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, blocking out the investments that are performing poorly. High self-rating goes hand-in-hand with overconfidence, which reflects 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 by researcher Terrance 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.
History of Finance
Finance, as a study of theory and practice distinct from the field of economics, arose in the 1940s and 1950s with the works of Harry Markowitz, William F. Sharpe, Fischer Black, and Myron Scholes, to name just a few.123 Particular realms of finance—such as banking, lending, and investing, of course, money itself—have been around since the dawn of civilization in some form or another.
The financial transactions of the early Sumerians were formalized in the Babylonian Code of Hammurabi (circa 1800 BCE). This set of rules regulated ownership or rental of land, employment of agricultural labor, and credit.4 Yes, there were loans back then, and yes, interest was charged on them—rates varied depending on whether you were borrowing grain or silver.
By 1200 BCE, cowrie shells were used as a form of money in China. Coined money was introduced in the first millennium BCE. King Croesus of Lydia (now Turkey) was one of the first to strike and circulate gold coins around 564 BCE—hence the expression, “rich as Croesus.”5
In ancient Rome, coins were stored in the basement of temples as priests or temple workers were considered the most honest, devout, and safest to safeguard assets. Temples also loaned money, acting as financial centers of major cities.6
Early Stocks, Bonds, and Options
Belgium claims to be home to the first exchange, with an exchange in Antwerp dating back to 1531.7 During the 16th century, the East India Company became the first publicly-traded company as it issued stock and paid dividends on proceeds from its voyages.8 The London Stock Exchange was created in 1773 and was followed by the New York Stock Exchange less than 20 years later.910
The earliest recorded bond dates back to 2400 BCE, as a stone tablet that recorded debt obligations that guaranteed repayment of grain.11 During the Middle Ages, governments began issuing debts to fund war efforts. In the 17th century, the Bank of England was created to finance the British Navy.12 The United States also began issuing Treasury bonds to support the Revolutionary War.13
Options contracts can be found dating back to the Bible. In Genesis 29, Laban offers Jacob the option to marry his daughter in exchange for seven years of labor. However, this example demonstrates the difficulty of preserving obligations, as Laban reneged on the agreement after Jacob’s labor was complete.14
In Aristotle’s 4th-century philosophical work Politics, the early practice of options is outlined through an anecdote by the philosopher Thales. Believing a great future harvest of olives in the coming year, Thales pre-emptively acquired the rights to all olive presses in Chios and Miletus.15 Regarding options on an exchange, both forward and options contracts were integrated into Amsterdam’s sophisticated clearing process by the mid-17th century.16
Advances in Accounting
Compound interest—interest calculated not just on principal but on previously accrued interest—was known to ancient civilizations (the Babylonians had a phrase for “interest on interest,” which basically defines the concept). But it was not until medieval times that mathematicians started to analyze it in order to show how invested sums could mount up: One of the earliest and most important sources is the arithmetical manuscript written in 1202 by Leonardo Fibonacci of Pisa, known as Liber Abaci, which gives examples comparing compound and simple interest.
The first comprehensive treatise on book-keeping and accountancy, Luca Pacioli’s Summa de arithmetica, geometria, proportioni et proportionalita, was published in Venice in 1494.17 A book on accountancy and arithmetic written by William Colson appeared in 1612, containing the earliest tables of compound interest written in English. A year later, Richard Witt published his Arithmeticall Questions in London in 1613, and compound interest was thoroughly accepted.
Towards the end of the 17th century, in England and the Netherlands, interest calculations were combined with age-dependent survival rates to create the first life annuities.
Types of 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.18 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 deposit (CDs); they may also buy other companies in an effort to boost revenue.