Massimo Acquaviva, 2R Capital Investment Management Limited co-CEO and co-founder, has established a practical training programme rooted in financial theory as part of his role. This article will take a closer look at financial theory, providing an overview of what it is and its potential to drive smarter investment decisions.
A career in finance centres around money and assets, requiring years of careful study to master. So complex and multilayered is the world of finance that entire systems have been devised to manage and facilitate the transfer of currency, assets and money.
Theories that underpin finance include behavioural finance, financial mathematics, quantitative analysis, quantum finance, financial economics and managerial finance. Finance is distinct from economics; while real value in economics centres around the provision of services and goods, finance focuses instead on shares, prices and interest rates.
Experimental finance is a relatively straightforward financial theory where the goal is to analyse participants’ behaviour and resulting trade flows. Information distribution, price setting mechanisms and market returns all factor into the final output of each study. Some experiments are completely hypothetical, taking place in a laboratory setting and involving willing participants who answer a series of questions. The purpose of experimental finance is to prove valid existing theories and extend them to other financial activities and decisions.
Managerial finance involves planning and controlling the financial aspect of operations, including managerial accounting and corporate finance. Managerial accounting involves close monitoring of a company’s financial health, ensuring that issues that affect business optimisation and revenue generation in the long term are carefully managed to ensure advantageous outcomes. Optimising cashflow and capital budgeting are tried and true methods of corporate finance, providing scrutiny to ensure that strategies remain sound in evolving circumstances.
Financial theory principles include the time value of money, which establishes that a certain amount of money is worth more today than it will be in the future. This concept forms the basis of discounted cashflow analysis and various valuation models.
Another important principle in financial theory is risk and return, which establishes that, in general, the higher the risk attached to a particular investment the greater the potential returns.
Developed by Harry Markowitz, portfolio theory is a concept that emphasises the need for diversity across an investment portfolio in order to mitigate risk. By combining a host of different assets within a portfolio, investors can achieve a more desirable risk-return trade-off.
Capital structure theory addresses the mix of equity and debt financing a firm uses to fund its operations. Capital structure theory also explores how a business’s capital structure affects its cost of capital, which in turn has a knock-on effect in terms of a company’s value.
Agency theory examines the relationships and potential conflicts of interest between a firm’s various different stakeholders such as shareholders, creditors and managers.
While not strictly a theory in the traditional sense, behavioural finance addresses psychological factors that come into play in financial decision-making, exploring how cognitive biases, social influences and emotions can impact investor behaviour, in turn swaying financial markets.
It is crucial for finance students to gain a solid grasp of how different and competing theories impact players in markets and how they behave. Teaching with historical perspectives (THP) enables finance experts to move beyond the premise that finance is a set of specific, distributionally neutral techniques, supporting the diversification of the curriculum by reflecting on the evolution of theories underpinning specific financial techniques or vehicles. THP can be used in a number of ways, helping to contextualize the genesis of a theory or model and introduce pluralism. It can also support in-depth analysis of a model and the evolution of its applications in financial practice.
