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What Is Finance?
Finance is a term broadly describing the study and system of money, investments, and other financial instruments. Some authorities prefer to divide finance into three distinct categories: public finance, corporate finance, and personal finance. Other categories include the recently emerging area of social finance and behavioral finance, which seeks to identify the cognitive (e.g., emotional, social, and psychological) reasons behind financial decisions.
The Basics of Finance
Finance, as a distinct branch of theory and practice from economics, arose in the 1940s and 1950s with the works of Markowitz, Tobin, Sharpe, Treynor, Black, and Scholes, to name just a few. Of course, topics of finance—such as money, banking, lending, and investing—had been around since the dawn of human history in some form or another.
Today, “finance” is typically broken down into three broad categories: Public finance includes tax systems, government expenditures, budget procedures, stabilization policy and instruments, debt issues, and other government concerns. Corporate finance involves managing assets, liabilities, revenues, and debts for a business. Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings, and retirement planning.
Key Takeaways
- Finance is a term broadly describing the study and system of money, investments, and other financial instruments.
- Finance can be divided broadly into three distinct categories: public finance, corporate finance, and personal finance.
- More recent subcategories include social finance and behavioral finance.
Public Finance
The federal government helps prevent market failure by overseeing the allocation of resources, distribution of income, and stabilization of the economy. Regular funding for these programs is secured mostly through taxation. Borrowing from banks, insurance companies, and other governments and earning dividends from its companies also help finance the federal government.
State and local governments also receive grants and aid from the federal government. Other sources of public finance include user charges from ports, airport services, and other facilities; fines resulting from breaking laws; revenues from licenses and fees, such as for driving; and sales of government securities and bond issues.
Corporate Finance
Businesses obtain financing through a variety of means, ranging from equity investments to credit arrangements. A firm might take out a loan from a bank or arrange for a line of credit. Acquiring and managing debt properly can help a company expand and become more profitable.
Startups may receive capital from angel investors or venture capitalists in exchange for a percentage of ownership. If a company thrives and goes public, it will issue shares on a stock exchange; such initial public offerings (IPO) bring a great influx of cash into a firm. Established companies may sell additional shares or issue corporate bonds to raise money. Businesses may purchase dividend-paying stocks, blue-chip bonds, or interest-bearing bank certificates of deposits (CD); they may also buy other companies in an effort to boost revenue.
For example, in July 2016, the newspaper publishing company Gannett reported net income for the second quarter of $12.3 million, down 77% from $53.3 million during the 2015 second quarter. However, due to acquisitions of North Jersey Media Group and Journal Media Group in 2015, Gannett reported substantially greater circulation numbers in 2016, resulting in a 3% increase in total revenue to $748.8 million for the second quarter.
Personal Finance
Personal financial planning generally involves analyzing an individual’s or a family’s current financial position, predicting short-term, and long-term needs, and executing a plan to fulfill those needs within individual financial constraints. Personal finance depends largely on one’s earnings, living requirements, and individual goals and desires.
Matters of personal finance include but are not limited to, the purchasing of financial products for personal reasons, like credit cards; life, health, and home insurance; mortgages; and retirement products. Personal banking (e.g., checking and savings accounts, IRAs, and 401(k) plans) is also considered a part of personal finance.
The most important aspects of personal finance include:
- Assessing the current financial status: expected cash flow, current savings, etc.
- Buying insurance to protect against risk and to ensure one’s material standing is secure
- Calculating and filing taxes
- Savings and investments
- Retirement planning
As a specialized field, personal finance is a recent development, though forms of it have been taught in universities and schools as “home economics” or “consumer economics” since the early 20th century. The field was initially disregarded by male economists, as “home economics” appeared to be the purview of housewives. Recently, economists have repeatedly stressed widespread education in matters of personal finance as integral to the macro performance of the overall national economy.
Social Finance
Social finance typically refers to investments made in social enterprises including charitable organizations and some cooperatives. Rather than an outright donation, these investments take the form of equity or debt financing, in which the investor seeks both a financial reward as well as a social gain.
Modern forms of social finance also include some segments of microfinance, specifically loans to small business owners and entrepreneurs in less developed countries to enable their enterprises to grow. Lenders earn a return on their loans while simultaneously helping to improve individuals’ standard of living and to benefit the local society and economy.
Social impact bonds (also known as Pay for Success Bonds or social benefit bonds) are a specific type of instrument that acts as a contract with the public sector or local government. Repayment and return on investment are contingent upon the achievement of certain social outcomes and achievements.
Behavioral Finance
There was a time when theoretical and empirical evidence seemed to suggest that conventional financial theories were reasonably successful at predicting and explaining certain types of economic events. Nonetheless, as time went on, academics in the financial and economic realms detected anomalies and behaviors which occurred in the real world but which could not be explained by any available theories. It became increasingly clear that conventional theories could explain certain “idealized” events, but that the real world was, in fact, a great deal more messy and disorganized, and that market participants frequently behave in ways which are irrational, and thus difficult to predict according to those models.
As a result, academics began to turn to cognitive psychology in order to account for irrational and illogical behaviors which are unexplained by modern financial theory. Behavioral science is the field which was born out of these efforts; it seeks to explain our actions, whereas modern finance seeks to explain the actions of the idealized “economic man” (Homo economicus).
Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to explain financial anomalies, such as severe rises or falls in stock price. The purpose is to identify and understand why people make certain financial choices. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.
Daniel Kahneman and Amos Tversky, who began to collaborate in the late 1960s, are considered by many to be the fathers of behavioral finance. Joining them later was Richard Thaler, who combined economics and finance with elements of psychology in order to develop concepts like mental accounting, the endowment effect, and other biases which have an impact on people’s behavior.
Tenents of Behavioral Finance
Behavioral finance encompasses many concepts, but four are key: mental accounting, herd behavior, anchoring, and high self-rating and overconfidence.
Mental accounting refers to the propensity for people to allocate money for specific purposes based on miscellaneous subjective criteria, including the source of the money and the intended use for each account. The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group or account, the result of which can be an illogical, even detrimental, set of behaviors. For instance, some people keep a special “money jar” set aside for a vacation or a new home while at the same time carrying substantial credit card debt.
Herd behavior states that people tend to mimic the financial behaviors of the majority, or herd, whether those actions are rational or irrational. In many cases, herd behavior is a set of decisions and actions that an individual would not necessarily make on his or her own, but which seem to have legitimacy because “everyone’s doing it.” Herd behavior often is considered a major cause of financial panics and stock market crashes.
Anchoring refers to attaching spending to a certain reference point or level, even though it may have no logical relevance to the decision at hand. One common example of “anchoring” is the conventional wisdom that a diamond engagement ring should cost about two months’ worth of salary. Another might be buying a stock that briefly rose from trading around $65 to hit $80 and then fell back to $65, out of a sense that it’s now a bargain (anchoring your strategy at that $80 price). While that could be true, it’s more likely that the $80 figure was an anomaly, and $65 is the true value of the shares.
High self-rating refers to a person’s tendency to rank him/herself better than others or higher than an average person. For example, an investor may think that he is an investment guru when his investments perform optimally (and blocks out the investments that are performing poorly). High self-rating goes hand-in-hand with overconfidence, whichreflects the tendency to overestimate or exaggerate one’s ability to successfully perform a given task. Overconfidence can be harmful to an investor’s ability to pick stocks, for example. A 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,” by researcher Terrence Odean found that overconfident investors typically conducted more trades as compared with their less-confident counterparts—and these trades actually produced yields significantly lower than the market.
Scholars have argued that the past few decades have witnessed an unparalleled expansion of financialization—or the role of finance in everyday business or life.
Finance Versus Economics
Economics and finance are interrelated, informing and influencing each other. Investors care about economic data because they also influence the markets to a great degree. It’s important for investors to avoid “either/or” arguments regarding economics and finance; both are important and have valid applications.
In general, the focus of economics—especially macroeconomics—tends to be more big picture in nature, such as how a country, region, or market is performing. Economics also can focus on public policy, while the focus of finance is more individual, company- or industry-specific. Microeconomics explains what to expect if certain conditions change on the industry, firm, or individual level. If a manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. If a major copper mine collapses in South America, the price of copper will tend to increase, because supply is restricted.
Finance also focuses on how companies and investors evaluate risk and return. Historically, economics has been more theoretical and finance more practical, but in the last 20 years, the distinction has become much less pronounced.
Is Finance an Art or a Science?
The short answer to this question is both. Finance, as a field of study and an area of business, definitely has strong roots in related-scientific areas, such as statistics and mathematics. Furthermore, many modern financial theories resemble scientific or mathematical formulas.
However, there is no denying the fact that the financial industry also includes non-scientific elements that liken it to an art. For example, it has been discovered that human emotions (and decisions made because of them) play a large role in many aspects of the financial world.
Modern financial theories, such as the Black Scholes model, draw heavily on the laws of statistics and mathematics found in science; their very creation would have been impossible if science hadn’t laid the initial groundwork. Also, theoretical constructs, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), attempt to logically explain the behavior of the stock market in an emotionless, completely rational manner, wholly ignoring elements such as market sentiment and investor sentiment.
And while these and other academic advancements have greatly improved the day-to-day operations of the financial markets, history is rife with examples that seem to contradict the notion that finance behaves according to rational scientific laws. For example, stock market disasters, such as the October 1987 crash (Black Monday), which saw the Dow Jones Industrial Average (DJIA) fall 22%, and the great 1929 stock market crash beginning on Black Thursday (Oct. 24, 1929), are not suitably explained by scientific theories such as the EMH. The human element of fear also played a part (the reason a dramatic fall in the stock market is often called a “panic”).
In addition, the track records of investors have shown that markets are not entirely efficient and, therefore, not entirely scientific. Studies have shown that investor sentiment appears to be mildly influenced by weather, with the overall market generally becoming more bullish when the weather is predominantly sunny. Other phenomena include the January effect, the pattern of stock prices falling near the end of one calendar year and rising at the beginning of the next.
Furthermore, certain investors have been able to consistently outperform the broader market for long periods of time, most notably famed stock-picker Warren Buffett, who at the time of this writing is the second-richest individual in the United States—his wealth largely built from long-term equity investments. The prolonged outperformance of a select few investors like Buffett owes much to discredit the EMH, leading some to believe that to be a successful equity investor, one needs to understand both the science behind the numbers-crunching and the art behind the stock picking.