Finance is the management of assets under conditions of risk and uncertainty.
Throughout this modules we will explore finance from two perspectives: corporate finance and personal finance.
Let’s explore the definition in more detail and how it applies to corporate and personal finance.
An asset is anything tangible or intangible that can be owned or controlled to produce value and that is held to have positive economic value.
Examples of corporate assets include machines, equipment, buildings, inventory, vehicles, intelectual property such as patents, etc.
Persons own assets like bank accounts, retirement accounts, houses, life insurane policies, cars, etc.
Corporations and persons manage their assets to create, enhance, or preserve value.
The management of assets happens under conditions of risk. Risk is typically defined as the probability of something going wrong. Risk is seen as a negative.
The Chinese symbol for risk is 危机.
- The first part of the symbol stands for danger.
- The second part stands for opportunity.
Therefore risk is not necessarily always a negative. Risk can also be an opportunity.
Corporations and persons need to assume certain risks to create value over time. Therefore for corporations and persons, the objective is not to completely avoid risk, but how to best incorporate it into their decision making to create value. Without risk, without taking chances, value creation stalls.
For example, when corporations invest in new technologies, new products, or new equipment, there are no guarantees they will produce a return. However, without these investments corporations can’t create value.
When a person buys a new house, there are many things that may go wrong. A fire or flood destroys the property. If you drive a car there is always the possibility of having an accident.
A key characteristic of risk is that it can be measured.
Risk Management Techniques
Risk management is a very complex topic. In this module we only discuss two basic and effective ways of mitigating the negative effects of risk.
Insurance is a very effective way of mitigating the negative effects of risk. Insurance offers corporations and persons protection against many risks associated with owing assets.
Depending on the situation, a corporation or person may need one of the following types of insurance: flood insurance, car insurance, property insurance, liability insurance, health insurance, identity theft protection, casualty insurance, disability insurance, workers’ compensation, etc.
Diversification is defined as the act of investing in many classes of assets as opposed to just one or a few. Corporations do not invest all of their funds in a single project, instead they spread the available funds over several projects. It is unlikely all the projects will be profitable, however it is also unlikely all the projects will not be successful.
Persons should also diversify their investments. For example, they can invest in the stock market, the bond market, the real estate market, etc. Not every year every investment will have a positive return, but history shows that over time a well diversified portfolio of investments yields positive returns.
Uncertainty deals with the unknown. There are events corporations and persons cannot anticipate, therefore they can’t buy insurance to protect their assets.
Uncertainty cannot be measured.
How to Protect against Uncertainty?
There are two ways to protect against an uncertain event:
- Diversification: By investing in various projects, corporations can minimize the overall effect to the whole corporation of an unexpected event affecting one of its projects.
- Cash reserves: corporations and individuals should have a “rainy day fund” for emergencies and unexpected events. For example, a corporation is facing a recall of its products, it is unexpected and will be expensive. It is imperative to have cash reserves to affront the immediate damage from the recall.
How are Risk and Uncertainty Different?
Consider the following example: When you bet on your favorite sports team you can estimate how risky the bet is by looking at your team’s winning record, the skills of individual players, etc. However, it doesn’t matter how well you study your team, you always face the uncertainty of an injury.
Therefore you can measure how risky your bet is by estimating the probability of your team winning the game but you can’t measure the uncertainties surrounding the game.
How do these concepts relate to students?
In your daily student life you apply many of the concepts covered in this module.
- If you drive to school you must have car insurance to protect yourself against the possibility of an accident.
- You have unexpected expenses, perhaps you need a new calculator or a new computer. For this you need a rainy day fund.
- You experience diversification in your course grades. Your final grade does not depend on a single project. Your final grade is calculated from various components: homework assignments, projects, exams, presentations, etc. If you don’t do well in one exam you don’t automatically fail the class because you can compensate by doing well in the other exams, projects, or assignments
- When you go to a conference or join a research group, it takes time away from your classes, however it opens new opportunities to advance your career.
- Your education is an asset you must manage: which classes do I take? I must maintain a high GPA. Which internships are more appropriate for my goals.