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Showing posts with label Finance. Show all posts
Showing posts with label Finance. Show all posts
Meaningful Metrics
The Return-on-Investment of Search Engine Optimization
(updated 2021)
Search Engine Optimization (“SEO”)
SEO encompasses all facets of making a website or a brand visible and readily accessible to the consumer through unpaid search engine tactics. A website’s SEO components may include the following:
• Metadata
• Strategic Keywords
• Internal Links
• Reputable Outbound Links
• Inbound Links
• Anchor Text
• Site Map
• Content Structure
• Load Time
• Comment Management
• Paid Advertisement Links
• Web Crawler Management
Branding SEO components may include the following:
• A Facebook status update that connects the consumer to a product promotion page
• A tweet that connects followers to a new blog post
• A LinkedIn post that connects job seekers to a career site
• A LinkedIn post that connects job seekers to a career site
This communication type appears in search results independent of the originating social network.1
Additionally, search results are also impacted by the number of shares and the amount of traffic generated, so it would be remiss not to include these results as a part of the SEO landscape.
”Acquiring new customers is important; but maintaining current loyal customers is arguably even more important: It costs less to market to and to maintain loyal customers, a 5% increase in retention increases profits by at least 25%, and loyal customers contribute up to ten times more to the bottom line than irregular customers.”
- Lifetime Value of a Customer
Return on Investment (“ROI”)
Whether you hire a professional or assign an internal resource, it’s easier to gain buy-in from stakeholders when the added monetary value can be conveyed.
If you are a non-web based business, with only occasional SEO needs, the choice between outsourcing and developing the talent internally, may be fairly easy decision. In the long-run, it will cost less to outsource and get occasional maintenance, than to pay a salaried specialist. Also, the cost to implement would be so nominal, you probably would not concern yourself with the nuances of deriving an estimate of the expected profit generated by SEO, versus the expected future cost for SEO. But, if you're a web dependent business, the choice to outsource versus develop talent, is not as evident. You'll need SEO updates as industry changes, and you'll want to know what to expect, and how to determine the value of the SEO efforts. In addition, if you are product based business with frequent website updates, you will want more regular monitoring to ensure that SEO settings remain optimal.
Fortunately, ROI is a measure that explicitly captures a project’s value. It's flexible enough to use as an initial indicator of value, as well as for ongoing analysis. ROI will also provide a basis for comparing the value of several projects, such as the expected benefits of implementation compared to the cost to outsource and the cost to develop in-house talent.
SEO-ROI METRICS
There are four key areas to assessing the ROI of SEO, no matter who executes the technical or branding SEO efforts:
• Pagerank is the value that search engine algorithms assign to your webpages. Monitor ranking by site, page, or link and see if you hit your target, e.g. top 10 search results.
• Traffic patterns can be monitored by referring site as well as geographic location. For branding and promotional efforts, the success of a specific link should be monitored concerning the volume of visits generated, which triggers consideration of link/site popularity.
• Keyword searches should be performed regularly for the top five keywords. Monitor the results and note the changes in position, positive or negative, for each keyword. Furthermore, track the search terms used by visitors. Note which are used most and note the trends for favored keywords that diverge from your organization’s current top five.
• Bounce Rate: Always scrub against the bounce rate data. It will help to determine if a chosen keyword association is detracting from SEO-ROI. It will also help to pinpoint the degree of effectiveness of traffic generated by branding and promotional links.
Monitoring performance is never an easy task, and is subject to the organization’s structure, goals, tactics, budget, etc. However, the exercise is well worth the headache. Establishing value puts the organization on the right track and helps to get the needed stakeholder buy-in.
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1. "Although this has not traditionally been considered a part of the SEO landscape."
This text was removed, because eight years later, this is commonly considered for SEO. A long time ago, I was ahead of the curve on this stuff!
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Capital Budgeting Across Business Units
(updated 2021)
To gain perspective on the choices of a large corporation, their budgeting process, and how (or if) they manage to avoid various measurement pitfalls, an interview was completed with the Facilities Manager of one Strategic Business Unit (SBU) of a Fortune 500 Corporation.
The Interview
His Capital Budgeting responsibility begins with a presentation of the site's needs assessment and a “wish list.” His responsibility terminates with the actual conclusion of the various projects’ execution. At this level, the Capital Budget is split into two categories, Major Capital Projects and Local Capital Budgeting.
Major Capital projects (over .5 million) are decided as a SBU. Individual sites compete with one another for funding of these projects and the decision criteria for funding are 1) business needs and 2) Return on Investment.
For Local Capital Budgeting, each site receives funding for improvements based on a certain percentage of the site’s value. Individual projects are prioritized by the greatest need. These projects are further broken down into two more categories, Infrastructure and Process Improvement. An infrastructure project includes safety, environmental, capital replacements, and energy saving projects while process improvements are primarily cost reductions. Infrastructure projects may take precedence over Process Improvement if it is a question of compliance.
Net Present Value (NPV) analysis is performed, and the Internal Rate of Return (IRR) is also examined.
Observations
In analyzing Company X’s methodologies, there are four areas we found of particular interest:
- The use of a hierarchy in the decision-making for projects over .5 million.
- The competitive element of the decision-making process.
- The use of a percentage of site value as a determinant for the Local Capital Budget.
- The use of the NPV method in conjunction with IRR for judgment of project attractiveness.
By utilizing a percentage of site value as a factor for Local Capital Budgeting it would seem that older sites are at a disadvantage, thereby leading to less funding. For infrastructure purposes in particular, an older site may require the most funding. The following clarification was provided:
“The factor that’s used is ERV (estimated replacement value)”. That levels the playing field in that it allows each site to get about the same percentage based on what it would cost to replace the site in total, in today’s dollars, with today’s technology. It’s not a good practical measuring stick as much as it is a good comparison tool. Being a financial tool and not an engineering or construction value measuring tool, the actual value of a site would be much more than what is provided using ERV. Older sites that have not kept up with year-to-year infrastructure needs are at a disadvantage. That’s why from day one of a facility’s existence it is important to plan for and to initiate modernization and renewal activities.”
From this statement it is interesting to note that although the use of ERV fulfills the need to provide an equitable financial measure, from the perspective of the Facilities Manager the tool does not provide an accurate measure of site value.
Like many organizations, Company X recognizes that NPV analysis provides an unbiased way to evaluate projects by taking into account both the time value of money and the opportunity cost of capital. By discounting anticipated cash flows at an appropriate hurdle rate, the site can objectively consider multiple projects side-by-side. This is especially important for mutually exclusive investments where the site must choose between competing projects.
With NPV as the key driver for project acceptability it is a constructive methodology to utilize IRR after NPV analysis. Although IRR can be misleading in the evaluation of mutually exclusive projects, it provides the percentage return on each dollar invested in a project. Employing IRR in this manner, giving it secondary consideration, avoids the associated problems and adds value to the decision- making process.
”Although the statement, “the psychology of financial matters,” will feel like an oxymoron, it’s actually a fairly accurate reflection of reality. At first assumption, finance seems as if it should be an objective and logical science. But, derivatives of mathematics do not necessarily retain all of the same characteristics as the parent. Like most derivatives, the ultimate behavior is inextricably tied to human behaviors.”
- Psychology of Finance
Conclusion
Categorically splitting the Capital Budget and utilizing a hierarchy in the decision-making for Major Capital Projects is a sound method for ensuring reduction in agency costs. The competitive element of the process further enforces diminished agency costs. Utilizing ERV as a determinant for the Local Capital Budget is a useful financial tool that ensures all sites receive equal valuation. However, it is not necessarily an adequate method for deciding actual project implementation. The use of NPV in conjunction with IRR is an appropriate method. NPV allows the site to determine in absolute terms the value in today’s dollars of a given project. By utilizing IRR on a project-by-project basis and not as a comparison tool across projects, common pitfalls are avoided and the greatest benefit is attained.
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The Undeniable Inextricability of the Entrepreneurial Spirit
(updated 2021)
Although the Small Business Act was passed in 1953 as a means of leveling the playing field for returning veterans, and the shift from war production to familial focus, the wing span of the SBA continues to change with our economic requirements. This is evidenced by our continued reliance on the small business for ingenuity, growth, and development, beyond the baseline competition.
Too Important to Ignore
The need to nurture the entrepreneurial spirit does not qualify as “too big to fail,” but it's obviously “too important to ignore.” During the COVID-19 pandemic, the government certainly recognized this, and sent the SBA to the front lines of Main Street with the Paycheck Protection Program to keep the economy afloat.
The SBA found that across the 16 years from 1998 to 2014, the small business share of GDP fell from 48.0 percent to 43.5 percent. Over the same period, the amount of small business GDP has grown by about 1.4 annually, while GDP for large businesses has grown faster, at 2.5 percent annually.1
There's no solid conclusions yet concerning the driver of the decline; but I'm sure the driver is multi-faceted, with the availability of capital to startup and to grow playing a small role.
”Integrity is one of those things that make our country desirable. In a free world, you worship as you please and move about at will; however, there are ground rules: we have morals and they are upheld. Without the promise to uphold our agreed upon morals society disintegrates into barbarism.”
- They Underestimate Integrity
There's no solid conclusions yet concerning the driver of the decline; but I'm sure the driver is multi-faceted, with the availability of capital to startup and to grow playing a small role.
Traditionally, workers at large corporations were expected to fit a mold. But we are indeed human - complex one-of-a-kind originals. Trying to fit us all into a few specific molds simply makes for an oppressed and unfulfilled workforce. In recent years, large corporations made changes to recognize individuality and to make room for creativity, so that they could retain their highly specialized talent. This may also be a factor in the decline in small business GDP share.
However, I doubt that it's a primary driver, as seasoned workers are choosing entrepreneurship over Corporate America. Generation X has opted for fulltime entrepreneurship, and Baby Boomers are choosing early retirement from Corporate America in pursuit of their entrepreneurial happiness.2
Recognizing the Happiness Quotient
Economic development refers to the enhancement of our productive capacity. It can be defined as the concerted actions of policymakers and communities to promote the standard of living and economic health. Economic development can also be considered as the quantitative and qualitative changes in the economy. As our old economic models become obsolete, or undergo revision due to their proven irrelevance, I think it’s time for us to develop new lines of thought, to observe new insightful correlations and interactions, and to incorporate what we may not have ever considered previously. We can't have an accurate measure of economic development without consideration of societal developments, including changes in attitudes, values, and expectations. It may be “fuzzy logic,” but our pursuit of happiness may in fact be a stronger driver than previously recognized.
Economic development refers to the enhancement of our productive capacity. It can be defined as the concerted actions of policymakers and communities to promote the standard of living and economic health. Economic development can also be considered as the quantitative and qualitative changes in the economy. As our old economic models become obsolete, or undergo revision due to their proven irrelevance, I think it’s time for us to develop new lines of thought, to observe new insightful correlations and interactions, and to incorporate what we may not have ever considered previously. We can't have an accurate measure of economic development without consideration of societal developments, including changes in attitudes, values, and expectations. It may be “fuzzy logic,” but our pursuit of happiness may in fact be a stronger driver than previously recognized.
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1 Small Business Administration: Small Business GDP 1998-2014
2 Kauffman Foundation: The Kauffman Index Startup Activity National Trends
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The Economic Evolution of Our Future Selves
(updated 2021)
All About Quality
Concepts such as the International Standardization and Six Sigma are taught to executives globally, and are well established as standards by which we work; improving upon predecessor concepts of Total Quality Management and Just-in-Time quality and delivery systems. Labor Unions have screamed about this for years – jobs leaving the US. But, it’s a catch 22. Americans simply will not work for the pennies on the dollar paid to foreign laborers. Given little other choice, Americans have become more highly educated and apply their skills to the ever growing services based economy.
The impact of this change is two-fold, ramping down physical labor intensity and ramping up brain power. Intensive thought processes and collaborative efforts to innovate and streamline mundane processes enable us to focus on more theoretical nuances, and should eventually evolve us into a better quality of life.
No Man Left Behind
As Big Brother obtains the latest and greatest technology to enhance the quality of life for his residents, he passes back the baton of older technology; now affordable by the advent of newer technology. Now, underdeveloped siblings can also continue their quest for an improved quality of life. Thus we witness the advancement of not one country or one people, but of the entire human race.
Our Future Selves
Demand for innovation requires that we not just learn, but that we actively apply our knowledge. We’ve adapted to the information age where knowledge is power and the “power” is more widely distributed via electronic means. Fewer are factory workers, working long hours on their feet, under poor conditions; and more sit at a desk, in a cubicle, at a laboratory, etc. and ideate solutions to problems. We organize information, we analyze data, we assess, we draw conclusions, we tweak processes, and we offer perspective. We evolve.
Concepts such as the International Standardization and Six Sigma are taught to executives globally, and are well established as standards by which we work; improving upon predecessor concepts of Total Quality Management and Just-in-Time quality and delivery systems. Labor Unions have screamed about this for years – jobs leaving the US. But, it’s a catch 22. Americans simply will not work for the pennies on the dollar paid to foreign laborers. Given little other choice, Americans have become more highly educated and apply their skills to the ever growing services based economy.
The impact of this change is two-fold, ramping down physical labor intensity and ramping up brain power. Intensive thought processes and collaborative efforts to innovate and streamline mundane processes enable us to focus on more theoretical nuances, and should eventually evolve us into a better quality of life.
No Man Left Behind
As Big Brother obtains the latest and greatest technology to enhance the quality of life for his residents, he passes back the baton of older technology; now affordable by the advent of newer technology. Now, underdeveloped siblings can also continue their quest for an improved quality of life. Thus we witness the advancement of not one country or one people, but of the entire human race.
”Since humans created the economic and financial systems, it should be no surprise that psychology plays a significant role.”
- The Psychology of Finance
Our Future Selves
Demand for innovation requires that we not just learn, but that we actively apply our knowledge. We’ve adapted to the information age where knowledge is power and the “power” is more widely distributed via electronic means. Fewer are factory workers, working long hours on their feet, under poor conditions; and more sit at a desk, in a cubicle, at a laboratory, etc. and ideate solutions to problems. We organize information, we analyze data, we assess, we draw conclusions, we tweak processes, and we offer perspective. We evolve.
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1 Bloomberg: Is Nike's Flyknit the Swoosh of the Future?
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They Underestimate Integrity
(updated 2020)
Crisis and The Lack of Integrity
The 2008 financial crisis was most unusual in that markets that were previously thought to be stable, crashed for the first time. Also, a fully interdependent global economy meant an extensive global impact. This was perhaps the most embarrassing crisis in recent history as executive after executive revealed a lack of standards, a lack of morals, a lack of forethought, a lack of competence, or a lack of concern as one of the major reasons for the role that they or their company played in the system failure.
Integrity is one of those things that make our country desirable. In a free world, you worship as you please and move about at will; but there are ground rules: we have morals and they are upheld.
Without the promise to uphold our agreed upon morals, society disintegrates into barbarism. So we found a pattern of loopholes that were exploited as opposed to closed or avoided:
Without the promise to uphold our agreed upon morals, society disintegrates into barbarism. So we found a pattern of loopholes that were exploited as opposed to closed or avoided:
- The highly-regulated banking industry agrees not to misinform the public and to deal fairly when lending; so the non-regulated mortgage brokers did the dirty work, mis-informed borrowers, lent beyond the borrower’s repayment capacity, and created unsound mortgages. What happened to the promise?
- Let’s not forget the derivatives brokers who had not taken responsibility to consider nor monitor the risks of each underlying instrument and the potential interactive risks created by a derivative instrument. Where was the standard to be upheld?
Culture and Integrity
Despite our differences, as a consumer we generally agree that we want a fair representation of the politician, the product, the service, or the system that we are buying into. It is our right-to-know and we are given the option to say no. If we expect this in our personal lives, why does this not necessarily translate to our work lives? The moral is: do unto others as you wish done unto you. Religion is an option; moral behavior is not.
As Greg Smith, former employee of Goldman Sachs explained:
“It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization.”
Somewhere along the line integrity was lost. For a civilized culture to persist integrity must be sustained.
As Greg Smith, former employee of Goldman Sachs explained:
“It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization.”
Somewhere along the line integrity was lost. For a civilized culture to persist integrity must be sustained.
”The negative energy of one individual’s interpretation of the solution can be the driver of negative results. Likewise, the positive actions of one optimistic person can drive positive results.”
- Five Actions for Success
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ROE: No Banks Allowed
(updated 2021)
The Evils
According to Mr. Jenkins, the use of ROE encouraged banks to maintain equity low and leverage high, which destabilizes the banking system. Although ROE is a measure shareholders are trained to monitor, it is meaningless for year over year performance comparison. When ROE is measured and monitored, the true test is for long-term
value. Therefore, the value in assessing the institution’s performance in relation to a ROE target does not exist prior to ~15 years. Unfortunately, institutions often misuse this measure and manipulate results to gain misguided shareholder buy-in.
BASEL III
Robert Jenkins believed that the right targets should be established to encourage maintenance of elevated levels of equity. His cause is helped by the research and development of new rules made effective by Basel III.2
Previously, financial institutions were required to measure the risk to capital; however, the system was not comprehensive. As we discovered during the 2008 financial crisis, the mortgage brokers that originated and sold bad assets to the banks were unregulated, and the rating agencies really had no way of identifying and rating the characteristics of complex mortgage derivatives. This disconnect created significant inaccuracies in the risk weighting of assets, leaving banks blind to the true level of risk on their balance sheets.
According to Mr. Jenkins, the use of ROE encouraged banks to maintain equity low and leverage high, which destabilizes the banking system. Although ROE is a measure shareholders are trained to monitor, it is meaningless for year over year performance comparison. When ROE is measured and monitored, the true test is for long-term
value. Therefore, the value in assessing the institution’s performance in relation to a ROE target does not exist prior to ~15 years. Unfortunately, institutions often misuse this measure and manipulate results to gain misguided shareholder buy-in.
BASEL III
Robert Jenkins believed that the right targets should be established to encourage maintenance of elevated levels of equity. His cause is helped by the research and development of new rules made effective by Basel III.2
Previously, financial institutions were required to measure the risk to capital; however, the system was not comprehensive. As we discovered during the 2008 financial crisis, the mortgage brokers that originated and sold bad assets to the banks were unregulated, and the rating agencies really had no way of identifying and rating the characteristics of complex mortgage derivatives. This disconnect created significant inaccuracies in the risk weighting of assets, leaving banks blind to the true level of risk on their balance sheets.
For a system to be effective, the right hand must know what the left hand is doing, and the same definitions must be used to create a common understanding. With Basel III the financial system is recognized as a system, so that systemic risks can be appropriately and sufficiently identified, measured, monitored, and controlled.
An Alternative
Mr. Jenkins further discussed the plausibility of a Return on Risk Weighted Assets (RORWA). Although RWA is utilized in capital calculations, (e.g. total risk adjusted capital to RWA), RORWA is a new concept, in considering profitability in relation to risk adjusted assets. I like the concept. It's a painless yet significant change; it works to shift the executive mindset, so that adjustments for risk become inherent in the business process; and as management utilizes a risk adjusted short-term measure, projections should converge toward the mean, becoming more reasonable and reliable.
”Since humans created the economic and financial systems, it should be no surprise that psychology plays a significant role.”
- The Psychology of Finance
An Alternative
Mr. Jenkins further discussed the plausibility of a Return on Risk Weighted Assets (RORWA). Although RWA is utilized in capital calculations, (e.g. total risk adjusted capital to RWA), RORWA is a new concept, in considering profitability in relation to risk adjusted assets. I like the concept. It's a painless yet significant change; it works to shift the executive mindset, so that adjustments for risk become inherent in the business process; and as management utilizes a risk adjusted short-term measure, projections should converge toward the mean, becoming more reasonable and reliable.
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1 CFA Institute: The Wrong Performance Measure for Banks
2 Basel Committee on Banking Supervision: BASEL III
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The Psychology of Finance
(updated 2020)
We may rule the world, but we are still vulnerable to nature, each other, and unknowns. We’re more optimistic when we are secure and confident in knowing what comes next in our story. We’re arguably much more pessimistic when we cannot be certain as to how our story ends. And when there are threats, and the magnitude of the impact from those threats cannot be known, fear will persist.
Banking
On October 14, 2008, the Treasury implemented the Troubled Assets Relief Program (TARP), which infused cash into institutions by purchasing illiquid assets, and the Capital Purchase Program, a subprogram, that provided a capital injection by way of the purchase of preferred stock.1,2 These efforts were intended to help financial institutions to stabilize their balance sheet, and to become willing to lend again to prime borrowers, and stimulate the economy. Many banks took the money, ($300 billion total); but, they hoarded the funds, and the goal of increased systemic liquidity was never realized. Recipients feared they may need the money later, for themselves; that additional assets might deteriorate, and that regulators would require yet more capital to cover fresh losses. Granted, the fear was not entirely unfounded; but, by this time, the systemic problems had been identified. It was after the March 2008 sell-off of Bear Sterns, the July 2008 IndyMac Bank failure, the September 2008 Lehman Brothers failure, the September 2008 Washington Mutual Bank failure, and the September 2008 AIG Bailout. The issues at these institutions were well known before it became a public disaster. That's the nature of bank regulation. Regulators are on the front lines identifying the weaknesses, and management's plan for resolution. When management can't figure it out, regulators step in; bankers know this. So, when the Federal Reserve devised a plan for aid, they were offering more than just a temporary bandaid; they were providing a substantial life raft to help ensure institutions could weather the storm.
Other financial institutions refused receipt of TARP funds for fear that shareholders would perceive them as weak or undisciplined for needing government funds for continuing operations. The problem was systemic and not necessarily indicative of risky behavior, at least not for the majority of institutions. Nonetheless, machismo prevented many from accepting much needed help. Descartes once said, “I think therefore, I am,” however, sometimes, we think too much.
Neither ideology concerning TARP really served the intended purpose. Fear ruled the day, and we effectively “psyched” ourselves out.
Amazingly, during the 2020 COVID-19 Crisis, the exact opposite phenomenon was witnessed as banks flocked to government programs to demonstrate to stakeholders that they had sufficient liquidity. But, then a lot of lessons were learned from the 2008 Financial Crisis, and the Federal Reserve stepped in immediately with a plethora of new and different programs to avert a liquidity crisis.
Wall Street
On Wall Street, pricing is more than just a simple function of reward or punishment for actual performance. Pricing incorporates a degree of speculation concerning future performance, based on current sentiment: do we “feel good” about the prospects, and to what degree of certainty can we say our feeling is accurate? Is it an inevitable plausibility, or a faint and distant marginal possibility? Yes, statistics, probability, calculus, and maybe even a little algebra can be in these considerations, when you are trying to arrive at the conclusion. But, the outcome is being driven by a qualitative wet finger in the air trying to gauge which way the wind is blowing, and how much fear may be warranted.
We have witnessed huge swings in the stock market, for no real apparent reason. A great example are the swings throughout the later half of 2011 when in August, October, and December large changes were likely triggered by the August 8, 2011 downgrade of sovereign debt from AAA to AA+. Still high quality investment grade debt, and likely the ratings agencies attempt to rectify some past wrongs. But, the response was as if the debt quality had fallen to BBB+. Fear permeated the air, and the ensuing volatile market schizophrenia was a direct reflection of our global sentiment. Other swings are more predictable and warranted, such as the March 2009 and March 2020 declines that directly correspond to cataclysmic events, e.g. the Financial Crisis and COVID-19. At these times, it probably seemed like the sky was falling. When the masses feel like this, stocks fall, and security blankets rise, in the form of gold prices and bank deposits.
In May 2012, CNN Money built a model to capture sentiment, as a measure of fear vs. greed. Their Fear & Greed Index includes seven equally weighted indicators to arrive at an overall sentiment:
This model is not intended to be not an indicator to buy or sell assets, but as a general indicator of market sentiment.
Consumers
At 70% of GDP consumer spending drives the economy. But, all purchases are not equal - some drive our emotions, while others are driven by our emotions.
Sixty-nine percent of Americans shop online at least yearly, 25% shop online at least monthly, 16% shop online at least weekly, and 2% shop online daily. And despite the convenience of online shopping, 56% of Americans still prefer to shop at brick-and-mortar stores.3 Visits to brick and mortar establishments will be a hard habit to break, as shopping remains one of America’s favorite pastimes. It’s often a social outing, a fun excursion with friends and family, promising to culminate in the fulfillment of a need, want, or desire. Happy social activities flood your system with feel good endorphins, so why would you give that up?
Amazingly, during the 2020 COVID-19 Crisis, the exact opposite phenomenon was witnessed as banks flocked to government programs to demonstrate to stakeholders that they had sufficient liquidity. But, then a lot of lessons were learned from the 2008 Financial Crisis, and the Federal Reserve stepped in immediately with a plethora of new and different programs to avert a liquidity crisis.
Wall Street
On Wall Street, pricing is more than just a simple function of reward or punishment for actual performance. Pricing incorporates a degree of speculation concerning future performance, based on current sentiment: do we “feel good” about the prospects, and to what degree of certainty can we say our feeling is accurate? Is it an inevitable plausibility, or a faint and distant marginal possibility? Yes, statistics, probability, calculus, and maybe even a little algebra can be in these considerations, when you are trying to arrive at the conclusion. But, the outcome is being driven by a qualitative wet finger in the air trying to gauge which way the wind is blowing, and how much fear may be warranted.
We have witnessed huge swings in the stock market, for no real apparent reason. A great example are the swings throughout the later half of 2011 when in August, October, and December large changes were likely triggered by the August 8, 2011 downgrade of sovereign debt from AAA to AA+. Still high quality investment grade debt, and likely the ratings agencies attempt to rectify some past wrongs. But, the response was as if the debt quality had fallen to BBB+. Fear permeated the air, and the ensuing volatile market schizophrenia was a direct reflection of our global sentiment. Other swings are more predictable and warranted, such as the March 2009 and March 2020 declines that directly correspond to cataclysmic events, e.g. the Financial Crisis and COVID-19. At these times, it probably seemed like the sky was falling. When the masses feel like this, stocks fall, and security blankets rise, in the form of gold prices and bank deposits.
In May 2012, CNN Money built a model to capture sentiment, as a measure of fear vs. greed. Their Fear & Greed Index includes seven equally weighted indicators to arrive at an overall sentiment:
- Stock Price Momentum: The S&P 500 versus its 125-day moving average
- Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
- Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.
- Put and Call Options: The trading volume of bullish call options / trading volume of bearish put options
- Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
- Market Volatility: The VIX which measures volatility
- Safe Haven Demand: The difference in returns for stocks versus Treasuries
This model is not intended to be not an indicator to buy or sell assets, but as a general indicator of market sentiment.
Consumers
At 70% of GDP consumer spending drives the economy. But, all purchases are not equal - some drive our emotions, while others are driven by our emotions.
Sixty-nine percent of Americans shop online at least yearly, 25% shop online at least monthly, 16% shop online at least weekly, and 2% shop online daily. And despite the convenience of online shopping, 56% of Americans still prefer to shop at brick-and-mortar stores.3 Visits to brick and mortar establishments will be a hard habit to break, as shopping remains one of America’s favorite pastimes. It’s often a social outing, a fun excursion with friends and family, promising to culminate in the fulfillment of a need, want, or desire. Happy social activities flood your system with feel good endorphins, so why would you give that up?
We may experience stress and anxiety when faced with a critical purchase, such as one that requires a long-term commitment, (e.g. a house), or one that will make the difference between abundance or scarcity, (e.g. groceries before a winter storm, or a pandemic). Stress releases a not so feel-good hormone, cortisol, to regulate your fight-or-flight response.
Then there are times that we make purchases specifically to relieve stress, those impulse buys - the splurge on the junk food or designer handbag that we don’t need. Or maybe you engage in retail therapy. If so, you’re not alone. Depending on which study you believe, approximately 65% of shoppers say they’ve also shopped to relieve stress. I googled “retail therapy” and arrived at an theory at Psychology Today, an advisory at Experian, and referenced psychological studies on Forbes. So it’s definitely a thing.4,5,6
Our emotions are inextricably tied to money, directly and indirectly, for business and personal reasons. As much as we like to imagine ourselves as completely logical beings, it’s not factual; we are also very emotional organisms. Since humans created our economic and financial systems, it really should be no big surprise that psychology makes a guest appearance.
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1 Investopedia: Troubled Asset Relief Program
2 Investopedia: Capital Purchase Program
3 NPR: NPR/Marist Poll
4 Psychology Today: Why Retail Therapy Works
5 Experian: How to Deal (and Prevent) Retail Therapy
6 Forbes: Retail Therapy, Does it Help?
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