The better you understand investment theory and how Omega thinks, the more confidence you will have in how we are managing your portfolio

At Omega, we believe that your wealth and how your portfolio is being managed should be sources of security and self confidence for you and your family— not causes of worry and anxiety. The more confidence you have in how your wealth is being managed, the more easily you will be able to devote your time, thoughts and energy to the people and causes you care most about.

To give you confidence in how we are managing your portfolio, we explain the thinking behind our asset allocations and investments. We keep you as fully informed as you would like to be.

We also believe that, the more clearly you understand the dynamics of the financial markets, the less susceptible you will be to the latest craze or panic sweeping across the internet, into the money magazines and onto the financial-pundit shows.

To give you some additional cognitive tools with which to make sense of whatever is going on in the markets, let us here take a few steps back from the financial-market fad or frenzy of the moment and review some of the basics of financial theory, investing and the dynamics of the financial markets.

As we proceed, we mix theory with application. We share with you how we translate basic principles into sound investment strategies and prudent asset allocations. We look at a few of the trends, cycles and developments we watch in our global 20/20 vision and how they are likely to affect the market prices of securities, commodities and currencies.

In most asset classes, we take only long positions. You gain when prices go up. In absolute-return and hedge-fund strategies, your gains need not depend on markets going up.

In most of the asset classes in which we invest, our goal is the fundamental one of investing: We seek to participate in the price appreciation of stocks, bonds, commodities or currencies in that class. In these asset classes, we take long positions. That is, we buy securities into your portfolio. When the market price of securities subsequently goes up, the value of your investment goes up.

While we take long-only positions in most of the asset classes in which we invest, going long is not the only way to invest. Investment returns need not always depend on market prices going up. Having some investments whose returns do not depend upon market prices going up helps reduce portfolio volatility.

In absolute-return strategies and hedge-fund strategies, the fund manager may or may not take long positions. If the fund manager expects the market price of a security to fall, he may sell it short. That is, he may borrow the security and sell it. Then, when the price of the security falls, he will buy it and return it.

The profit on a short sale is the difference between the price at which the fund manager sold the security and the price at which he subsequently buys it— minus the cost of borrowing the security.

In some absolute-return strategies and hedge-fund strategies, fund managers take combinations of long and short positions. For example, in a market-neutral stock-trading strategy, a fund manager may buy a stock she considers undervalued and, within the same industry or sector, simultaneously sell short a stock she considers overvalued.

If the fund manager’s analysis is correct, then the market price of the undervalued stock should go up relative to the market price of the overvalued stock— regardless of whether prices of stocks in that industry or sector go up or down in general. You profit not from absolute price movements of the stocks, but from their relative price movements.

Success of absolute-return strategies and hedge-fund strategies depends strongly on the investment acumen of the fund manager.

In every asset class, whether they take long positions only, short positions only or combinations of long and short positions, Omega fund managers seek to identify under-, over- and fairly priced securities. In different asset classes, different factors drive market prices of securities.

A company's earnings determine the long-term value of its stock.

In financial theory, the value of anything is the probability-weighted present value of its future cash flows. In theory, to calculate the value of any investment, you figure out a range of future cash flows possible under different economic scenarios. You weight each cash flow by its likelihood. You discount the probability-weighted values back to the present. You use a discount rate that reflects the riskiness of the investment.

In theory, the fundamental value of a share of a company's stock is primarily a function of the company's future earnings. If a company pays out a high proportion of its earning as dividends, then the fundamental value of the stock is a proportionate share of the discounted present value of expected future dividends.

Most companies today, however, pay little or no dividends. No one knows what the future earnings of any company will be. Hence, the fundamental value of a company’s shares is unknown and unknowable.

Financial markets are auctions. Expectations about a company's future earnings strongly influence bid and ask prices.

To buy and sell things of unknown value, societies frequently resort to auctions. Great works of art, for example, are almost always sold through auctions.

Based on what they think the item up for auction is worth, auction participants submit bid and ask prices. The market price of the item can be taken to be either the last price at which the item sold or the midpoint between current bid and ask prices.

Financial markets are auctions. Prices that market participants bid for and at which they offer a company's shares largely reflect participants' expectations about the company's future earnings. Expectations about future earnings include expectations about how much the company's earnings are likely to grow over time. When the market-equilibrium view is that a company's earnings will grow significantly over time, the company's stock will sell at a high ratio of price to current earnings.

The market price of a company's shares also reflects market participants’ risk appetites and aversions. If a company's earnings are volatile or its future earnings are highly uncertain, then, ordinarily, investors are likely to bid less for the stock than they would if earnings were more stable or future earnings were more certain.

Yet, the risk aversions of market participants are not constant over time. When markets are going up, investors may turn into risk seekers (otherwise known as gamblers). When markets are going down, investors may not want to take on any risk whatsoever.

In precise financial theory, a stock price is said to be in a bubble if the stock's market price exceeds the stock's fundamental value. The catch, of course, is that the stock's fundamental value is unknown and unknowable.

As time passes, a company's earnings either meet, exceed or fall short of investors' expectations. If earnings exceed investor expectations, then the company's stock price is likely to rise. If a stock is not in a price bubble and earnings fall short of expectations, then the stock price is likely to fall.

If a stock is in a price bubble and the company's earnings fall short of investor expectations over an extended period of time, investors are likely to recognize eventually that they have been and are in a bubble. Investor expectations will shift. Suddenly they will become risk averse. Liquidity (in this case, bid prices) may dry up. Stock owners will offer to sell at lower and lower prices. The bubble will burst. The stock price will drop, perhaps precipitously.

When a bubble bursts, investors revise their expectations about a company's likely future earnings. The stock's new market price will reflect investors' bid-ask equilibrium expectations about future earnings and investors' risk aversions.

Putting all of these considerations together, the prudent portfolio manager seeks to invest in stocks of companies whose earnings are likely to grow— but only if, in his analysis, those stocks are fairly priced or under priced in the financial markets.

The faster an economy is growing, the more the stock prices of its companies are likely to go up

In growing economies, demand for companies' products and services goes up. In general, rising demand allows companies to sell more products and services at higher prices. Selling more products and services allows companies to utilize more of their capacity. Greater utilization of capacity allows companies to spread their fixed costs over more output and thereby reduce their costs per unit output.

Selling more at lower costs per unit increases a company's profits and its earnings. Hence, to the degree stock prices reflect earnings, they are likely to go up in growing economies. The faster an economy is growing, the faster the stock prices of its companies are likely to go up.

Accordingly, Omega invests in companies in both the strongest economy— that of the United States— and in companies in some of the fastest growing economies, currently including China, Korea, Singapore and Ireland.

In the economies that are growing fastest currently, financial markets are generally less efficient than financial markets in western Europe, the U.S. and Japan. In less efficient markets, Omega fund managers can find under-priced assets more easily. In these markets, under-priced assets are opportunities for additional gains.

When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

Sitting back and collecting interest isn’t the best way to think about how a bond works. To understand why bond prices go up and down as interest rates change, think about the present value of the cash flow to which the bond entitles you.

The easiest bond to think about is a zero-coupon bond. A zero-coupon bond repays you principal and pays you interest all in one lump sum at the time of the bond’s maturity.

When you buy a zero-coupon bond, you’re buying the promise of a payment at a certain time in the future.

Say you buy a bond that will pay you $10,000 in ten years. The prevailing simple interest rate is 6% per annum. What will the bond cost you?

Assuming the interest is compounded annually, the bond will cost you $5,584. That’s the value of $10,000 to be received in ten years discounted back to today at 6% compounded annually.

A year goes by. Have you collected any interest? No.

What do you now own? You now own the promise of receiving $10,000 in nine years. If the nine-year interest rate has dropped and is now 4%, what is your promise of receiving $10,000 in nine years now worth? Or, to put the question another way, at a 4% interest rate, what would the promise of receiving $10,000 in nine years cost you now?

It would cost you $7,026. Hence, your bond is now worth $7,026. $10,000 discounted over nine years at 4% is $7,026. Your bond is worth $1,442 more than it was a year ago.

If you held the bond until maturity, you would still get the $10,000 you were promised initially; but, today, the present value of that future payment is worth more.

Had the nine-year interest rate gone up to 8%, the value of receiving $10,000 in nine years would be $5,002. Over the course of a year, the bond would have lost $581 in value.

If interest rates remain the same, a bond’s value increases roughly proportionately as its time to maturity decreases. (The increase is not exactly proportionate because interest rates are usually different for different times to maturity.)

Bond funds typically do not hold bonds until maturity. Instead they sell old bonds and buy new bonds at a pace that allows them to maintain a specified average time to maturity for their overall portfolio. A bond portfolio’s weighted average time to maturity is called its duration.

Adding bonds to a portfolio usually reduces the volatility of the portfolio’s return because stock prices and bond prices usually do not move in tandem. That is, the correlation between bond-price changes and stock-price changes is low.

Interest rates in different countries usually do not move in perfect sync with one another. Hence, owning bonds denominated in different currencies improves portfolio diversification further.

Under-priced bonds are usually bonds that are less risky than their market prices imply

Market prices of particular bonds reflect not only prevailing interest rates but also market participants’ assessments of how risky the bonds are. Market participants demand to receive higher interest rates for riskier bonds.

In their search for under-priced bonds, Omega bond-fund managers often look for bonds that they think are less risky than the bonds’ market prices imply.