predictor of liquidity than the current ratio since it excludes inventories, which are significantly less liquid than other current assets. A fast ratio of 1 or above is frequently seen as desirable.

Quick ratio = (Current assets – Inventories)/Current liabilities

It is crucial to note that a high current or quick ratio is not necessarily indicative of a problem-free organization. It may signal that the company is hoarding too much cash and not investing in other long-term assets necessary to create greater earnings.

For both ratios, a larger ratio suggests a higher level of liquidity; there is a greater availability of short-term resources to cover short-term obligations.

For example, a company’s balance sheet might give investors information about the company’s capacity to fulfill its outstanding commitments in the short term, commonly known as its liquidity. Investment managers utilize information on a company’s balance sheet to compute the current and quick ratios to measure liquidity. Let’s follow along to see how this is done.

As is the case for most ratios, comparing them with industry norms in the form of average ratios for the industry, ratios for comparable companies, or prior ratios provides a broader context for evaluating the ratios.

Is the Company Generating Enough Returns from Its Assets?


A widely used statistic for analyzing a company’s profitability is the net profit margin, which measures the percentage of revenues that is profit, in other words the percentage of revenues remaining for the shareholders after all expenses have been accounted for. 

Net profit margin = Net income/Revenues

Generally, the bigger the net profit margin the better.

Return on Assets


Another ratio used to analyze profitability is return on assets (ROA).

Return on assets = ROA = Net income/Total assets

Return on assets specifies how much return, as measured by net income, is created per monetary unit invested in total assets. Generally, the bigger the return on assets the better.

Some analysts utilize operational income rather than net income when assessing return on assets.

Recall that operating income is the money derived by a company’s assets, excluding how those assets are financed. When calculated using operating income, a better name for the ratio is operational return on assets or basic earning power. 

The basic earning power ratio compares the profit earned from operations with the assets utilized to create that income.

Basic earning power = Operating income/Total assets

Whatever ratio is chosen to quantify profitability per unit of assets, it should be utilized consistently when making comparisons.  

A Deeper Dive into Return on Assets


To study how the company earns more money from its assets than comparable companies, return on assets can be divided into two components:

ROA = Net income/Total assets = Net income/Revenues x Revenues/Total assets

Similarly, the basic earning power ratio can be divided into two components:

Basic earning power = Operating income/Total assets = Operating income/Revenues × Revenues/Total assets

OPERATING INCOME 
The first component of these two enlarged equations is a measure of profitability: It is net profit margin in the return on assets ratio and a ratio called operational profit margin in the basic earning power ratio. Net profit margin and operating profit margin reflect how good the company is at turning revenues into net income or operating income. 

In other words, they reflect how successful the organization is at limiting the costs of creating its sales. 

ASSET TURNOVER
The second component is a measure of asset utilization called as total asset turnover. This ratio is expressed as a multiple and represents the volume of revenues being generated by the assets used in the firm, or how successfully the company uses its assets to generate revenues. An growing ratio may imply increased performance, although care should be exercised in interpreting this data. 

An increasing ratio may also suggest static revenues and declining assets related to depreciation; in other words, sales are not expanding, and the company is not reinvesting to maintain its plant and machinery up to date. It is always necessary to examine the cause of changes in a ratio. 

​Does the Company Have Too Much Debt?


To analyze financial leverage, which is the extent to which debt is used in the financing of the business, experts use the debt-to-equity ratio. This ratio reflects how much debt the company has relative to equity.

Debt-to-equity ratio = Debt/Equity

Typically, the debt examined is solely interest-bearing debt, which includes the following: 
Short-term borrowing
Portion of long-term debt due within the reporting period 
Long-term debt 

It does not contain accounts payable and accrued expenses that do not necessitate an interest payment.

Another popular ratio used for analyzing the amount of debt employed by the corporation is the financial leverage ratio, or equity multiplier ratio.

Financial leverage = Equity multiplier = Total assets/Equity

This equity multiplier estimates the amount of total assets supported by one monetary unit of equity. The bigger the equity multiplier, the more debt is being used by the corporation to finance its assets. 

A corporation with a low equity multiplier is one largely financed by equity.

Holding a higher amount of debt is riskier because a firm is obligated to service its debt by paying interest, whereas it does not have a similar duty to serve its equity by paying dividends. 

For a company with relatively large debt, it may not be in a position to satisfy its interest payments or to respond as fast as its competitors to new opportunities. 

In certain nations, the usage of debt finance is referred to as gearing rather than leverage. Highly leveraged or geared corporations are generally referred to as being less solvent. Thus, leverage and solvency are notions that are inversely related.

A company that employs little debt financing is generally considered to be more solvent than a company that uses a high amount of debt financing.

Is the Company Providing Sufficient Returns to Its Shareholders? 
It is crucial to examine whether the return made by the company is sufficient from the standpoint of the shareholders. Is the return high enough for investors to still want to purchase the share? One ratio typically employed to answer this question is the return on equity (ROE).

Return on equity = ROE = Net income/Equity

A company’s ROE reveals how much return, as measured by net income, is made per monetary unit of stock. 

This statistic can be compared with the company’s ROE over time, with the ROE for other companies, and with the appropriate industry average ROE.

ROE can also be broken into three components: net profit margin, asset turnover, and financial leverage: 

ROE = Net income/Equity = Net income/Revenues × Revenues/Total assets × Total assets/Equity

or

ROE = Net profit margin × Asset turnover × Financial leverage

The product of the first two components produces the company’s return on assets. Another element potentially affecting the return on equity is the amount of leverage or debt the company has.

A corporation with more debt will have a higher return on equity as long as the debt returns more than it costs by supporting a return on assets that is greater than the after-tax cost of debt.

Thus, the third component of the ROE decomposition is the financial leverage ratio, the equity multiplier.

When any of these component ratios improve, all else being equal, the return on equity increases. Although it makes obvious sense that a firm’s performance increases when generating more profit from revenues and more revenues from its assets, a corporation can also boost its return on equity by supplementing its equity with borrowing, or in other words, employing leverage. 

But borrowing may not be a viable idea if the company would struggle to satisfy its financial obligations. An increase in return on equity due to borrowing comes with increased risk.

Decomposing ROE into the three components, net profit margin, total asset turnover, and financial leverage, is valuable because it allows analysts to better understand why the company’s return on equity is changing and to analyze the origins of that change.

Market Valuations
So far, we have measured performance using financial statements. Another way is to evaluate performance in terms of creating or destroying value for the company’s shareholders.

Two ratios, both dependent on a company’s share price, are often used to judge management’s success.

PRICE-TO-EARNINGS
The first ratio compares a company’s share price with its earnings per share.
A price-to-earnings ratio, or P/E multiple, informs us how much investors are ready to pay for every dollar of earnings per share. For example, a firm with a P/E of 15 suggests that investors are willing to pay 15.00 for every 1.00 of earnings per share. 

If the price-to-earnings ratio is higher for one company than it is for another in the same industry, it may signal that investors think that the company with the higher price-to-earnings ratio has more growth potential. Alternatively, the firm with the lower price-to-earnings ratio may be undervalued by the market. 

Price-to-earnings ratio = Market price per share/Earnings per share

PRICE-TO-BOOK
The second ratio based on the share price is the price-to-book ratio (P/B). It compares the company’s share price with the company’s book value per share.



The book value of stock generally represents historical costs and measures the amount shareholders have invested in the company across its lifetime. Therefore, a P/B ratio larger than 1 suggests that investors feel the company is worth more in the long run than the money shareholders have put in it.



In other words, the company’s management has created value for shareholders since their original investment. A ratio less than 1 is often an indicator that the company’s managers have destroyed value. But in actuality, listed businesses could trade at a price-to-book ratio of less than 1 for many other reasons, ranging from ephemeral undervaluation, negative industry sentiment, or a substantially inflated book value. 

Price-to-book ratio = Market price per share/Book value per share

Where Book value per share = Equity recorded on the balance sheet/Number of shares outstanding

​Investment - Links Between Financial Statements 
Although the balance sheet, income statement, and cash flow statement give different sorts of financial information, they are not fully independent.

The income statement displays a company’s profit, but profit is not the same as net cash flow, which is how much cash the company made during the period. The statement of cash flows reconciles the difference between reported net income and the amount of net cash flow generated by the company during the period.

What explains this sharp difference? One reason is that many cash transactions that are recorded on the balance sheet, such as changes in inventory, sales or repurchases of new stock, and the issuance or repayment of debt, do not appear on the income statement.

Another explanation for the disparity is due to accrual accounting. 

Accounting standards normally mandate that revenue and expenses be recorded when they are incurred, even if the cash is not collected from the sale or paid for the charge. These transactions lead to revenues and expenses shown on the income statement without cash being exchanged, and that leads to disparities between net income and net cash flow.

Analysts and investors rely on the statement of cash flows to better comprehend the difference between reported net income and net cash flow.

A corporation must eventually make profits to offer returns to shareholders, but it must generate cash to keep itself operating. Suppliers, staff, costs, and debts must be paid for the company to remain running. The income statement demonstrates how good a firm is at earning profit, but it is also crucial to assess how good the company is at generating cash. 

A corporation can be profitable but have negative cash flows; for example, it may be delayed at collecting payment from its customers. Or a corporation may operate at a loss but have positive cash flows, which could be the situation for a company with large depreciation and amortisation charges. 

A corporation can function at a loss as long as the owners allow it, providing the company can create cash flows to maintain its survival. But a corporation cannot live long with negative cash flows, no matter how profitable it is. Negative cash flows may shut off access to resources, such as material and manpower, and they can cause a company to go bankrupt.

​Investment - Cash Flow 
The statement of cash flows, or cash flow statement, details the sources and uses of cash during a period and explains the change in the cash balance recorded on the balance sheet.

There are cash inflows and outflows in a given reporting period that are not shown in a company’s income statement, such as purchases of new inventory, the repayment of debt, and purchases or sales of property, plant, and equipment. In fact, many of the year-over-year changes indicated on a company’s balance sheet reflect cash inflows or outflows that are not reflected on the income statement. 

The statement of cash flows serves to reconcile disparities in a firm’s reported profit (net income) and the amount of net cash flow generated by the company during the reporting period.

The statement’s cash flows split into three categories:
Operating activities 
Investment activities 
Financing activities

Cash flows from operating activities (CFO) 
Cash flows connected to the company’s primary business operations, including changes in net working capital 
Cash inflows received for sales of products or services 
Cash outflows paid for operating expenses 
Inventory purchases and sales 
Cash inflows or outflows from changes in accounts receivable and accounts payable 
Borrowing or repayment of supplier debt

Cash flows from investment activities (CFI)
Cash flows related to purchases or sales of long-term assets 
Purchase or sale of property, plant, and equipment 
Cash outflow for an acquisition 

Cash flows from financing activities (CFF)
Cash flows pertaining to the company’s debt and equity securities 
Borrowing new long-term debt (issue new bonds)
Issuance of new equity securities
Repayments of long-term debt
Repurchases of shares
Payment of dividends

​Investment - Income Statement 
The income statement identifies the profit or loss created by a company for a certain time period, such as a year. Generating profit over time is vital for a firm to continue in business. In practice, the income statement may be referred to as the P&L (short for profit and loss).

In its most basic form, the income statement can be expressed by the following equation:


Profit (loss) = Revenues – Expenses

Expenses are the cost of firm resources — cash, inventories, equipment, and so on — that are utilized to earn sales. Expenses can be classified into categories that reflect their role:

Operating expenses comprise the cost of sales or cost of products sold; selling, general, and administrative expenses (SGA); and depreciation expenses

Financing charges, which include interest expenses

Income taxes

Gross Profit, Operating Profit, and Net Profit


Analysts refer to three metrics of profit: gross profit, operating profit, and net profit.

Gross Profit
Gross profit, which accounts for the cost of creating or acquiring the company’s products or services, is measured as:

Gross profit = Revenues – Cost of sales
Of course, cost of sales is not the only cost borne by a corporation in its efforts to sell products or services

Operating Profit
Other operating expenses include marketing expenses, which are the costs of promoting the products or services to customers; administrative expenses, which are the costs of running the company that are not directly related to production or sales, such as executive salaries and utility costs; and depreciation expenses, which are the annual non-cash expenses allocated to long-term assets, such as equipment.

Subtracting these additional costs from gross profit generates operating profit or operating income: 

Operating profit = Gross profit – Other operating expenditures 

Operating profit is typically referred to as earnings before interest and taxes, or EBIT.1 Operating income is the income (profits) earned by the company before factoring finance costs (interest) and taxes.

Another measure of income widely used by analysts is earnings before interest, taxes, depreciation, and amortisation (EBITDA), which is operational profit before depreciation and amortisation expenditures are deducted: 

EBITDA = EBIT (or operational income) + Depreciation + Amortisation 

The depreciation and amortisation values are not cash flows, and they are decided by the choice of accounting system rather than by operating actions. EBITDA is a measure of the company’s operating performance and its management’s ability to produce revenues and control expenses that are relevant to its operations. EBITDA may be a better measure than EBIT of management’s capacity to manage the revenues and expenses within its control. But EBITDA does not appear on a company’s income statement.

Net Profit
If the corporation has borrowed money to finance its activities, it will have to pay interest. Deducting interest expense from operational income determines a company’s earnings before taxes, or profit before tax: 



Earnings before taxes = EBIT (or operating profit) – Interest expense 



The income taxes owing by the corporation on its earnings are then deducted to arrive at net income or net profit or profit after tax: 



Net income = EBIT (or operating income) – Interest expense – Tax expense

= Earnings before taxes – Tax expense 



Net income indicates the income that the company has available to retain and reinvest in the company (retained earnings) or to distribute to owners in the form of dividends (disbursements of profit). 



Note in the sample income statement that the net income of USD76 million minus the dividends paid of USD43 million equals USD33 million, which is the same amount as the change in retained earnings from 20X1 to 20X2 as shown on the balance sheet from Lesson 2 ($148 million – $115 million = $33 million).

The company’s owners (shareholders) are interested to know how much income the company has created per share, which is called earnings per share (EPS). It is approximated as net income divided by the number of shares outstanding. Investors are also interested in the amount of dividends the company pays for each share outstanding, or dividend per share. 

​Investment - Balance Sheet 
The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter.

Balance sheet often referred to as statement of financial position or statement of financial condition displays what the company owns, its assets and how the assets are financed at a specific point in time. The finance include what it owes others, the debt or liabilities, and shareholders' investment on equity. 

Income statement often referred to as profit and loss account, the statement of profit or loss, profit or loss statement, or statements of operation, identifies the profit or loss generated by the company over the time covered by the financial statements 

Cash flow statement is a statement of cash flows which displays the soruces of cash received and the uses of cash expended over the period covered by financial statements. 

Notes to the financial statements give information relevant to understanding and assessing the financial statements.

Other reports may also be requested. In the United Kingdom, firms are required to produce a report from the directors as well as a report from the auditors. The directors’ report comprises information regarding the following:

The directors of the firm 
The directors’ remuneration 
Review of the business’s performance throughout the reporting year 
Statement on the company’s compliance with corporate governance norms of conduct

In the United States, a 10-K report must be filed annually with the SEC. The 10-K report includes the following:
Financial statements 
Management’s appraisal of financial conditions 
Discussion of operating results 
Quantitative and qualitative disclosures on the risks that the company faces

The Balance Sheet


The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter. Essentially, it displays the following:

The resources the corporation controls (assets)

Its commitments to lenders and other creditors (liabilities or debt)

Owner-supplied capital (shareholders’ equity or owners’ equity)

The fundamental relationship underlying the balance sheet is known as the accounting equation: 

Total assets = Total liabilities + Total shareholders’ equity

Another way of looking at the balance sheet is that total assets indicate the resources available to the organization for creating profit. Total liabilities plus shareholders’ equity demonstrate how such resources are financed, either by borrowing from creditors (liabilities) or by equity capital contributed by shareholders.



The value of the assets on one side of the balance sheet must equal the sum of the value of the debt and equity capital on the other side of the balance sheet, which is given to buy the assets. In other words, the balance sheet must balance.

The valuations of many assets are stated at their historical cost, which is the actual cost of acquiring the asset minus any cost expensed to date, which is also referred to as book value. An alternative to reporting an asset’s value at its book value is to declare its fair value, which indicates the amount it could be sold for in a transaction between willing and unconnected parties, called an arm’s length transaction. Fair value accounting is often used to only a few assets, such as some financial instruments. Most corporations choose to list assets, where allowed, at historical cost.

Let’s adjust the accounting equation to calculate shareholders’ equity:

Total shareholders’ equity = Total assets – Total liabilities

Total shareholders’ equity reflects the residual value of the company’s shares. Note that this is not the same as the market value of the firm’s equity, which is what the company’s shares are worth or what the market feels the company is worth. Differences arise in part because the balance sheet shows the book value of most assets and not their fair market value.

Although it is usual practice to use parenthesis or minus signs to indicate subtraction, some organizations will presume that the reader knows which numbers are generally subtracted from others and will not use minus signs or parentheses. 

Assets
Balance sheets traditionally classify assets as current and non-current, and assets are presented in order of their liquidity, which is the ease with which an asset can be changed into cash at fair market value. Being the most liquid asset, cash is placed first.

The distinction between current and non-current assets is the period of time over which they are expected to be transformed into cash, used up, or sold.

Current assets comprise cash, inventories, which are unsold units of production on hand that are also referred to as stocks in various parts of the world, and accounts receivable, which is the money due to the company by customers who purchase on credit.

Current assets are projected to be transformed into cash, used up, or sold within the current operating term. A company’s operating period is the average amount of time spent between acquiring inventory and collecting the cash from sales to customers, which is normally one year, but can vary.

Non-current assets are often referred to as fixed assets or long-term assets. They include tangible assets, such as land, buildings, machinery, and equipment, and intangible assets, such as patents. 

These assets are projected to create money for the organization over a period of years. A company’s tangible assets are frequently bundled together on the balance sheet as property, plant, and equipment (PP&E). Non-current assets may also include financial assets, such as shares or bonds issued by another company. 

Asset Depreciation 
When a corporation purchases a long-term (non-current) asset, it does not report that purchase as an expense on the income statement in the current operating period. Instead, the purchase amount is capitalized and recorded as an asset on the balance sheet. The corporation then allocates the cost of that asset throughout the asset’s expected useful life, often a span of years. This process is termed depreciation.

The amount of cost allotted each year is referred to as depreciation expense and is presented on the income statement as an expense.

The purchase amount represents the gross worth of the item and remains the same throughout the asset’s life.

The net book value of the long-term asset, however, decreases each year by the amount of the depreciation charge.

An asset’s net book value is computed as the gross value of the asset minus cumulative depreciation, where accumulated depreciation is the sum of the reported depreciation charges for the particular asset.

Details concerning the original costs, depreciation expenses, and accumulated depreciation of property, plant, and equipment can normally be found in the notes to the financial statements.

Other Non-Current Assets

Other non-current assets are long-term financial investments, intangible assets, such as patents, and goodwill. Similar to the depreciation of tangible assets, intangible assets are expensed during their useful lives through amortisation. 

Goodwill is recognised and reported if a firm buys another company and paid more than the fair value of the net assets (assets minus liabilities) of the company it purchased. This value difference is created by other items not mentioned on the balance sheet, such as a devoted client base or skilled personnel.

Liabilities
Similar to assets, debt is separated on the balance sheet into current or short-term liabilities and long-term debt.

CURRENT LIABILITIES
Current liabilities must be repaid in the next year and include operating debt, such as accounts payable, which is credit granted by suppliers, short-term borrowing (such as loans from banks), and the amount of long-term debt that is due within the reporting year. 

Unpaid operating expenses, such as money due to workers, are commonly shown combined as accumulated liabilities.

LONG-TERM DEBT
Long-term debt is money obtained from banks or other lenders that is to be returned over periods longer than one year.

Equity
Shareholders are the residual owners of the firm; they possess the residual worth of the company once its liabilities are satisfied. The quantity of the company’s equity is indicated on the balance sheet in two parts:


Amount received from selling stocks in the company to common shareholders, which is called common stock in the sample balance statement for ABC Company.


Retained profits (retained income), which reflects the company’s undistributed income, as opposed to dividends that represent distributed income. Retained earnings are an indirect contribution of capital by shareholders who allow the company to retain profits and constitute a link between the company’s income statement and the balance sheet.

When a firm produces profit and does not pay the proceeds to shareholders as dividends, the profit adds value to the company’s equity. After all, the firm exists to produce a profit; when it does, that makes the company more valuable. 

Likewise, if the company has a net loss, that diminishes the value of its retained earnings and consequently its equity; the corporation becomes less valuable because it has lost, rather than earned, value.

​Investment -  Value of Currencies 
There are numerous elements that influence the value of a currency. The relative worth of a currency relies on the economic activity and outlook of a country. This section analyzes factors that determine the value of a currency and describes how to measure the relative value of currencies. 

Major Factors That Affect the Value of a Currency 
The key elements that determine the value of a currency include the country’s (1) balance of payments, (2) inflation, (3) interest rates, (4) government debt, and (5) the political and economic environment. 

Balance of Payments
A current account deficit tends to lead to a devaluation of the home currency.    

Level of Inflation
High inflation tends to lead to a devaluation of the indigenous currency.   

 Level of Interest Rates
High interest rates tend to lead to an appreciation of the home currency.

Level of Government Debt
High government debt tends to lead to a depreciation of the domestic currency

Political and Economic Environment
Political instability and bad economic prospects tend to lead to a depreciation of the domestic currency.   

Balance of Payments 
As noted, the current account balance has an impact on the value of a currency. In a floating exchange rate system, the exchange rate should adjust to remedy an unsustainable current account deficit or surplus. 

If a country has a big current account deficit, the domestic currency should devalue relative to foreign currencies. The relative price of that country’s exports in international markets should reduce, making exports more competitive.



At the same time, the relative price of imports in the country should rise, making imports more expensive. Exporting more and importing less should in principle lower the current account deficit and could even transform it into a surplus. In contrast, if a country has a high current account surplus, the native currency should gain relative to foreign currencies. The home currency’s appreciation, or getting stronger compared to the foreign currency, should have a negative influence on exports and a positive effect on imports, diminishing the current account surplus.   

A floating exchange rate system tends to be self-adjusting. But the self-adjusting method does not always operate in practice since factors besides international commerce influence exchange rates. In addition, the natural correction that should lead to a reduction of the current account deficit or surplus may not occur if the country belongs to a single currency zone, such as the European Union (EU). France, Belgium, and Italy run huge current account deficits, although the euro is used by other EU members that might have current account surpluses. It is difficult, if not impossible, for natural corrections to take place if the countries in question utilize the same currency but confront extremely different economic situations.  

Level of Inflation

Inflation erodes the purchasing power of a country’s currency, so when prices climb, a unit of domestic currency buys less international products and services. 

The following example illustrates the effect of inflation on the purchasing power of a country’s currency.  

Example: Effect of Inflation on a Country’s Currency  

Consider the pricing of similar loaves of bread in Ireland and in the United Kingdom in January and in June.

In January, the loaf of bread costs EUR1.20 in Ireland and GBP1.00 in the United Kingdom, which implies an exchange rate of EUR1.20/GBP1. If inflation in the United Kingdom raises the price of the bread to GBP1.10 in June, but the price remains EUR1.20 in Ireland, then the purchasing power of the pound is lower in June than it was in January. The exchange rate has increased from EUR1.20/GBP1 to EUR1.20/GBP1.10, or EUR1.09/GBP1. Because a pound now buys fewer euros, it has depreciated relative to the euro.  

A country with a consistently high level of inflation will see the value of its currency diminish relative to the currency of a country that has a consistently low level of inflation. 

Level of Interest Rates 
Higher interest rates, unless they are driven by inflation, normally enhance capital flows into a country since they make investments in that country more attractive, all other circumstances being equal. Increased investments in the country create a demand for the country’s currency. Thus, higher interest rates push the value of the currency higher.  

Increasing interest rates is a technique for central banks to control inflation. When a central bank boosts interest rates, it may entice more foreign investors to buy that currency, making the currency gain. The strengthening currency makes imports less expensive and helps lower inflation.  

Some countries that have balanced economic development and higher relative interest rates may see increasing interest in their currency. This increase occurs because many investors regard rising interest rates as a way of earning a higher yield, so they buy the currency to partake in that yield. But high interest rates can also decrease capital inflows if investors believe they lead to rising inflation and currency devaluation.

Level of Government Debt

If it looks that a government is functioning with too much debt and may be unable to fulfill a promised payment of interest or principal, investors may decide that they no longer wish to retain the bonds issued by that country. 

If investors sell the government bonds they own and take their money out of the country, it will trigger a depreciation of the country’s currency.

" " Political and Economic Environment 
Capital tends to flow to countries with political stability and excellent economic performance. Countries with political instability or poor economic prospects, such as low growth and high unemployment, are likely to see the value of their currencies drop. 

As an economy grows, capital flows will also often increase. Government policies towards international investors will also effect capital flows.

Foreign direct investments (FDIs)
Capital flows normally increase when a country becomes more open to outside investors and liberalises foreign direct investments (FDIs), the investments made by foreign investors and companies.  

Reserve currency
A reserve currency is a currency that is held in considerable amounts by governments and financial organizations as part of their foreign exchange reserves.

A reserve currency tends to be what globally traded items are priced in, including commodities, such as oil and gold. Because the US dollar is a reserve currency, the demand for US financial assets and for US dollars is stronger than it would be based on the country’s macroeconomic outlook alone.  

Relative Strength of Currencies  

The idea of purchasing power parity has long been used to explain relative currency valuations.

Purchasing power parity is an economic theory based on the premise that a basket of commodities in two different countries should cost the same, after taking into account the exchange rate between the two countries’ currencies.  
Purchasing power parity is the premise underpinning the Economist’s Big Mac index. On a regular basis, the Economist records the price of McDonald’s Big Mac hamburgers in various nations across the world, and then it estimates what the exchange rates should be to make the price of Big Macs the same in all the countries. 

This exchange rate relies on buying power parity and assumes that an identical product, the Big Mac, should have the same price everywhere on Earth. The Economist evaluates the purchasing power parity exchange rates compared to the US dollar and compares them with the actual exchange rates to assess if currencies are under- or overvalued relative to the US dollar.

 In June 2022, a Big Mac cost USD5.15 in the United States and ZAR39.90 in South Africa, which implies a purchasing power parity exchange rate of ZAR7.75/USD1 (ZAR39.90/USD5.15). Suppose the real exchange rate was ZAR17.04/USD1. This means, based on purchasing power parity, the South African rand is undervalued relative to the US dollar since it takes more South African rand than buying power parity implies to acquire a US dollar. 

Put another way, if a Big Mac cost ZAR39.90 in South Africa and the real currency rate was ZAR17.04/USD1, the cost of a Big Mac in the United States should be USD2.34. But the actual cost is USD5.15, which suggests that the South African rand was devalued by more than 50%. In other words, changing ZAR39.90 to US dollars would only provide USD2.34, which is not enough to buy a Big Mac in the United States.  

The purchasing power parity exchange rates created using Big Macs are only roughly indicative of actual exchange rates because they are based on just one product. In truth, purchasing power parity exchange rates should reflect a representative basket of products, but the Big Mac index serves as a readily accessible proxy.  

Although buying power parity provides a mechanism to explain comparable currency valuations, it has drawbacks. Two of these constraints are the difficulty of establishing a basket of items for comparison between countries and the impediments to international trade.  

These factors help explain why data suggests that purchasing power parity does not persist very well in the short to medium term. But in the long term, aberrations of actual exchange rates from purchasing power parity rates gradually fix themselves. In other words, buying power parity tends to apply only in the long term.  

Investment - Roles in Financial Reporting
Financial statements describe how lucrative a firm is and how efficiently it manages its resources and commitments, and they are read and used by a wide variety of people. 

The financial performance of a corporation important to many different people.

Company managers utilize financial performance to analyze the effectiveness of their strategies relative to historical and expected performance and comparing to competitors' performance 

Employees care because the financial success of the company effect their job security and salary. 

The company's financial performance important to investors since it influences the return of investment. 

Tax authorities may be fascinated with the company 's financial performance so that they can tax the earnings. 

Investment analyst examine the financial performance of the firm and provide recommendation to the customer whether to buy or sell securities such as bond and share issued by the company. 

One way to analyze a firm is to look at its historical performance, which is shown in a company’s financial statements.

The financial accounts demonstrate, among other things, how effective a company has been at generating earnings (profits) to repay their obligations or reward shareholders.

Accountants collect this information and convey it to investors, management, and employees through three key financial statements:

Balance sheet
Income statement 
Statement of cash flows

Key Characteristics of Financial Statements


Financial statements: Show the monetary value of the economic resources under a company’s control and how those resources have been employed to create value over time. 

Are historical and forward-looking at the same time; they represent previous performance, and they provide signals about future performance. 

Include notes that summarize the selected accounting methods, accounting practices, and other information crucial to analyzing a company’s results. These notes are a crucial component of a shareholder’s judgment. 

Describe how profitable a company is and how efficiently it handles its resources and commitments.

The value of a company’s debt and equity securities depends on its predicted success and its capacity to repay its debt and to produce returns for shareholders to compensate for the risks they assume when investing in the firm. 

Financial statements provide hints to future success by recounting the tale of past performance. They are read and utilized by a wide range of individuals for a vast variety of purposes; sooner or later, it will help you to know how to make sense of them.

Roles of Standard Setters, Auditors, and Regulators in Financial Reporting

Standards for financial reporting are often set at the national or worldwide level by accounting standard-setting groups. Standard setters, regulators, and auditors all have roles in assuring the uniformity of the financial information disclosed by corporations.

STANDARD SETTERS
Detailing one set of ‘rules’ for financial reporting are the International Financial Reporting Standards (IFRS), produced by the International Accounting Standards Board (IASB). 

Most nations require or allow corporations to produce financial reports using IFRS. Publicly traded corporations situated in the United States, however, must report following generally accepted accounting principles (US GAAP). US-based corporations report using GAAP and non-US-based companies may report using IFRS.

There is a push to have accounting standards converge and to create a single set, or at least a compatible set, of high-quality financial reporting standards worldwide. In nations that have not implemented IFRS, attempts to converge with or transition to IFRS are going place. 

When standards provide some option, the accounting system that a corporation adopts influences the reported earnings. 

A corporation may utilize aggressive accounting practices that enhance reported earnings, or it may use conservative accounting methods that decrease stated profitability.
A corporation may recognise more or less revenue, and so display higher or lower profitability, depending on how the company interprets the accounting standards.
Despite guidelines that lead corporations to generate generally similar financial statements, there is still flexibility in their selection and interpretation.
The choice of appropriate alternative accounting methods are provided in the notes, which accompany the statements and explain parts of them, including the accounting judgments underlying them. The notes are an aid to interpreting the financial statements. 

REGULATORS

Regulators assist financial reporting standards by recognising them and by enforcing rules that complement them.

Companies that issue securities traded in public markets are typically required to file reports that comply with standards specified by their country’s regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States, the Prudential Regulation Authority (PRA) in the United Kingdom, and the Financial Services Commission in South Korea. These reports comprise the financial statements and material that documents company operations. 

AUDITORS
Before they can be released, the financial accounts must first be verified by independent accountants called auditors. An auditor offers an opinion on the correctness and presentation of a firm’s financial statements, which indicates to the reader how trustworthy the statements are in reflecting the financial performance of the organization.

Opinions can range from an unqualified or clean opinion, meaning that the financial statements are prepared in accordance with the applicable accounting standards, to an adverse opinion, which indicates that the financial statements do not comply with the accounting standards and, therefore, do not provide a fair representation of the company’s performance. 

Note that a clean audit report does not suggest a financially sound organization. It just confirms that the financial statements were generated and presented accurately. In other words, an audit opinion is not a verdict on the company’s performance, but on how well it has accounted for its performance.

​Investment - Balance of Payments
A country needs to document all economic transactions. The balance of payments gives crucial information to examine and comprehend economic dealings with other countries.

Imports and exports are crucial components of a country’s balance of payments.

The balance of payments tracks transactions between a country and the rest of the globe over a period of time, usually a year. It depicts the flow of money in and out of a country as a result of exports and imports. It also reflects financial transactions and financial transfers between resident and non-resident economic entities, such as individuals, firms, governments, and government agencies.  

The balance of payments contains two accounts: the current account and the capital and financial account. 

Current Account
The current account reflects how much the country spends and invests (outflows) contrasted with how much it gets (inflows). It is primarily driven by the trade of products and services with the rest of the globe, so exports and imports.

Capital and Financial Account
The capital and financial account records the ownership of assets. In particular, it reflects investments by domestic entities in foreign entities and investments by foreign entities in domestic entities. These investments can be the acquisitions of production facilities or the purchases and sales of financial securities, such as debt and stock.

Analysing a country’s balance of payments supports an understanding of the country’s macroeconomic climate. The balance of payments quantifies a country’s levels of consumption and savings. It can also provide insight into a country’s degree of reliance on foreign cash to fuel its consumption and investments. 

In theory, the total of the current account and the capital and financial account is zero. In other words, the balance of payments should sum to zero. Before explaining why this is the case, we need to understand what drives each account.  

Current Account  


The exhibit below displays the current account’s three components:
Products (commonly referred to as products in this context) and services 
Income 
Current transfers

Components of the Current Account  
Current Account Goods and Services

Exports – Imports = Net exports = Balance of Trade Income

Salaries + Income on financial investments
Current Transfers

Unilateral transactions, such as presents or workers' remittance

Components of the Current Account 

The goods and services account is usually the largest component of a country’s current account. It reflects the flow of money in and out of a country as a result of the trade of products and services; in other words, the inflow of money (a positive number) from exporting products and services to foreign entities, and the outflow of money (a negative number) from importing products and services.

The difference between exports and imports of items and services is called net exports, commonly referred to as the balance of trade or trade balance.

Balance of trade may be used by some to refer exclusively to the difference between exports and imports of goods. When we refer to balance of commerce, we include both products and services.

If the value of exports is equal to the value of imports — if net exports are zero — the country’s commerce is balanced, which in practice is rarely the case. If the value of exports is higher than the value of imports, which means net exports are positive, the country has a trade surplus. Alternatively, if the value of exports is lower than the value of imports, making net exports negative, the country has a trade deficit.

The income account depicts the movement of money in and out of the country from salaries and from the income received from financial investments. For example, if a domestic company has a debt or equity investment in a foreign company, any income, such as interest payments on the debt securities it holds or dividend payments on the equity securities it holds, received by the domestic company is included in income in the country’s current account.

In this case, the interest or dividend payments are recorded as inflows since they represent money pouring into the country from other countries.  

The third current account, the current transfers account, comprises unilateral transactions, such as gifts and workers’ remittances. Gifts of aid from one country are outflows for that country and inflows for the receiving country. Money sent home by migrant workers, or workers’ remittances, is an outflow from the nation where they work and an inflow to the country to which the money is remitted.  

A country’s current account balance is the total of the goods and services account, the revenue account, and the current transfers. A positive balance is called a current account surplus, whilst a negative balance is called a current account deficit. For most countries, the goods and services account are higher than the combination of the income account and the current transfer's account; the trade balance tends to dominate. 

Countries that have a trade surplus because they export more than they import tend to have a current account surplus. In contrast, countries that have a trade deficit because they import more than they export tend to have a current account

A current account surplus suggests that the country is saving. That is, the country has more inflows than outflows, providing it the opportunity to lend to or invest in other countries. As can be seen in the above, Germany, Japan, China, the Netherlands, Switzerland, and Russia had the highest current account surpluses in 2019. 

By contrast, a country that is running a current account deficit spends more than it earns, thus it needs to borrow or accept investments from other countries. As seen in the table, the United States, the United Kingdom, Kenya, Brazil, Ireland, and Canada had the greatest current account deficits in 2019.

Capital and Financial Account 


As the name suggests, the capital and financial account refers to the merging of two accounts. The capital account generally reports capital transfers between domestic entities and international entities, such as debt forgiveness or the transfer of assets by migrants entering or leaving the country. The financial account reflects the investments domestic entities make in foreign entities and the investments foreign entities make in domestic entities.

In essence, the capital and financial account tells us how a country with a current account surplus is investing its savings, or how a country with a current account deficit is supporting its necessities.  

Capital and Financial Account
Capital

Capital transfers between domestic and international entities
Financial

Direct investments + Portfolio investments + Other investments + Reserve account

Direct Investments
Direct investments are long-term investments between domestic entities and international entities. If a Brazilian firm purchases a production facility in the United Kingdom, the transaction will be reported as an inflow to the financial account in the United Kingdom because it is money flowing in from another country. 

The same transaction will be reported as an outflow from the financial account in Brazil because it is money sent outside.   

Portfolio Investment
Portfolio investments indicate the purchases and sells of securities, such as debt and equity securities, between local entities and foreign entities.  

 Other Investments
Other investments are generally made up of loans and deposits between domestic firms and international entities. 

Reserve Account Reserve accounts represent the transactions made by the monetary authorities of a country, often the central bank.

Relationship between the Current Account and the Capital and Financial Account  


The capital and financial flows travel in the opposite direction of the goods and services flows in the current account that give rise to them. We indicated that the total of the current account balance and the capital and financial account balance should in theory be equal to zero. 

If a country has a current account surplus, it should have a capital and financial account deficit of the same magnitude; the country is a net saver and thus ends up being a net lender to the rest of the world. 

Alternatively, if a country has a current account deficit, it should have a capital and financial account surplus of the same magnitude, implying the country is a net borrower from the rest of the world in order to pay its deficit.

In practice, however, the capital and financial account balance does not exactly offset the current account balance because of measurement inaccuracies. All the components included in the balance of payments are measured independently using different sources of data. Data are collected from customs officials on exports and imports, from surveys on tourist numbers and expenditures, and from financial institutions on capital inflows and outflows. Some of the inputs are based on sampling methodologies, therefore the figures are estimates.  

Because measuring the items reported in the balance of payments is complex, it is in reality rare, if not impossible, to wind up with a capital and financial account balance that perfectly offsets the current account balance. As a result, there is a need for a ‘plug’ figure that makes the sum of the flows in and out equal to zero. This plug figure is termed errors and omissions.

Why Does a Country Run a Current Account Deficit and How Does It Affect Its Currency?  

We observed earlier that some countries, such as the United States, the United Kingdom, Brazil, India, and Canada, have huge current account deficits.

Is running a current account deficit a bad indicator, and should all countries try to maximise their current account balance? The answer to both queries is not necessarily. The aggregate of the current account balances of all countries is, by definition, equal to zero. 

In other words, an influx for one country equals an outflow for another country. Accordingly, it is impossible for all countries to have a current account surplus.



A current account deficit must be put in context before reaching conclusions. A developing country may have a current account deficit because it needs to import various things, such as machinery and equipment, and services, such as communication services, to enable its economy evolve. As the initial period of heavy investment ends and the economy gets stronger, the developing country may experience a decline in imports and an increase in exports, steadily reducing or even eliminating the current account deficit. This situation can also apply to countries in transition that are shifting from a socialistically managed economy to a market economy, in which case the current account deficit may be transient.

Alternatively, a mature country may have a current account deficit because its spending greatly surpasses its production and its ability to export. Thus, when analyzing the economic forecast for a country running a current account deficit, an investment professional must factor in the country’s stage of economic development and comprehend what is driving the current account balance.  

There is a long-standing discussion over the risk to a country for maintaining a sustained current account deficit. As discussed before, a current account deficit means that the government spends more than it gets and makes up the difference by borrowing or receiving investments from other countries. 

Some economists claim that having a current account deficit does not matter as long as foreign entities hold the assets and the currency of the country running the deficit. But what would happen if foreign entities were hesitant to hold the assets and currency?  

Consider the example of the country operating the highest current account deficit, the United States. Because the United States has a big trade deficit with several countries, those countries hold US currency. These US dollars can be maintained as bank deposits in the United States, or they can be invested. For example, foreign corporations may use their US dollars to acquire US companies, or they may invest in debt and equity instruments produced by US companies. Other governments may also invest in the bonds issued by the US government, termed Treasuries 

But if other countries decide that they want to minimize their exposure to the United States, they may start selling US assets, which will have a negative influence on the price of those assets. In addition, they may elect to convert their US dollars into other currencies, which will cause a devaluation of the US dollar relative to other currencies. The US dollar will get weaker, and a unit of the US currency will buy fewer units of a foreign currency.


In other words, foreign currencies will get stronger relative to the US dollar, or they will appreciate relative to the US dollar. To entice entities in other countries to invest in the United States, the US Central Bank, the Federal Reserve Board (which is sometimes called the Fed), may increase interest rates. An increase in interest rates would increase the cost of funding for individuals, companies, and the government in the United States. 

The combination of lower asset prices, a weaker US dollar, and higher interest rates would definitely harm the US economy, potentially leading to a lower GDP, maybe even a recession, and a higher unemployment rate.

​Investment - Foreign Exchange Rate Systems 
International trade requires a system for transferring currencies across nations because every country does not utilize the same form of money. To pay for items from another country, money from one country must be changed into the currency of another country.

International trade needs payments between countries. These payments involve an exchange of currencies and are affected by international exchange rates and foreign exchange rate systems.

The rate at which a unit of one currency can be exchanged for a unit of another currency is referred to as the foreign exchange rate or exchange rate. An exchange rate is expressed as the number of units of one currency it takes to convert into the other currency.  

International commerce payments may be done in the country’s own currency or in a foreign currency. Assume a supermarket chain located in France imports dairy products from the United Kingdom and has to pay the UK producers in British pounds. The exchange rate between the pound and the euro is commonly given in euros per pound (EUR/GBP).

An exchange rate of EUR1.20/GBP1 means that it takes 1 euro and 20 cents to acquire 1 pound. If the French grocery chain has to make a payment of GBP100,000 to the UK producers, it will need to exchange EUR120,000 to obtain GBP100,000 (£100,000 × €1.20/£1).

The exchange rates between world currencies, such as the US dollar (USD), euro (EUR), British pound (GBP), and Japanese yen (JPY), are like the pricing of goods and services. Like most commodities and services, exchange rates move frequently depending on supply and demand. If a lot of people desire to acquire a certain currency, such as the euro, demand for the euro will increase and the price of the euro will rise, or appreciate, relative to other currencies; consequently, it will take more of another currency to buy a euro. 

Alternatively, if the euro falls out of popularity, demand for the euro would diminish and the price of the euro will fall, or depreciate, relative to other currencies.   

There are three primary types of exchange rate systems:

Fixed rate 
Floating rate 
Managed floating rate 

At the Bretton Woods conference in 1944, the major nations of the Western world agreed on an exchange rate system in which the value of the US dollar was defined as USD35 per ounce of gold. That is, a dollar was equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined with relation to, or ‘pegged’ to, the US dollar.

Such a system of exchange rates, which does not allow for volatility, is known as a fixed exchange rate system. 

The advantage of a fixed exchange rate system is that it removes currency risk (or foreign exchange risk), which is the risk connected with the fluctuation of exchange rates.

In a fixed-rate environment, importers and exporters know with certainty the amount that they will pay or get for the items and services they trade.
 
A downside of a fixed-rate regime is that, as the competitiveness of countries varies over time, an economy that becomes uncompetitive would see its current account balance worsen because its currency gets overvalued. Its exports are too expensive from the buyer’s standpoint, while its imports are too cheap from the seller’s perspective. Under a fixed exchange rate system, the only answer to this dilemma is for the government to legally depreciate its currency.

Devaluation is the decision made by a country’s central bank to decrease the value of the domestic currency relative to other currencies, an action that many governments are reluctant to perform.  

To overcome the problems of a fixed exchange rate system, the Bretton Woods agreement was abandoned in 1973, and currency values were left to fluctuate up and down, or float, with the market forces of supply and demand. Since 1973, the major currencies have existed under a floating exchange rate regime. In a fully floating exchange rate system, a country’s central bank does not intervene and allows the market determine the value of its currency. Under this structure, the exchange rate between the domestic currency and foreign currencies is exclusively driven by the supply of and demand for each currency.  

In a controlled floating exchange rate regime, a central bank intervenes to stabilise its country’s currency. To strengthen the domestic currency, it buys domestic currency using foreign currency reserves, or it buys foreign currency using domestic currency to weaken the domestic currency.


In the wake of the European sovereign debt crisis in 2012, many investors switched their euros to Swiss francs, perceiving the Swiss franc as a safer currency than the euro. The rise of the Swiss currency started weakening the competitiveness of Swiss exporters and led the Swiss National Bank, Switzerland’s Central Bank, to interfere. 


To drive the price of the Swiss franc down, the Swiss National Bank sold its own currency and bought foreign currencies, such as the euro; in other words, the Swiss National Bank did the reverse of what investors were doing. In the process, it accumulated foreign cash reserves. 

This example indicates that central banks do not usually aim for a perfectly fixed exchange rate, but typically endeavor to maintain the value of their country’s currency within a particular range. Central banks tend to intervene infrequently, therefore generally, such a system runs as a floating exchange rate system.

​Investment - Risk and Portfolio Diversification 
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.

Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.  


Systematic Risk, Specific Risk, and Diversification 


How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.

In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.


Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return. 

Systematic and Specific Risk

The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment. 

Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.

Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials. 

The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.  


Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.


Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.  

Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk. 

Diversification 

Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.

Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.

Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market. 

Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.

Portfolio Risk 
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen. 

Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.