Advantages and Disadvantages of Free Market Economies - Assignment Example

Human Resources (HR) of the of the Number Part A: Question a. One of the fundamental reasons behind the enactment of the Retail Distribution Review by the Financial Services Authority was to enhance the transparency with which financial institutions conducted business with their customers (investors). The authority introduced this review by paying heed to the negative impact caused by a relatively deregulated free market economy witnessed during the financial crisis in 2007-08. The review has made it mandatory for financial consultants or advisers to charge their consultation fee upfront from the investors instead of earning any form of commission from the company whose products were being sold. The review has exposed the indirect fees that investors actually paid while consulting the advisers which they previously considered to be free. The review which was enacted in the year 2012 has had many implications since its enactment. Given the fact that RDR regulation has mandated the disclosure of any hidden cost related to investment, investors will have to pay even greater fees for consulting a financial adviser. However, this will make them aware of the total cost they will have to pay should they consult a financial consultant. In that way they will be able to make an informed decision whether or not they want to consult while making an investment based upon the investment that they are willing to make. This promotes transparency which in turn helps investors to formulate and implement their financial strategies appropriately. Although this cost may seem initially high to many an investor, but the use of institutional standard funds in shares combined with very low or no dealing charges would actually result in the investor to enjoy investment expertise at a cost which is far lower than the cost price paid by a major investment institution. Investors may also resort to seek their own methods of investment rather than consulting a financial adviser which in turn may lead to the reduction in the availability of this service in the long term. This further increases the probability of an amplified consultancy fee to be paid by investors who actually need expert’s advice. On the other hand investors are also resorting to the use of DIY (do-it-yourself) investment platforms which have the capability to advice investors on picking the right portfolio of stocks for investment. In that way the investors will be able to do away with the consultancy fee that they had to pay previously while consulting with financial advisers. On the flip side investors resorting to the use of DIY platforms without an adviser may incur significant losses on their investment if the platforms fail to provide to provide the accurate consultation. The chances of failure with an independent adviser on board would have been less for an investor. After the enactment of the RDR, investment advisers would remain independent anymore. The consultation in one way gets limited by t enactment of this review. Nonetheless, the review has made the medium of communication between the investor and the adviser very transparent. Given the fact that, the commission scheme availed by investors, where they could earn money by providing consultation in favour of a company’s product, is no more active, it is believed that the investment advices provided by them would be more unbiased. They would be more focused on the requirements of their customers as their prosperity depends upon the satisfaction index of the investors (Reynard, “The RDR: An explosive effect on funds, investors and advisers”). However, with the introduction of DIY investment platforms, the number of investors, who are gradually resorting to the use of this platform, is increasing. This has resulted in a decreased demand for the services provided by financial advisers and has also brought down the fees charged by them for providing independent consultation. Consequently their margin of income has decreased by an unprecedented level. It is expected that the enactment of the RDR will bring down the number of registered financial advisers from 30000 to 25000 (Cass Business School, “Challenge and Opportunity - The impact of the RDR on the UKs market for financial advice”). b. As far as reality is concerned, a perfectly free market economy does not exist. Each and every economy is governed in some manner by higher authorities. Even in countries like the UK and the US, who advertise themselves to be the ultimate free market economy, some degree of governmental control does exist. Given that in a free market economy, the degree of governmental control is relatively low, organizations have been found to have engaged in aggressive or unethical means in order to achieve their organizational objective, which by far has always been to generate profit. As mentioned above, the fundamental objective of a company in a free market economy is to maximize the value for the owners. In many cases managers have been found to compromise the safety of their workers as well as the requirements and needs of their customers so as to safeguard their own interest. Therefore one of the consequences for an investor to buy a product in the free market is that the individual may be exposed to a higher degree of risk given that the investment made by him/her is actually benefiting the company instead of him. Therefore, the investors investing in this market may incur huge losses which may in turn be hard to recover from. If a free market loses its stability and goes into a spin of economic turmoil, the consequences can be adverse. These consequences were quite evident during the great depression in the 1930s as well as during the global financial crisis in the late 2000s. Such degree of market failures has jeopardized the life of many investors who have lost millions of their hard earned income. Therefore it can be said that investment in a relatively unregulated market may prove to be profitable both the investors as well as for the company’s in the short term, but in the long run both the former and the later may incur significant losses should the market starts fluctuating abruptly. This is largely because of the fact that a majority of the investors as well as companies seek profits in the short term rather than having a steady and sustainable source of income in the long run. Such desire to earn profits in the short run are aided by minimum government jurisdiction, highly leveraged assets and availability of loose credit which in turn exposes the investors to a relative degree of risk (Hanks, “Explain the Advantages & Disadvantages of Free Market Economies”). Part A: Question 2 a. One of the two behavioural factors that can be attributed a reason behind Will having savings for his retirement is the fact that he earns a meagre salary of £1100. He might have a perception that a further savings for retirement would mean compromising even more on his monthly salary. If he saves for a retirement scheme, hi might not have sufficient income left at his disposal to pay off his obligations if any. Another important factor that can be attributed to Wills unwillingness for retirement savings is his unawareness of actual retirement returns. He might be apprehensive of the savings that he may do for his retirement thinking that the investment will never bear any return after his retirement. So as a behavioural aspect he may have thought to not invest anything for his retirement and may be reap the benefits of social security. b. i. the total monthly contribution that will go into the pension scheme for Will, including tax relief and the contribution from his employer, but before deducting any up-front charge is £54.12. ii. Will’s total monthly contribution to NEST after deducting any up-front charge is £53 (rounded off to nearest pence). Will’s total monthly contribution to The People’s Pension scheme after deducting any up-front charge £54 (rounded off to nearest pence). iii. Data to be put in the investment tool (Will’s NEST scheme) Gross interest rate (advertised, %) = 5% Tax rate (per annum, %) = 20% Inflation rate (per annum, %) = 3% Term (years) = 40 Regular monthly saving (£) = £53 Lump sum saving (£) = £636 How often is interest credited = Monthly iv. Data to be put in the investment tool: (Will’s The People’s Pension scheme) Gross interest rate (advertised, %) = 5% Tax rate (per annum, %) = 20% Inflation rate (per annum, %) = 3% Term (years) = 40 Regular monthly saving (£) = £54 Lump sum saving (£) = £648 How often is interest credited = Monthly c. Data to be put in the investment tool: (Shivani’s NEST scheme) Gross interest rate (advertised, %) = 5% Tax rate (per annum, %) = 20% Inflation rate (per annum, %) = 3% Term (years) = 15 Regular monthly saving (£) = £53 Lump sum saving (£) = £636 How often is interest credited = Monthly Data to be put in the investment tool: (Shivani’s The People’s Pension scheme) Gross interest rate (advertised, %) = 5% Tax rate (per annum, %) = 20% Inflation rate (per annum, %) = 3% Term (years) = 15 Regular monthly saving (£) = £54 Lump sum saving (£) = £648 How often is interest credited = Monthly d. (Explanation depends on the answers of b.iii, b.iv and c) Part B: Question 3 After careful consideration of all the investment schemes that have been provided for analysis by the researcher, the investment scheme offered by Henderson Multi-Manager Diversified has been identified as the best possible scheme for Meg to invest in. There are many factors that are responsible behind the researcher’s conclusion in favour of this investment scheme. The reasons will be explained in terms of the aspects of the investment scheme that have been provided with appropriate justifications and on the basis of a thorough comparative analysis. First of all it has to be mentioned that the investment scheme offered by Henderson Multi-Manager diversified requires the customer to make an investment of £1000 every year which is relatively manageable considering that Meg’s annual income is £25,000 and the annual expenditures is close to £19,000. This in turn leaves Meg with a savings of £6000 out of which a meagre amount of £1000 can easily be kept apart for the purpose of retirement savings given that it will bear a return once the individual enters his/her retirement phase. Of all the investment schemes this one proves to be a tad bit expensive considering the fact that the initial charge to be levied upon the customer is 5% of the investment amount. Following that Meg will have to bear an annual cost of 1.25% in the first year and thereafter an ongoing charge of 1.40% has to be paid every year till this scheme is continued. However, given the benefits that this investment scheme has on offer, the upfront cost to be borne would not be a matter of concern. The investment scheme has been designed in a way where the payments made by customers will be used by the company to make investments in a diversified pool of portfolio. The payment made by the customer will be further allocated in the following in the following portfolio according to the stated proportion: Specialist equity and other assets (28.90%); International fixed interest (24.00%); UK fixed interest (21.20%); UK equities (9.90%); Cash (6.40%); International equities (9.60%). Given the fact that the funds provided by the customer will be allocated amongst diversified return generating sources, the risk borne by the customer through this investments will also be diversified. Moreover, it has to be mentioned that the funds will be allocated in risk free investment sources in a considerable proportion. The risk free return generating sources in this investment scheme with their appropriate proportion are International fixed interest (24.00%); UK fixed interest (21.20%) and Cash (9.60). The above figures imply that the portfolios constitute of more than half of the allocation promotions thereby shielding the customer’s investment from a considerable amount of risk. The above mentioned investment portfolios will provide the client with assured returns once the investment reaches its maturity. Therefore the risk borne by the client through investment in other portfolios such as Specialist equity and other assets, UK and international equities is being compensated with the assured return to be realized by the customer (Bali and Engle 377-390). In addition, the other aspects of this investment scheme also suggests that it has performing considerably better over its life time thereby posing virtually very little or no risk to the investor. The next aspect that is to be considered is the standard deviation value of this investment scheme. The standard deviation value of stock or a portfolio is measures of the stock’s validity over a certain period of time. The value of this determinant enables an investor to assess the degree to which the value of a particular stock or a portfolio of stocks has fluctuated over time. Therefore the lesser the value the less is the fluctuation. An investor will always prefer an investment which has a lesser standard deviation (Nagel and Singleton 873-909). The standard deviation value of the investment scheme being offered by Henderson Multi-Manager Diversified is 4.37. This is its variation from the expected normal return. Given the fact that the return associated with this investment scheme is very high, it is a highly less volatile investment portfolio when compared to other investment schemes offered by L&G Tracker, Scottish Widows UK Growth and Thread needle China opportunities with standard deviation values of 12.95, 14.06 and 19.98 respectively. Only the money market investment schemes and the UK gilt investment schemes have lesser standard deviation value. However, it has to be kept in mind that this less risky investment schemes have a much lesser yield when compared to the return promised or generated by Henderson Multi-Manager Diversified considering the fact that the latter’s standard deviation value stands between the less risky schemes and the riskier ones. Following the assessment of the standard deviation, the next aspect that had to be taken into account was the alpha value of the investment scheme. The alpha value of an investment portfolio is a determinant of the portfolio’s performance on a risk adjusted basis. The value compares the risk adjusted performance of a portfolio of stocks or an individual stock with respect to the benchmark index (Yunusoglu and Selim 908-920). Therefore a positive alpha value denotes that the return of an investment portfolio is greater than the return generated by the benchmark index. In this case, the investment portfolio is said to have outperformed the benchmark index. Correspondingly a negative alpha would imply an underperformance. Therefore taking this idea into account it can be said that the investment scheme offered by Henderson Multi-Manager Diversified has outperformed the benchmark by a considerable margin as is evident from its alpha value of 4.57. Moreover, the alpha value of this investment scheme is higher than all the other investment schemes. In fact majority of the investment schemes have negative alpha values which implies that they have underperformed when compared to their respective benchmark index. The only other investment scheme with a positive alpha is the one offered by Thread needle China Opportunities with an alpha value of 2.79. However, this investment portfolio is highly volatile given is standard deviation value of 19.98. Moreover this investment scheme is not at all diversified like the one offered by Henderson Multi-Manager Diversified thereby making it a better investment scheme compared to the former. The next most important factor that needs to be analyzed when evaluating an investment portfolio is its beta. Beta is the measure of the portfolio’s volatility, or systematic risk compared to the market as a whole. This value is generally considered during the implementation of the capital asset pricing model which calculates the return of a portfolio based on its beta value as well expected return of the market. Given the fact that beta is calculated through the application of a regression model, its value denotes the propensity of a stock or a portfolio of stocks’ movement in its response to the variations in the market (Kishore 63-70). This implies that a beta value of less than 1 would mean that a stock is less volatile than the market. The beta value of exactly 1 implies that the movement of the stock or portfolio of stocks is in perfect correlation to the swings in the market and the beta value of more than 1 would mean that a stock is more than the market (Stevanović and Pucar 1673-1682; Dardan, Busch and Sward 688-697). For example a beta value of 1.3 would imply that the portfolio is 30% volatile than the market. In this particular case the investment scheme offered by Henderson Multi-Manager Diversified has a beta value of 0.78 which is less than 1 meaning that the investment portfolio is considerable less volatile than the market. Although the beta value of this investment scheme is more than the beta value of other investment scheme but if the return of this stock is taken into consideration and compared with the return generated by other investment portfolios then this portfolio should come first in the priority list of any investor. As far as the Shape ratio is concerned, this measure helps an investor to determine the risk based performance of a stock or a portfolio of stocks. One way of measuring the Sharpe ratio of particular stock would be deduct the risk free rate of return from the return of the portfolio. Thereafter the resultant value is to be divided by the standard deviation of the portfolio’s return. This ratio helps the investor to assess whether the return generated by a portfolio has been due to smart decision made by the investor itself or it is as a result of excess risk taken by the investor. An investor would consider those investments to be good which reap higher return with the lowest possible risk borne. A higher value of Sharpe ration indicates that a portfolio or an individual stock has exhibited a better risk adjusted performance than its peer stocks or portfolios (Baum, Crosby and MacGregor 36-49). It would never be wise on the part of an investor to take additional risk in order to achieve higher returns. Therefore taking the aforementioned facts into consideration it can be said that opting for the investment scheme offered by Henderson Multi-Manager Diversified would always be safe bet given that the Sharpe ratio of this investment scheme is higher than all the other investment schemes offered to Meg. Therefore over the due course of this investment portfolio has delivered a better risk adjusted performance when compared to the peer portfolios making it a less risky investment choice that is at the disposal of the investor. Following the analysis of the Sharpe ratio, the next aspect that had to be considered is the information ratio. The information ratio of a particular stock is the measure of a portfolio’s return less the return generated by the benchmark index with respect to the volatility of the returns. It helps a potential investor to assess the portfolio manager’s ability to outperform the return generated by the benchmark index as well as the individual’s consistency of performance. The ratio enables the investor to identify if a portfolio manager has been able to outperform the benchmark by a significant margin in few months or by a little margin but every month (McParland, Adair and McGreal 127-141). A higher value of this ratio denotes the consistency with which a manager has outperformed the benchmark. In this case the information ratio of the investment scheme offered by Henderson Multi-Manager Diversified is 1.13 which is again the highest among information ratios of all the other investment schemes making this investment scheme a prospective one that can be considered by Meg. The last but not the least is the mean return generated by an investment portfolio. It measures the actual return that can be expected to be realized after the maturity of this investment schemes (Deb 55-67). As far as Henderson Multi-Manager Diversified investment scheme is concerned, the mean return is 8.06% which is higher than all the other investment portfolios presented in front of Meg. Therefore after a thorough analysis of the cost, risk and reward associated with all the portfolios that can be chosen from, the investment scheme offered by Henderson Multi-Manager Diversified is the best scheme that can be availed by Meg. Works cited Bali, Turan G., and Robert F. Engle. "The intertemporal capital asset pricing model with dynamic conditional correlations." Journal of Monetary Economics 57.4 (2010): 377-390. Print. Baum, Andrew, Neil Crosby, and Bryan MacGregor. "Price formation, mispricing and investment analysis in the property market: A response to “A note on ‘The initial yield revealed: explicit valuations and the future of property investment’”." Journal of Property Valuation and investment 14.1 (1996): 36-49. Print. Cass Business School. “Challenge and Opportunity - The impact of the RDR on the UKs market for financial advice.” Cass Business School. Cass Business School, 18 July 2013. Web. 28 September. 2014. Dardan, Shana, Doug Busch, and David Sward. "An application of the learning curve and the nonconstant-growth dividend model: IT investment valuations at Intel® Corporation." Decision support systems 41.4 (2006): 688-697. Print. Deb, Rajat K. "Transmission investment valuations: Weighing project benefits." The Electricity Journal 17.2 (2004): 55-67. Print. Hanks, Gerald. “Explain the Advantages & Disadvantages of Free Market Economies.” Chron. Hearst Newspapers, LLC, 2014. Web. 28 September. 2014. Kishore, Rohit. "Discounted cash flow analysis in property investment valuations." Journal of Property Valuation and Investment 14.3 (1996): 63-70. Print. McParland, Clare, Alastair Adair, and Stanley McGreal. "Valuation standards: A comparison of four European countries." Journal of Property Investment & Finance 20.2 (2002): 127-141. Print. Nagel, Stefan, and Kenneth J. Singleton. "Estimation and evaluation of conditional asset pricing models." The Journal of Finance 66.3 (2011): 873-909. Print. Reynard, Cherry. “The RDR: An explosive effect on funds, investors and advisers.” Interactive investor. Interactive investor, 27th November 2012. Web. 28 September. 2014. Stevanović, Sanja, and Mila Pucar. "Investment appraisal of a small, grid-connected photovoltaic plant under the Serbian feed-in tariff framework." Renewable and Sustainable Energy Reviews 16.3 (2012): 1673-1682. Print. Yunusoglu, Mualla Gonca, and Hasan Selim. "A fuzzy rule based expert system for stock evaluation and portfolio construction: An application to Istanbul Stock Exchange." Expert Systems with Applications 40.3 (2013): 908-920. Print. Read More