Investment Theory: Sample Capital Flow Analysis
Capital Flow Analysis focuses on understanding the causes of systemic risk in securities markets and goes beyond Modern Portfolio Theory.
The technique is used to forecast trends in securities markets.
Capital Flow Analysis can be used to forecast trends To illustrate the use of the method, here are three analyses of market segments in May 2005:
Unlike the case studies about the Brazilian market in 1971 and the American market in 2000, these analyses are not intended to be relevant to predicting significant turning points in these three markets.
Instead, these examples show how Capital Flow Analysis can set up a general background for long term market behavior, against which current news can be interpreted.
Analyses of this type needs to be constantly updated, based on the new flow of funds statistics and current events.
A Learning Tool
These studies show how Capital Flow Analysis is used and the conclusions are supported by arguments and data, with links to explanations, lessons, essays, and research materials.
Starting with the final product, you can work through the arguments and reasoning.
These sample analyses serve as a gateway for exploring techniques of Capital Flow Analysis.
In contrast to the learning modules, these analyses start with a final product and link back to the arguments and reasoning.
You can get a quick start by reading Capital Flow Analysis in Practice on this page, and the training modules:
Capital Flow Analysis in Practice
Explaining Systemic Risk
Modern Portfolio Theory holds that systemic risk is unknowable and may be reduced but not eliminated by security analysis and diversification.
Capital Flow Analysis says that by studying flow of funds accounts in historical and sociological context, it is possible to explain forces of supply and demand that move financial markets.
Systemic risk can be explained and better avoided.
Therefore, systemic risk can be explained.
We can better avoid risks that we understand.
The method does not deal with individual securities or short-term market movements.
The Risk Diagram
The diagram illustrates how investment risk is broken into 'systemic risk' (or market risk) and 'non-systemic risk' (or fundamental risk).
Fundamental Risk is uncertainty regarding the future intrinsic worth of an investment. For example, credit risk in the case of bonds, or future earnings in the case of equities.
Fundamental risk is also called non-systemic risk
Non-systemic risk is controlled by security analysis and by diversification.
Market Risk refers to uncertainty regarding the future market value of securities due to variations in supply and demand that are not the result of changes in the intrinsic value of a security.
Market risk is also called systemic risk.
Systemic risk is handled, in part, by Modern Portfolio Theory, a technique that reduces, but does not eliminate, market risk.
Systemic risk often accounts for half or more of total risk.
Modern Portfolio Theory is a method of constructing portfolios that have less volatility than the individual securities that make up the portfolio.
Market risk may be further classified as short-term and long-term.
Because the heaviest expense of Capital Flow Analysis — the preparation of the national flow of funds accounts — is paid by the U.S. government, the cost of this technique is much less than the cost of analyzing individual securities.
Hedging and Asset Allocation
Going beyond selection for intrinsic value (security analysis), and portfolio diversification and management of volatility (Modern Portfolio Theory), Capital Flow Analysis helps to avoid or at least to reduce long-term systemic risk by market timing and asset allocation.
Capital Flow Analysis can be used in hedging and asset allocation strategies.
Capital Flow Analysis leads to informed market timing:
Hedging: Risk insurance through hedging can be expensive. By understanding the bias of systemic risk, it sometimes is possible to reduce the cost of hedging.
Asset Allocation: Knowledge of long-term systemic risk permits asset allocation so as to reduce exposure to or avoid investment categories with high market risk.
Through Capital Flow Analysis, the investor is aware of otherwise unexplained market risk — a large part of total risk. This knowledge requires a relatively modest investment of research time.
Not For Day Traders
Capital Flow Analysis is not intended for short-term market speculation because:
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Federal reserve flow of funds accounts are published quarterly, with a lag in the data;
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Short-term markets are subject to factors not explained by long-term capital flows, such as crowd psychology and random impacts on order flow.
Locked-in Portfolios
Capital Flow Analysis helps in asset allocation for 'locked-in' portfolios.
A locked-in portfolio is one in which asset-class allocation decisions cannot be changed or are unlikely to be changed.
Asset allocation for 'locked-in' portfolios can not be readily changed.
Examples of locked-in portfolios are:
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Asset-allocation fixed in a will, deed of trust, investment contract, or by the fundamental investment policy of an investment fund.
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Investments made through payroll deduction 401(k) plans in which the worker is unlikely to modify the initial allocation, although permitted to do so.
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An investment is made in a variable annuity in which asset allocation can be changed, but when costs, fees, or tax consequences discourage reallocation of assets, or when the person who may make reallocation decisions is mentally or otherwise unable to do so, or when an agent with such powers may have conflicts of interests that prelude reallocation.
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Any investment in which those that may reallocate assets are unlikely to do so because of social, psychological, or cultural pressures, or because of conflicts of interest.
Capital Flow Analysis provides a basis for making long-term asset allocation decisions based on an understanding of current intrinsic values and long-term trends in market supply and demand.
Of course, it is better not to have to make locked-in asset allocation decisions, but sometimes circumstances make this necessary.
The Basis For Predictions
By explaining supply and demand, Capital Flow Analysis provides a basis to evaluate relative risk, predicated on assumptions of persistence or interruption of trends.
Risk is evaluated based on assumptions regarding persistence of trends.
Capital Flow Analysis helps to evaluate the likelihood that the average level of prices of a class of securities, months or years hence, will be higher or lower than current levels, by providing insights relative to the continuation or interruption of current social, economic, demographic, and political behavior.
However, no one can truly foresee the future and Capital Flow Analysis does not offer guarantees that projected trends will occur.
For more in-depth information on Capital Flow Analysis, see the training modules.
