Classic Question: Annuities or Bonds?

Classic Question: Annuities or Bonds?
Sponsored by by Don Taylor
Saturday, February 14, 2009
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Dear Dr. Don,

I have been considering an immediate annuity, but was wondering what the benefit is over buying a long-term corporate bond or bonds with a similar yield.

Assuming I seek 30 years of income, it seems the annuity is implying something like a 4.5 percent to 5 percent yield. Wouldn't I be better off buying a corporate bond that yields a similar amount? That way, I'd still have the principal to spend at maturity in case I lived longer than planned.

Am I not taking the same default risk with either investment since the insurance company could go out of business just like any other company? And finally, are there tax reasons that would make an immediate annuity better?

-- Laurence Longevity



Dear Laurence,

Yours is a classic question in retirement planning. To restate: "If you can invest at the same yield and the same risk as the immediate annuity, aren't you better off investing in the bonds versus buying the immediate annuity?"

For many the answer will be "no," but making it an apples-to-apples comparison is more difficult than just comparing the interest income from the bonds with the income from the annuity.

In addition, getting the risk levels equal is nigh impossible. State insurance commissions have reserve and other requirements that make an investment in an annuity from a highly rated insurance company safer than an investment in a highly rated corporate bond.

You purchase an immediate annuity with a lump sum and buy an income stream that lasts for your lifetime. The immediate annuity allows you to achieve a higher income stream than you could earn from living off the interest income paid by the bonds. That's because a straight life immediate annuity doesn't return principal when you die, and the annuity only lasts for your lifetime.

There are a multitude of options in how you structure the annuity. You can have it pay over your lifetime, over a joint lifetime or over a set time horizon. The payment can be indexed to inflation. There may or may not be a death benefit to a beneficiary. There may be a guarantee that you or your beneficiaries will at least receive in distributions the amount of money you have invested.

As soon as you start adding options, however, the value of the annuity payment declines because you have spent part of the purchase price to buy that option.

I used the annuity quote function on ImmediateAnnuities.com and assumed a $1 million investment for a 66-year-old male. (The annuity calculator on Vanguard.com is also recommended.) You can do your own calculation based on your age and the money you have available to purchase the annuity. The site will return almost two dozen different monthly payments based on typical annuity options.

I'm going to focus on the straight life annuity, which is the type of annuity that ensures a fixed income for the rest of the purchaser's life. The $1 million purchase secures a monthly income stream of $7,397. If you assume a 30-year life, it equates to a yield of roughly 8.4 percent (assuming the 66-year-old lives to 96). The longer you live, the higher the implied yield on the annuity.

A portfolio of 30-year, single-A rated corporate bonds isn't currently yielding in that ballpark. However, even if the two products were yielding a similar rate, the bonds are riskier than the annuities (for the reasons stated earlier).

I'm going to beg off on the tax discussion between the two investments and leave that to you and a tax professional. However, there's more to consider here than just taxes. Two other considerations are how the choice of an annuity versus the bond portfolio could impact your eligibility for Medicaid and potential estate-planning issues.

The bottom line is that the law of large numbers should allow an insurance company to pay a higher income stream on a single life annuity than you can earn off a similar amount invested in a high-quality bond portfolio.

This is true because the insurance company doesn't have to return your principal if you die sooner than expected, and dealing with a large pool of annuity owners means it can use mortality figures to estimate the average life of that pool to price the annuity.

Annuities are going to make the most sense for people who are worried about outliving their income and don't have a large retirement nest egg as a backstop.

Before signing an annuity contract, get a second opinion on the decision from a fee-only financial adviser. The National Association of Personal Financial Advisors maintains a listing of fee-only advisers.

Copyrighted, Bankrate.com. All rights reserved.

http://finance.yahoo.com/focus-retirement/article/106589/Classic-Question:-Annuities-or-Bonds?mod=retirement-post-spending

Paradox of thrift

Go ahead and save. Let the government spend.
By Robert H. Frank

Sunday, February 15, 2009
A psychotherapist friend says that several of her patients are fretting about whether they have an obligation to help the nation spend its way out of the current downturn. Some of them are having a hard time making ends meet, she said, yet are reluctant to cut back for fear they would cause the economy to slide further.

The role of consumers has had considerable attention in the press because the economy desperately needs additional spending right now. But it is not — and should not be — the responsibility of middle-income families to provide that spending. If financially comfortable families want to support their favorite restaurants during hard times by eating out more often, who could object? But if others are inclined to pay down their bills or save a little more, concerns about the economy shouldn't stop them.

Government is in a far better position to provide immediate economic stimulus. It is in fact the only player that can significantly alter the economy's short-run trajectory. In a recession, as in ordinary times, a family's first economic priority should be to spend its income prudently.

The "paradox of thrift," a celebrated chestnut first described by John Maynard Keynes in the 1930s, has been the source of much confusion about how saving affects the health of the economy. Intuition suggests, correctly, that if any one family saves an extra $100 this year, its bank balance at year's end will be higher by that amount. According to the paradox of thrift, however, if everyone tries to save more at once, total savings will actually fall.

How could that happen? The explanation begins with the observation that, to save more, a family must spend less. Because consumption spending is part of national income, which in turn is the total amount spent by everyone in the economy, more saving causes national income to fall. Income will actually fall by more than the initial decline in consumption, because when one family spends less, other families earn less and respond by cutting their own consumption. When the dust settles, the story concludes, each family ends up saving less than before.

But that doesn't mean that people should stop saving for retirement or their children's education. If we're going to ask people to make sacrifices, it should be for something that will actually make a difference. (My colleague David Leonhardt wrote a column on Wednesday suggesting that by making certain kinds of investments — like making their homes more energy efficient — families could boost current spending while also increasing their long-run savings, despite the paradox of thrift.)

But even by mortgaging itself to the hilt (as many families have indeed already done during the recent national spending spree), no family could spend enough to affect the current downturn.

Nor is it reasonable to demand that individual businesses pick up the slack, since most of them already have more capacity than they currently need. At moments like these, government is the only actor with both the motivation and the ability to jump-start the economy.

Passage of a robust stimulus bill has rightly been the Obama administration's highest priority since taking office last month. As Keynes explained during the Great Depression, increased public spending would help end the downturn even if it were for useless activities like digging holes and filling them back up. It would obviously be better if the extra spending went for something useful. And as it happens, decades of infrastructure neglect, combined with huge state and local government budget shortfalls, provide more than enough valuable projects to put everyone back to work.

Bizarrely, however, some congressional critics have denounced the administration's stimulus proposals as "mere spending programs." Of course they're spending programs! More spending is exactly what we need. The imperative is to get this legislation passed and get the spending started right away.

The paradox of thrift has been a pernicious idea. By casting saving in such a negative light, it has encouraged people to think that thrift no longer matters. And most Americans have been only too happy to spend more freely. Household savings rates have fallen sharply for several decades. For two of the past three years, they have actually been negative, meaning that spending has exceeded income.

By fueling the housing bubble, this spending not only helped cause the current crisis, but also led to substantially increased borrowing from abroad. We're poorer each year by the hundreds of billions of dollars that we must pay in interest on these loans.

The "paradox of thrift" applies only during economic downturns, and even then only when government fails to stimulate spending. Most of the time, however, the economy operates near full employment. Before long, it will again. Under those circumstances, if every family saved a little more, extra money would flow into the capital market, causing interest rates to fall and investment spending to rise.

Because the fall in consumption from increased savings would be exactly offset by the rise in investment, total demand would still be sufficient to maintain full employment. The extra investment would boost productivity, causing national income to grow faster in the long run. As a result of the spending spree of recent decades, however, our growth rate has fallen sharply. Much of the nation's credit-card debt is now carried at annual interest rates of 20 percent or more. In just five years, each dollar invested in paying down such debt would support more than $2.50 of additional consumption; in just 10 years, more than $6. It is unreasonable to ask families to spend more when government can stimulate the economy so much more efficiently.

THE financial health of the nation and the financial health of individual families are not conflicting goals. A family that wants to help put the economy back on its feet while increasing its own future standard of living should consider saving a little more or paying down debt. Those who want a tangible symbol of their patriotism can buy additional government bonds, which will help repair an extra bridge or hire an extra math teacher.




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Copyright © 2009 The International Herald Tribune www.iht.com

http://www.iht.com/articles/2009/02/15/business/15view.php

A generation shy of risk?

A generation shy of risk?
FEB 15 – You did what you were supposed to do. College. Graduate school, maybe. Bought a home. Invested in mutual funds. Bought a house.

And now? You have student loan debt. Your degree has not shielded you from unemployment (or the fear of it). The house is worth 20 per cent less than two years ago, and your retirement portfolio is down 40 per cent from its peak.

So at this moment, can you blame people in their 20s and 30s for giving up altogether on risk of any sort? It’s one of the bigger questions preoccupying those who think about money management all day.

Are we in the process of minting a new generation of adults who are averse to taking chances, whether it’s buying real estate or investing in stocks?

“We trained people that if you took risk and diversified and played by the rules that you’d have a great life for yourself,” said Howard L. Simons of the bond specialist Bianco Research. “But all of that can disappear in a hurry. And most of us can look in the mirror and say, ‘What did I do to cause this?’ And nothing springs to mind.”

I’m not sure we can say for sure whether there has been some permanent change in attitudes toward risk. It’s easy to overestimate the extent to which the world – and our perception of it – has changed in the middle of a crisis. But this one has not lasted long. And its duration does not come close to matching the period in the 1930s that left a permanent imprint on so many people’s financial habits.

Even before the downturn, younger adults were not necessarily enthusiastic about riskier forms of investing, even though they are far from retirement.

A joint study by the Investment Company Institute and the Securities Industry and Financial Markets Association noted that just 45 per cent of households headed by people under 40 held 51 per cent or more of their portfolios in stocks, mutual funds and other, similar investments last spring. That is less than what households headed by those 40 to 64 owned. Fifty per cent of them invested more than half their money in equities.

Data from Vanguard, however, suggests that its investors under 45 who use target-date mutual funds, which allocate assets among stocks and bonds for the investor, tend to have significantly more money in stocks than those who do not use these mutual funds.

As more employers automatically sign up younger workers for 401(k) plans and use fairly aggressive target-date funds as a default investment, those employees’ exposure to stocks will grow.

So perhaps a better question to ask is not whether people in the first half of their working lives are becoming more risk-averse, but whether they should be.

On Thursday night, Kevin Brosious, a financial planner in Allentown, Pa., polled the students in his financial management class at DeSales University on the percentage of their portfolios they would allocate to stocks right now. The majority would put less than half in stocks; among their reasons were fear of job loss, lack of accountability on Wall

Street and economic fears amplified by the news media.

The problem with their approach, according to Brosious, is that by investing conservatively they are probably guaranteeing themselves a smaller return and a more meagre standard of living in retirement.

Or, as Robert N. Siegmann, chief operating officer and senior adviser of the Financial Management Group in Cincinnati, wrote to me in an e-mail message, “Why would you consider taking less risk NOW after most of the risk has already been paid for in the market over the past 12 months?”

If investing still seems too risky to you right now, you’re not alone. At Charles Schwab, according to a spokesman, younger 401(k) participants are not making many big investment moves. But there is a sense that at least some younger investors may divert 401(k) contributions to other uses, especially as more companies reduce or suspend their 401(k) matches.

In that case, one sensible way to reduce overall risk is to pay down high-interest debt, like credit cards or private student loans. That, at least, offers a guaranteed return, since every extra dollar you pay now keeps you from having to pay more interest later. Also, the sooner you rid yourself of debt payments, the less you would need in your monthly budget if you lost your job.

“I think the only thing younger people should be more risk-averse about is the leverage they take on,” said Jeffrey G. Cribbs, president of Chicago Wealth Management in Oak Park, Ill.

In particular, he suggested they buy real estate and cars at levels below what they can actually afford.

So what kind of risk should you take on with the savings you have left over? To Moshe A. Milevsky, the author of “Are You a Stock or a Bond?,” risk should have less to do with the era in which you live and more to do with what you do for a living.

If you are a tenured professor, a teacher, a firefighter or other government employee, you have better job security than most other people. Your income stream is stable, like a bond. Certain service providers, like plumbers and doctors, have similar security.

Investment bankers and many technology and media workers, however, have more volatility in their career paths. A chart of their income might bounce around like one showing a stock’s price.

“The idea is that we should focus on our human capital and invest in places where our human capital is not,” Milevsky said. “It’s not about risk tolerance or time horizon but about what you do for a living.”

As a tenured professor, he invests entirely in equities. Other people with bond-like characteristics who are far from retirement could take similar risks, and withstand 2008-level losses, because their incomes are fairly stable. Those who have more stock-like careers, however, probably ought to invest a bit more conservatively, in both their retirement accounts and in their primary residences.

For most young people, however, their biggest asset is not a 401(k) account or a home but the trajectory of their career and the value of 20 or 30 or 40 years of future earnings. It makes nearly everyone a millionaire on paper.

So whether you are taking on too much risk right now or not, all of that money will provide many more chances to fix any mistakes you have already made.

Has your risk tolerance changed forever? – NYT

Without a cure for toxic assets, credit crisis will persist

Without a cure for toxic assets, credit crisis will persist
By Steve Lohr

Friday, February 13, 2009
NEW YORK: Many of the large U.S. banks, according to economists and other finance experts, are like dead men walking.

A sober assessment of the growing mountain of losses from bad bets, measured in today's marketplace, would overwhelm the value of the banks' assets, they explain. The banks, in their view, are insolvent.

None of the experts' research focuses on individual banks, and there are certainly exceptions among the 50 largest banks in the country. Nor do consumers and businesses need to fret about their deposits, which are federally insured. And even banks that might technically be insolvent can continue operating for a long time, and could recover their financial health when the economy improves.

But without a cure for the bad-asset problem, the credit crisis that is dragging down the economy will linger, as banks cannot resume the ample lending needed to restart the wheels of commerce. The answer, the economists and experts say, is a larger, more direct government role than in the Treasury Department's plan outlined this week.

The Treasury program leans heavily on a sketchy public-private investment fund to buy up the toxic, mortgage-backed securities held by the banks. Instead, the experts say, the government needs to plunge in, weed out the weakest banks, pour capital into the surviving banks and sell off the bad assets.

It is the basic blueprint that has proved successful, they say, in resolving major financial crises in recent years. Such forceful action was belatedly adopted by the Japanese government from 2001 to 2003, by the Swedish government in 1992 and by Washington in 1987 to 1989 to overcome the savings and loan meltdown.

"The historical record shows that you have to do it eventually," said Adam Posen, a senior fellow at the Peterson Institute for International Economics. "Putting it off only brings more troubles and higher costs in the long run."

Of course, the stimulus plan put forward by the administration of President Barack Obama could help to spur economic recovery in a timely manner and the value of the banks' assets could begin to rise.

Absent that, the prescription would not be easy or cheap. Estimates of the capital injection needed in the United States range to $1 trillion and beyond. By contrast, the commitment of taxpayer money is the $350 billion remaining in the financial bailout approved by Congress last fall.

Meanwhile, the loss estimates keep mounting.

Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, has been both pessimistic and prescient about the gathering credit problems. In a new report, Roubini estimates that total losses on loans by American financial companies and the fall in the market value of the assets they hold will reach $3.6 trillion, up from his previous estimate of $2trillion. Of the total, he calculates that American banks face half that risk, or $1.8 trillion, with the rest borne by other financial institutions in the United States and abroad.

"The United States banking system is effectively insolvent," Roubini said.

For its part, the banking industry bridles at such broad-brush analysis. The industry defines solvency bank by bank and uses the value of a bank's assets as they are carried on its books, rather than the market prices calculated by economists. "Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.

Roubini's numbers may be the highest, but many others share his rising sense of alarm. Simon Johnson, a former chief economist at the International Monetary Fund, estimates that the U.S. banks have a capital shortage of $500 billion. "In a more severe recession, it will take $1 trillion or so to properly capitalize the banks," said Johnson, an economist at the Massachusetts Institute of Technology.

At the end of January, the IMF raised its estimate of the potential losses from loans and other credit securities originated in the United States to $2.2 trillion, up from $1.4 trillion in October. Over the next two years, the IMF estimated, U.S. and European banks would need at least $500 billion in new capital, an estimate more conservative than those of many economists.

Still, those numbers are all based on estimates of the value of complex mortgage-backed securities in a very uncertain economy. "At this moment, the liabilities they have far exceed their assets," said Posen of the Peterson Institute. "They are insolvent."

Yet, as Posen and other economists note, there are crucial issues of timing and market psychology that surround the discussion of bank solvency. If one assumes that current conditions reflect a temporary panic, then the value of the banks' distressed assets could well recover over time. If not, many banks may be permanently impaired.

"We won't know what the losses are on these mortgage-backed securities, and we won't until the housing market stabilizes," said Richard Portes, an economist at the London Business School.

Raghuram Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between "liquidation values" and those of calmer times, or "going concern values." In a troubled time for banks, Rajan noted, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.

"If they had to sell these securities today, the losses would be far beyond their capital at this point," he said. "But if the prices of these assets will recover over the next year or so, if they don't have to sell at distress prices, the banks could have a new lease on life by giving them some time."

That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before. In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a meltdown of the banking system.

In the current crisis, experts warn, banks need to get rid of bad assets quickly. The Treasury's public-private investment fund is an effort to do that.

But many economists and other finance experts say that the government may soon have to move in and take on troubled assets itself to resolve the credit crisis. Then, they say, the government could have the patience to wait for the economy to improve.

Initially, that would put more taxpayer money on the line, but it might reduce overall losses if the government-controlled entity were a shrewd seller. That is what happened during the savings and loan crisis, when the troubled assets, mostly real estate, were seized by the Resolution Trust Corp., a government-owned asset manager, and sold over a few years.

The eventual losses, an estimated $130 billion, were far less than if the hotels, office buildings and residential developments had been sold immediately.

"At the end of the day, the taxpayer money would be used to acquire assets, and behind most of those securities are mortgages, houses, and we know they are not worthless," said Portes, the London Business School economist, who is president of the Center for Economic Policy Research.

"So the taxpayers would not be out anything like the back-of-the-envelope, headline numbers people toss around."


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Copyright © 2009 The International Herald Tribune www.iht.com

http://www.iht.com/articles/2009/02/13/business/insolvent.php

How To Tell When The Economy's Getting Better

How To Tell When The Economy's Getting Better
Rick Newman
Friday February 13, 2009, 8:19 am EST

The stimulus package is finally finished. President Obama is promising a tough new bank-rescue plan to boost lending and limit outrageous pay. Troubled homeowners may even get some relief. All told, the government could spend more than $3 trillion to help end the recession.

So now all we have to do is sit back and watch the economy grow like a beanstalk, right?

If only. One risk of the unprecedented government intervention is that it won't do all that much to hasten the end of the recession. Another risk is that consumers, expecting a magic-bullet fix, could fail to prepare for tough times that still lie ahead. "This is going to be a difficult year," Obama himself said at his first press conference. "If we get things right, then starting next year we can start seeing some significant improvement."
[Read 4 myths about Obama's bank-rescue plan.]

Next year? Afraid so. Most economists agree that it will take that long, at least, before the biggest problems - mounting layoffs, the housing bust, the banking crisis, and plunging confidence - start to turn around. Here's what to watch for to tell whether the stimulus package is actually working, and when the economy might start to mend.

An improvement in the unemployment rate.
Of all the economic indicators, this is probably the single most important. But you might want to avert your eyes for awhile.

Obama has talked about creating 3 to 4 million new jobs, and if the stimulus plan works, it might come close to that - over several years, combined. But it's almost certain that through this summer and into the fall, there will be a net job loss, not a gain. Most economists expect the unemployment rate, now 7.6 percent, to hit at least 9 percent by the end of this year. That represents up to 2 million more lost jobs. Many of those cuts are already in the works - just follow the recent layoff announcements from companies like Caterpillar (20,000), Boeing (10,000), SprintNextel (8,000) and Home Depot (7,000). But the pink slips haven't all gone out yet, so the layoffs haven't shows up in the official numbers.
[See 15 companies that might not survive 2009.]

The first sign of an improvement will be...corporate silence. As in no more draconian job-cut announcements. Once that happens (or doesn't), the unemployment rate will plateau. Then, companies might start hiring again, and a couple of months after that, the unemployment rate will start to fall. Three straight monthly declines would be a good sign that the economy is really on the rebound. That probably won't happen until 2010.

If you're wondering what's the point of the stimulus package if it won't do much to help workers in 2009, look to 2010. And 2011. That's where the plan will make a bigger difference. Moody's Economy.com estimates that by the middle of 2010, the unemployment rate will start to drift back toward 8.5 percent. But without any stimulus plan, it would have hit 11 percent. Viva la government.

More stable home prices.
The real estate boom and bust is what torpedoed the economy in the first place, and the economy won't start to recover until the housing bubble fully deflates. The good news is that housing prices have already been falling for more than two years, with prices down more than 20 percent nationwide. And we might be more than halfway toward the bottom: Moody's Economy.com predicts that housing prices should stop falling nationwide by the second half of 2009. Overall, the forecasting firm predicts a 30 percent drop in home values from the peak values of 2006.
[See why the feds rescue banks, not homeowners.]

Others think it will take longer, but whenever it happens, an end to the housing slide will mark an important turning point. Hardly anybody thinks that prices will shoot back up or there will be another buying binge. But a boomlet, maybe. Once prices stabilize, buyers will stop worrying that they could be purchasing a costly asset that's falling in value. As they buy, other kinds of consumer activity - like shopping for furniture and kitchen upgrades - will follow. Slowly.

A consumer confidence rebound.
Since consumer confidence closely tracks the job market, the dismal numbers of the last few months probably won't improve by much until late in 2009, or 2010. Homeowners have lost more than $3 trillion worth of value in their homes over the last three years, and investors have seen their stock portfolios shredded. So even people who feel secure in their jobs are dour.
[See how Wall Street continues to doom itself.]

A turnaround in the housing or stock markets would break the gloom and help some people feel better off. So would easier lending by banks, which would help solvent consumers buy a few more cars, appliances, and other goods. But consumer confidence won't really start to improve until workers start to feel more secure about their jobs and income. Think 2010.

A less volatile stock market.
Every investor hopes that beleaguered stocks will come roaring back in 2009 and regain some of the ground lost since the peak in 2007 - when the S&P 500 stock index was nearly 50 percent higher than it is today. But a better indicator of economic health would be a steady recovery - without the manic swings that seem to come from every hint of undisclosed trouble at some big bank or rumor of new government intervention.

The stock market is harder to predict than most other parts of the economy, since it's deeply dependent on psychology and other intangibles. The market could bounce back by mid-summer. Or it could remain stagnant for years, like it did for most of the 1970s. The experts can't be any more sure than you or I.
[See why "Wall Street talent" is an oxymoron.]

One hopeful sign would be less market sensitivity to events in Washington. The biggest market mover these days is the federal government, since fortunes stand to be won or lost - mostly lost - depending on how deeply the government intervenes in the activities of megabanks like Citigroup and Bank of America, and how much federal spending will be available to stand in for plunging consumer spending. The markets will be back to their old selves when earnings reports, IPO announcements, and M&A deals are what send stocks up or down, and utterings from Washington amount to little more than an echo. Since the government seems to be the only institution spending money so far in 2009, it could be awhile before Wall Street returns to form.

Economic growth turns positive.
By economic standards, the current downturn has already lasted longer than the typical post-World War II recession. Yet there's still a lot more pain to endure. A recent survey of economists by the Wall Street Journal found that the majority think the economy will continue to contract for the first half of 2009, with growth turning positive in the second half of the year. That outlook is much worse than a few months ago, and even when growth turns positive the economy could sputter along without many new jobs or bold moves in the private sector.
[See why lousy unemployment numbers are no surprise.]

It's always possible that impatient consumers will get sick of holding back, and start running up their credit card balances once again (if the banks let them). The bank-rescue plan might spur more lending than expected, goosing businesses and consumers alike. Or the stimulus plan might spread goodwill and optimism throughout the land. If you get the urge to spend, that might be the strongest indicator of all. Call the economists.

http://finance.yahoo.com/news/How-To-Tell-When-The-Economys-usnews-14351762.html


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Economic Recession, Consumer Depression
Why More Saudi Oil Could Harm American Consumers
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Adam Smith: The Father Of Economics

Adam Smith: The Father Of Economics
by Lisa Smith (Contact Author Biography)


Adam Smith is often touted as the world's first free-market capitalist. While that designation is probably a bit overstated, Smith's place in history as the father of modern economics and a major proponent of laissez-faire economic policies is quite secure. Read on to learn about how this Scottish philosopher argued against mercantilism to become the father of modern free trade.


Early Life
The recorded history of Smith's life begins on June 16, 1723, at his baptism in Scotland. His birthday is undocumented. Smith attended the University of Glasgow at age 14, later transferring to Balliol College in Oxford, England. He spent years teaching and tutoring, publishing some of his lectures in "The Theory of Moral Sentiments" in 1759. The material was well received and laid the foundation for the publication of "An Inquiry Into the Nature and Causes of the Wealth of Nations" (1776), which would cement his place in history.

Invisible Hand Theory
"An Inquiry Into the Nature and Causes of the Wealth of Nations" documented the industrial and development in Europe. While critics note that Smith didn't invent many of the ideas that he wrote about, he was the first person to compile and publish them in a format designed to explain them to the average reader of the day. As a result, he is responsible for popularizing many of the ideas that underpin the school of thought that became known as classical economics. (Learn economics principles such as supply and demand, elasticity, utility and more in our tutorial, Economics Basics.)

Other economists built on Smith's work to solidify classical economic theory, which would become the dominant school of economic thoughtthrough the Great Depression. (Learn more about the causes of this global economic crisis in What Caused The Great Depression?)

Laissez-faire philosophies, such as minimizing the role of government intervention and taxation in the free markets, and the idea that an "invisible hand" guides supply and demand are among the key ideas Smith's writing is responsible for promoting. These ideas reflect the concept that each person, by looking out for him- or herself, inadvertently helps to create the best outcome for all. "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest," Smith wrote. (Read about one implementation of Smith's "invisible hand" in The Rise Of The Modern Investment Bank.)

By selling products that people want to buy, the butcher, brewer and baker hope to make money. If they are effective in meeting the needs of their customers, they will enjoy the financial rewards. While they are engaging in their enterprises for the purpose of earning money, they are also providing products that people want. Such a system, Smith argued, creates wealth not just for the butcher, brewer and baker, but for the nation as whole when that nation is populated with citizens working productively to better themselves and address their financial needs. Similarly, Smith noted that a man would invest his wealth in the enterprise most likely to help him earn the highest return for a given level of risk. (Read more in Risk And Diversification: The Risk-Reward Tradeoff.)

Published Philosophy
"The Wealth of Nations" is a massive work consisting of two volumes divided into five books. The ideas it promoted generated international attention and helped to drive the move from land-based wealth to wealth created by assembly-line production methods driven by division of labor. One example Smith cited involved the labor required to make a pin. One man undertaking the 18 steps required to complete the tasks could make but a handful of pins each week, but if the 18 tasks were completed in assembly-line fashion by 10 men, production would jump to thousands of pins per week. (Read more about this concept in What Are Economies Of Scale?)

He applied a similar logic regarding wealth generation and efficiency to British rule over the American colonies. According to his calculations, the cost of maintaining the colonies was simply not worth the return on investment. Interestingly, while much of the philosophy behind Smith's work is based on self-interest and maximizing return, his first published work, "The Theory of Moral Sentiments", was a treatise about how human communication relies on sympathy. While this may seem to be at odds with his economic views of individuals working to better themselves with no regard for the common good, the idea of an invisible hand that helps everyone through the labor of self-centered individuals offsets this seeming contradiction.

Today, the invisible hand theory is often presented in terms of a natural phenomenon that guides free markets and capitalism in the direction of efficiency, through supply and demand and competition for scarce resources, rather than as something that results in the well-being of individuals. (Read more about the evolution of our current economic system in History Of Capitalism.)

Still Relevant
The ideas that became associated with Smith not only became the foundation of the classical school of economics, but also gained him a place in history as the father of economics. His work served as the basis for other lines of inquiry into the field of economics, including ideas that built on his work and those that differed. Smith died on July 19, 1790, but the ideas he promoted live on. In 2007, the Bank of England even placed his image on the £20 note.

For further reading see, How Influential Economists Changed Our History and The History Of Economic Thought.
by Lisa Smith, (Contact Author Biography)

http://www.investopedia.com/articles/economics/08/adam-smith-economics.asp


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Giants Of Finance: John Maynard Keynes

Giants Of Finance: John Maynard Keynes
by Andrew Beattie (Contact Author Biography)


If ever there was a rock star of economics, it would be John Maynard Keynes. Keynes shares his birthday, June 5th, with Adam Smith and he was born in 1883, the year communist founder Karl Marx died. With these auspicious signs, Keynes seemed to be destined to become a powerful free market force when the world was facing a serious choice between communism or capitalism. Instead, he offered a third way, which turned the world of economics upside down. In this article, we'll examine Keynes' doctrine and its impact. (To read about Adam Smith, be sure to check out Adam Smith: The Father Of Economics.)


The Cambridge Seer
Keynes grew up in a privileged home in England. He was the son of a Cambridge economics professor and studied math at university. After two years in the civil service, Keynes joined the staff at Cambridge in 1909. He was never formally trained in economics, but over the following decades he quickly became a central figure. His fame initially grew from accurately predicting the effects of political and economic events. His first prediction was a critique of the reparation payments that were levied against the defeated Germany after WWI. Keynes rightly pointed out that having to pay out the cost of the entire war would force Germany into hyperinflation and have negative consequences all over Europe. He followed this up by predicting that a return to the prewar fixed exchange rate sought by the chancellor of the exchequer, Winston Churchill, would choke off economic growth and reduce real wages. The prewar exchange rate was overvalued in the postwar damage of 1925, and the attempt to lock it in did more damage than good. On both counts, Keynes was proved right. (For related reading, see War's Influence On Wall Street.)

A Big Miss, But a Great Rebound
Keynes was not a theoretical economist: he was an active trader in stocks and futures. He benefited hugely from the Roaring '20s and was well on his way to becoming the richest economist in history when the crash of 1929 wiped out three-quarters of his wealth. Keynes hadn't predicted this crash, and was among those who believed a negative economic event was impossible with the Federal Reserve watching over the U.S. economy. Although blindsided by the crash, the adaptable Keynes did manage to rebuild his fortune by buying up stocks in the fire sale following the crash. His contrarian investing left him with a fortune of around $30 million at his death, making him the second richest economist in history. (For more on this period in economic history, check out What Caused The Great Depression? and Crashes: The Great Depression.)

The General Theory
Many others fared far worse in the crash and the resulting depression, however, and this is where Keynes' economic contributions began. Keynes believed that free market capitalism was inherently unstable and that it needed to be reformulated both to fight off Marxism and the Great Depression. His ideas were summed up in his 1936 book, "The General Theory of Employment, Interest and Money". Among other things, Keynes claimed that classical economics - the invisible hand of Adam Smith - only applied in cases of full employment. In all other cases, his "General Theory" held sway. (Read Can Keynesian Economics Reduce Boom-Bust Cycles? to learn more.)

Inside the General Theory
Keynes' "General Theory" will forever be remembered for giving governments a central role in economics. Although ostensibly written to save capitalism from sliding into the central planning of Marxism, Keynes opened the door for government to become the principal agent in the economy. Simply put, Keynes saw deficit financing, public expenditures, taxation and consumption as more important than saving, private investment, balanced government budgets and low taxes (classical economic virtues). Keynes believed that an interventionist government could fix a depression by spending its way out and forcing its citizens to do the same, while smoothing futures cycles with various macroeconomic techniques.

Holes in the Ground
Keynes backed up his theory by adding government expenditures to the overall national output. This was controversial from the start because the government doesn't actually save or invest as business and private business do, but raises money through mandatory taxes or debt issues (that are paid back by tax revenues). Still, by adding government to the equation, Keynes showed that government spending - even digging holes and filling them in - would stimulate the economy when businesses and individual were tightening budgets. His ideas heavily influenced the New Deal and the welfare state that grew up in the postwar era. (To learn the differences between supply-side and Keynesian economics, read Understanding Supply-Side Economics.)

The War on Saving and Private Investing
Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of the people would be able to guarantee full employment and economic prosperity. Even when forced to rework his model to allow for some private investment, he argued that it wasn't as efficient as government spending because private investors would be less likely to undertake/overpay for unnecessary works in hard economic times.

Macroeconomics: Magnifying and Simplifying
It is easy to see why governments were so quick to adopt Keynesian thinking. It gave politicians unlimited funds for pet projects and deficit spending that was very useful in buying votes. Government contracts quickly became synonymous with free money for any company that landed it, regardless of whether the project was brought in on time and on budget. The problem was that Keynesian thinking made huge assumptions that weren't backed by any real world evidence. For example, Keynes assumed interest rates would be constant no matter how much or how little capital was available for private lending. This allowed him to show that savings hurt economic growth - even though empirical evidence pointed to the opposite effect. To make this more obvious, he applied a multiplier to government spending but neglected to add a similar one to private savings. Oversimplification can be a useful tool in economics, but the more simplifying assumptions are used, the less real-world application a theory will have.

The Theory Hits a Rut
Keynes died in 1946. In addition to "The General Theory", he was part of a panel that worked on the Bretton Woods Agreement and the International Monetary Fund (IMF). His theory continued to grow in popularity and caught on with the public. After his death, however, critics began attacking both the macroeconomic view and the short-term aims of Keynesian thinking. Forcing spending, they argued, might keep a worker employed for another week, but what happens after that? Eventually the money runs out and the government must print more, leading to inflation. This is exactly what happened in the stagflation of the 1970s. Stagflation was impossible within Keynes' theory, but it happened nonetheless. With government spending crowding out private investment and inflation reducing real wages, Keynes' critics gained more ears. It ultimately fell upon Milton Friedman to reverse the Keynesian formulation of capitalism and reestablish free market principles in the U.S. (Find out what factors contribute to a slowing economy, in Examining Stagflation and Stagflation, 1970s Style.)

Keynes for the Ages
Although no longer held in the esteem that it once was, Keynesian economics is far from dead. When you see consumer spending or confidence figures, you are seeing an outgrowth of Keynesian economics. The stimulus checks the U.S. government handed out to citizens in 2008 also represent the idea that consumers can buy flat-screen TVs or otherwise spend the economy out of trouble. Keynesian thinking will never completely leave the media or the government. For the media, many of the simplifications are easy to grasp and work into a short segment. For the government, the Keynesian assertion that it knows how to spend taxpayer money better than the taxpayers is a bonus. (To learn more about the stimulus checks, read How do government issued stimulus checks improve the economy?)

Conclusion
Despite these undesirable consequences, Keynes' work is useful. It helps strengthen the free market theory by opposition, as we can see in the work of Milton Friedman and the Chicago School economists that followed Keynes. Blind adherence to the gospel of Adam Smith is dangerous in its own way. The Keynesian formulation forced free market economics to become a more comprehensive theory, and the persistent and popular echoes of Keynesian thinking in every economic crisis caused free market economics to develop in response. Friedman once said, "We are all Keynesians now." But the full quote was, "In one sense we are all Keynesians now; in another, no one is a Keynesian any longer. We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions."

by Andrew Beattie, (Contact Author Biography)

Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.

http://www.investopedia.com/articles/economics/09/john-maynard-keynes-keynesian.asp?partner=basics2

The Currency Market Information Edge

The Currency Market Information Edge
by Investopedia Staff, (Investopedia.com) (Contact Author Biography)


The global foreign exchange (forex) market had an average daily turnover of $3.2 trillion as of April 2007, an increase of 69% from the previous year, according to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, conducted by the Bank for International Settlements. It is by far the largest financial market in the world, and its size and liquidity ensure that new information or news is disseminated within minutes. However, the forex market has some unique characteristics that distinguish it from other markets. These unique features may give some participants an "information edge" in some situations, resulting in new information being absorbed over a longer period. (For background reading, see the Forex Tutorial.)


Unique Characteristics of the Forex Market
Unlike stocks, which trade on a centralized exchange such as the New York Stock Exchange, currency trades are generally settled over the counter (OTC). The OTC nature of the global foreign exchange market means that rather than a single, centralized exchange (as is the case for stocks and commodities), currencies trade in a number of different geographical locations, most of which are linked to each other by state-of-the-art communications technology. OTC trading also means that at any point in time, there are likely to be a number of marginally different price quotations for a particular currency; a stock, on the other hand, only has one price quoted on an exchange at a particular instant. The global forex market is also the only financial market to be open virtually around the clock, except for weekends.

Another key distinguishing feature of the currency markets is the differing levels of price access enjoyed by market participants. This is unlike the stock and commodity markets, where all participants have access to a uniform price. (For more insight, read Basic Concepts Of The Forex Market.)

Market Participants
Currency markets have numerous participants in multiple time zones, ranging from very large banks and financial institutions at one end of the spectrum, to small retail brokers and individuals on the other. Central banks are among the largest and most influential participants in the forex market. However, on a daily basis, large commercial banks are the dominant players in the forex market, on account of their corporate customers and currency trading desks. Large corporations also account for a significant proportion of foreign exchange volume, especially companies that have substantial trade or capital flows. Investment managers and hedge funds are also major participants.

Differing Prices
Banks' currency trading desks trade in the interbank market, which is characterized by large deal size, huge volumes and tight bid/ask spreads. These currency trading desks take foreign exchange positions either to cover commercial demand (for example, if a large customer needs a currency such as the euro to pay for a sizable import), or for speculative purposes. Large commercial customers get prices from these banks that have a markup embedded in them; the markup or margin depends on the size of the customer and the size of the forex transaction.

Retail customers who need foreign currency have to contend with bid/ask spreads that are much wider than those in the interbank market. (For more insight, see The Foreign Exchange Interbank Market.)

Speculative Positions Vs. Commercial Transactions
In the global foreign exchange market, speculative positions outnumber commercial foreign exchange transactions, which arise due to trade or capital flows, by a huge margin, although the exact extent is difficult to quantify. This makes the forex market very sensitive to new information, since an unexpected development will cause speculators to reassess their original trades and cause them to adjust these trades to reflect the new information.

For example, if a company has to remit a payment to a foreign supplier, it has a finite window in which to do so. The company may try to time the purchase of the currency so as to obtain a favorable rate, or it may use a hedging strategy to cover its exchange risk; however, the transaction has to occur by a definite date, regardless of conditions in the foreign exchange market.

On the other hand, a trader with a speculative currency position seeks to maximize his or her trading profit or minimize loss at all times; as such, the trader can choose to retain the position or close it at any point. In the event of new information, the adjustment process for such speculative positions is likely to be almost instantaneous. The proliferation of instant communications technology has caused reaction times to shorten dramatically in all financial markets, not just in the forex market.

However, this "knee jerk" reaction is generally followed by a more gradual adjustment process as market participants digest the new information and analyze it in greater depth.

Information Edge
While there are numerous factors that affect exchange rates, from economic and political variables to supply/demand fundamentals and capital market conditions, the hierarchical structure of the forex market gives the biggest players a slight information edge over the smallest ones.

In some situations, therefore, exchange rates take a little longer to adjust to new information. For example, consider a case where the central bank of a major nation with a widely-traded currency decides to support it in the foreign exchange markets, a process known as "intervention." If this intervention is unexpected and covert, the major banks from which the central banks buy the currency have an information edge over other participants, because they know the identity and the intention of the buyer. Other participants, especially those with short positions in the currency, may be taken by surprise to see the currency suddenly strengthen. While they may or may not cover their short positions right away, the fact that the central bank is now intervening to support the currency may cause these participants to reassess the viability and implications of their short strategy. (For more on interventions, see Profiting From Interventions In Forex Markets.)

Example – Forex Market Reaction to News
All financial markets react strongly to unexpected news or developments, and the foreign exchange market is no exception. Consider a situation in which the U.S. economy is weakening, and there is widespread expectation that the Federal Reserve will reduce the benchmark federal funds rate by 25 basis points (0.25%) at its next meeting. Currency exchange rates will factor in this rate reduction in the period leading up to the expected policy announcement. However, if the Federal Reserve decides at its meeting to leave rates unchanged, the U.S. dollar will in all likelihood react dramatically to this unexpected development. If the Federal Reserve implies in its policy announcement that the U.S. economy's prospects are improving, the U.S. dollar may also strengthen against major currencies. (For a related strategy, see Using Interest Rate Parity To Trade Forex.)

Conclusion
While the massive size and liquidity of the foreign exchange market ensures that new information or news is generally absorbed within minutes, its unique features may result in new information being absorbed over a longer period in some situations.

In addition, the hierarchical structure of the forex market can give the biggest players a slight information edge.

by Investopedia Staff, (Contact Author Biography)
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.

http://www.investopedia.com/articles/forex/09/forex-information-currency-market.asp?partner=basics2

Stashing Your Cash: Mattress Or Market?

Stashing Your Cash: Mattress Or Market?
by Lisa Smith (Contact Author Biography)


When stock markets become volatile, it makes investors nervous. In many cases, this prompts them to take money out of the market and keep it in cash. Cash can be seen, felt and spent at will and for most people, having money in hand feels safe. But how safe is it really? Read on to find out whether your money is safer in the market or under your mattress.


All Hail Cash?
There are definitely some benefits to holding cash. When the stock market is in free fall, holding cash helps you avoid further losses. Even if the stock market doesn't fall on a particular day, there is always the potential that it could have fallen. This possibility is known as systematic risk, and it can be completely avoided by holding cash.

Cash is also psychologically soothing. During troubled times, you can see and touch cash. Unlike the rapidly dwindling balance in your brokerage account, cash will still be in your pocket or in your bank account in the morning.

However, while moving to cash might feel good mentally and help you avoid short-term stock market volatility, it is unlikely to be a wise move over the long term.

A Loss In Not a Loss ...
When your money is in the stock market and the market is down, you may feel like you've lost money, but you really haven't. At this point, it's a paper loss. A turnaround in the market can put you right back to breakeven and maybe even put a profit in your pocket. If you sell your holdings and move to cash, you lock in your losses. They go from being paper losses to being real losses with no hope of recovery. While paper losses don't feel good, long-term investors accept that the stock market rises and falls. Maintaining your positions when the market is down is the only way that your portfolio will have a chance to benefit when the market rebounds. (For more insight, see How are realized profits different from unrealized, or so-called "paper", profits?)

Inflation: The Cash Killer
While having cash in your hand seems like a great way to stem your losses, cash is no defense against inflation. You think your money is safe when it's in cash, but over time, its value erodes. (Coping With Inflation Risk explains how inflation is less dramatic than a crash, but can be more devastating to your portfolio.)

Opportunity Costs Add Up
Opportunity cost is the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, opportunity cost refers to the benefits you could have received by taking an alternative action. In the case of cash, taking your money out of the stock market requires that you compare the growth of your cash portfolio, which will be negative over the long term as inflation erodes your purchasing power, against the potential gains in the stock market. Historically, the stock market has generally been the better bet.

Time Is Money
When you sell your stocks and put your money in cash, odds are that you will eventually reinvest in the stock market. The question then becomes, when you should make this move. Trying to choose the right times to get in and out of the stock market is referred to as market timing. If you were unable to successfully predict the market's peak and sell, it is highly unlikely that you'll be any better at predicting its bottom and buying in just before it rises. (This strategy is popular, but can few do it successfully, read Market Timing Fails As A Money Maker for tips.)

Common Sense Is King
Common sense may be the best argument against moving to cash, and selling your stocks after the market tanks means that you bought high and are selling low. That would be the exact opposite of a good investing strategy. While your instincts may be telling you to save what you have left, your instincts are in direct opposition with the most basic tenet of investing. The time to sell was back when your investments were in the black - not when you are deep in the red. (To learn more, read To Sell Or Not To Sell.)

Buy and Hold on Tight
You were happy to buy when the price was high because you expected it to go higher. Now that it is low, you expect it fall forever. Look at the markets over time. They have historically gone up. Companies are in business to make money. They have a vested interest in profitability. Investing in equities should be a long-term endeavor, and the long term favors those who stay invested. (My comment: Totally in agreement.) (For additional reading, check out Long-Term Investing: Hot Or Not?)

Nerve Wracking, but Necessary
Serious investors understand that the markets are no place for the faint of heart. Of course, with private pension plans disappearing and the future of Social Security in question, many of us have no other choice. (Be sure to read, The Demise Of The Defined-Benefit Plan, which provides a closer look at this situation.)

Once you've faced the facts, you need to have a plan.

1. Figure out how much money you need to amass to meet your future needs, and develop a plan to help your portfolio get there.
2. Find an asset allocation strategy that meets your needs.
3. Monitor your investments.
4. Rebalance your portfolio to correspond with market conditions, making sure to maintain your desired mix of investments.
5. When you reach your goal, move assets out of equities and into less volatile investments.

While the process can be nerve-wracking, approaching it strategically can help you keep your savings plan on track, despite market volatility.
by Lisa Smith, (Contact Author Biography)

Investing During Uncertainty

Investing During Uncertainty
by Investopedia Staff, (Investopedia.com) (Contact Author Biography)


Every day it seems like the world is getting smaller. If you watch any financial television station or read the newspaper, you are most likely aware of how events in one country seem to have an ever-increasing affect on other countries around the world. We are more interconnected now than at any other time in history. It goes without mention that globalization definitely has its positives, but when threats of financial crisis, war, global recession, trade imbalances, etc, do occur it often leads to talk of moving money to safer investments and increasing government deficits. This rising uncertainty can confuse even the well-informed investor.


Uncertainty
Any time you put money at risk for the chance of profit there is an inherent level of uncertainty. When new threats such as war or recession arise, the level of uncertainty increases significantly as companies can no longer accurately predict their future earnings. As a result, institutional investors will reduce their holdings in stocks considered unsafe and move the funds to other sources like precious metals, government bonds and money-market instruments. This sell-off, which occurs as large portfolios reposition themselves, can cause the stock market to depreciate.

Effects of Uncertainty
Uncertainty is the inability to forecast future events; people can't predict the extent of a possible recession, when it's going to start/end, how much it will cost, or what companies will be able to make it through unscathed. Most companies normally predict sales and production trends for the investing public to follow assuming normal market conditions, but increasing levels of uncertainty can make these numbers significantly inaccurate. (For more, see Recession: What Does It Mean To Investors.)

Uncertainty itself can affect the economy on both the micro and macro level; a description of uncertainty on a micro level focuses on the effect on individual companies within an economy faced with the threat of war or recession, whereas the view of uncertainty on a macro level looks at the economy as a whole (To learn more, see Economics Basics.):

From a company-specific point of view, uncertainty provides a major concern for those that produce consumer goods every day. For example, consumption may fall on the threat of a recession as individuals refrain from purchasing new cars, computers and other non-essentials. This uncertainty may force the companies in certain sectors to layoff some of its employees so that it can combat the impacts of lower sales. The level of uncertainty that surrounds a company's sales also extends into the stock market. Consequently, stock prices of companies that produce non-essential goods sometimes experience a selloff when levels of uncertainty rise. (For more, see The Impact Of Recession On Businesses.)

On a macro level, uncertainty is magnified if the countries at war are major suppliers or consumers of goods. A good example is a country that supplies a large portion of the world's oil. Should this country go to war, uncertainty regarding the level of the world's oil reserves would grow. Because the demand for oil would be high and the supply uncertain, a country unable to produce enough oil within its own borders would be required to ensure that enough oil was stored to cover operations. As a result, the price of oil would increase.

Another macro-level event that affects companies and investors is the flight of capital and devaluation of exchange rates. When a country faces the threat of war or recession, its economy is considered uncertain. Investors attempt to move their currency away from unstable sources to stable ones; the currency of a country under a threat of war is sold and the currencies from countries without the threat are bought. The average investor probably would not do this; however, the large institutional investors and currency futures traders would. These actions translate into a devaluation of exchange rates.

What's an Investor to Do?
When situations of heightened uncertainty arise, the best defense is to be as well informed as possible. Keep updated by reading the newspaper and researching individual companies. Analyze which sectors have more to gain and lose with a war and decide on a long-term plan. Times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it. Some investors might decide to be offensive and search for companies that provide goods or services that will lead to great returns when things turn around. It is difficult to commit capital during uncertain times, but it can often reap huge rewards in the longer run. Those who want to mitigate uncertainty and risk might be content leaving their money where it is or perhaps moving it to safer securities. Regardless of which strategy you decide to take (if any), you can't go wrong over the long term by keeping yourself well informed and getting into a position so that you can take advantage of prices when the things reverse.

For further reading, see Intro To Fundamental Analysis.
by Investopedia Staff, (Contact Author Biography)Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.

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