Classic Finance

Classic finance, also known as traditional finance, operates on a set of established principles rooted in rational economic behavior and market efficiency. It provides the bedrock for understanding how investment decisions are made and how assets are priced.

At its core lies the Efficient Market Hypothesis (EMH). This theory posits that market prices fully reflect all available information. There are three forms: weak (historical price data is already reflected), semi-strong (all public information is reflected), and strong (all information, public and private, is reflected). While debated, the EMH suggests it's difficult to consistently "beat the market" without insider information. Passive investment strategies, like index funds, often align with this view.

Risk and Return are fundamental concepts. Classic finance dictates a direct relationship: higher potential returns demand higher risk. This is often quantified using metrics like beta (measuring volatility relative to the market) and standard deviation (measuring overall price fluctuation). Investors are expected to be risk-averse, requiring compensation for bearing additional risk. The Capital Asset Pricing Model (CAPM) is a cornerstone model that calculates the expected return on an asset based on its beta, the risk-free rate of return, and the market risk premium.

Valuation is crucial for determining the intrinsic worth of an asset. Discounted cash flow (DCF) analysis is a prominent valuation method. It projects future cash flows expected from an investment and discounts them back to their present value using an appropriate discount rate. This allows investors to compare the present value to the current market price and determine if the asset is overvalued or undervalued. Other valuation techniques include relative valuation, comparing a company's metrics (e.g., price-to-earnings ratio) to those of its peers.

Portfolio Management focuses on constructing diversified portfolios to optimize risk-adjusted returns. Modern Portfolio Theory (MPT), developed by Harry Markowitz, emphasizes the importance of diversification to reduce unsystematic risk (company-specific risk). By combining assets with low or negative correlations, investors can achieve a portfolio with a higher expected return for a given level of risk, or a lower risk for a given level of return. The efficient frontier, a key concept in MPT, represents the set of portfolios that offer the highest expected return for each level of risk.

Corporate Finance principles guide companies in making financial decisions that maximize shareholder value. These decisions include capital budgeting (deciding which investment projects to undertake), capital structure (determining the optimal mix of debt and equity financing), and dividend policy (deciding how much of the company's earnings to distribute to shareholders). Free cash flow (FCF) is a critical metric used to assess a company's financial health and its ability to generate cash for investors.

While classic finance provides a solid framework, it's important to acknowledge its limitations. Behavioral finance, for example, recognizes that investors are not always rational and can be influenced by emotions and cognitive biases. This can lead to market inefficiencies and deviations from the predictions of classic finance models. Nevertheless, understanding the core principles of classic finance remains essential for anyone involved in investment or financial decision-making.