Behavioural Finance and Psychology of Investment - Assignment Example

Number: Question The ment, “stock market is regarded as the best asset for very long-term investor” is controversial. Evidences have proved that stock prices do not follow a definite pattern and there exists cognitive biasness such as, overreaction, overconfidence, information bias and various human errors, which cause mistakes in processing information. The following paragraphs elaborate on facts that reason incorrectness of the statement. The paper also highlights evidences that relates to Efficient Market Hypothesis (EMH), along with challenges encountered by the same. 1 (n1) Efficient market hypothesis (EMH) EMH elaborates that “stock market prices follow a random walk” (Shleifer, 2000). This means that daily variations in the stock prices are randomly distributed according to the Guassian Theory (Malkiel, 2003). The theoretical and empirical success of the theory was experienced by its founders in 1960. The theoretical evidence of the hypothesis rests in three arguments, which depend on weak assumptions. Primarily, investors in the financial markets are expected to be rational, which is why they value the securities randomly. Secondly, when the investors are not rational about their trades, they try to balance the prices. Thirdly and lastly, investors are irrational and on encountering rational arbitrageurs in the market, the latter eliminate effects on the prices (Shleifer, 2000). The investors value each security after considering a fundamental value. The value is identified as net present value of the future cash flows or the discounted cash flow, taking into consideration the risk characteristics. Investors acquire knowledge regarding fundamental value of the securities and respond to the information through trade, when there is favourable news in the stock market. However, in competitive markets where there are risk-neutral investors, return on the securities is unpredictable; the value and price of the securities follow a random walk. Efficient security prices are allotted for the risk-averse investors, which are linked with both levels and tolerance of risk over time. Nevertheless, it is incorrect to predict that EMH exist or ceases to do so with rationality of the investors. It is observed that when investors are not rational, the market is predicted to be efficient (Shleifer, 2000). The irrational investors conduct trade randomly in the market. When there are large numbers of such investors and strategies for trading are correlated, then balance is created by cancelling both of them. It is observed that in the concerned market, trading volume is huge owing to these irrational buyers’ trade securities. In this case, price of the stock is close to the fundamental value. This particular information relies on the fact that there is lack of correlation between trading strategies and irrationality of the investors (Shleifer, 2000). The evidence provided by Friedman (1953) and Fama (1965) about arbitrage is important for the financial market since it involves securing the stocks from risk. In a market, a stock is considered to be overpriced in comparison to its fundamental value, when purchase is correlated with irrationality of investors. The stock is recommended as a bad buy when the price exceeds the risk adjusted net present value of the dividends. At this particular point, intelligent investors sell the expensive stock and simultaneously purchase others in order to hedge the risk associated (Malkie, 2003). From the three abovementioned evidences, it can be inferred that stock market is the best asset class for investing in long-term. The rationality of investors fetch them good return since the market is predicted to be efficient and follows a random walk. The investors can gain profit even if they are irrational (Cootner, 1964). In such a situation, investors involve in arbitraging so as to sell the stocks at high price as well as purchase other stocks at low prices. Through this mechanism, they are able to hedge the risk that is associated with both the activities (Friedman, 1953). The theoretical challenges of EMH indicate that the statement stated above is incorrect. The theoretical factors prevent EMH from generating any experimental results, which implies that the market is inefficient. The challenges are stated below. Trader’s trade by noise Fundamental value of securities is very difficult to determine since constant fluctuations are seen in price due to several factors like, exchange rate (Malkiel, 1973). So, the stock market is defined by risks that are associated with incessant fluctuations. The potential arbitrageurs make use of this additional risks and extracts profit out of it. Shleifer (2000) had argued that noise trader risk had become a severe challenge for the market in order to become efficient. The noise trader risk is defined as one that traders undertake while purchasing securities in rising markets and selling them when market is declining. This restricts the degree to which arbitrage is expected for bringing down the prices to a rational level, despite presence of noticeable risk in the market (Black, 1986). The professional arbitrageurs are not ready to sell a stock in short since they believe that trading the stock at twice the fundamental value is less profitable, compared to trading the same security to one who is deceived into paying thrice the same value. Attitude to risk Fama (1991) had surveyed substantial empirical work from studies that concentrates on determining whether or not stock prices respond efficiently to the information. The survey highlighted events such as, stock splits, announcements related to the earnings, initial public offerings, mergers, dividend actions and new exchange listings. Fama (1991) had confirmed that expected under-reaction to the information is the main cause to the “post event continuation of abnormal returns and post event reversals” (Fama, 1991). He had also indicated that irregularities in returns occur due to a particular model and the outcome tends to appear when exposed to such a model that normalises the returns. The models, thus, tend to adjust the risk with the help of different statistical methods. Deviation in price De Bondt & Thaler (1985) had argued that investors encounter waves of pessimism and optimism. As a result, the price deviates systematically from the fundamental values and later highlights the mean decline. The authors suggested that overreaction to past events is aligned with the behavioural decision theory established by Kahneman & Riepe (1998). The theory elaborates that investors are overconfident about their ability to rightly forecast the future stock prices or corporate earnings. The findings support the investment practice, which depends on the contrarian strategy. This strategy explains that stocks or bunch of stocks that are not favoured for long periods of time should be avoided in order to prevent large run-ups. 1 (n2) Stock market is not at all a secure place to invest for the long-term since there are various challenges and risks that make the market unpredictable. As a result, the investor can encounter huge loss. However, fixed deposit is a safe place to invest from where a secured amount can be drawn after a particular period of time. It is not associated with the market risk. The rate of interest is fixed and specified by the authorities and do not fluctuate with changing performance of the market. Another sound alternative for investing money is purchasing of assets like, land and flat. This investment generates huge profit when value of the assets increase and the owner decides to sell it. Question 2 Active investing is the investment strategy, which involves purchasing and selling of the ongoing securities by investors. The investors purchase the securities and continuously monitor the activities for examining associated profitability conditions (Jegadeesh & Titman, 1993). Passive investing is the strategy that involves purchasing and selling of limited ongoing securities. This kind of investors purchase investments with an intention of gaining in the long run and has limited access to its maintenance. Active investing does not involve long-term appreciation like, that of passive investing. This only takes the daily movement of stock prices into consideration. The passive investors seek long-term gains; whereas, the active investor desires short-term profit. Question 3 Passive investors believe in modern finance and evidence of EMH. Market efficiency depends on the extent to which price of the securities reveal available information. It is noticed that in an efficient market, stocks are accurately valued and there is no need for active investment since investors are not capable enough to outperform the market. So, the statement that passive investors tend to believe in modern finance and EMH is quite justifiable. The passive investors believe in long-term appreciation and avoid taking any abrupt decision without considering nature of the market. Contrarily, they examine whether the market is efficient or not and undertakes the investment decision accordingly. Question 4 Passive investment is preferred because of the following reasons. 4 (p1) The modern finance and EMH elaborate that the stock prices do not follow a definite path. So, it is difficult to predict long-term return of the stocks since there is a lot of fluctuation in the market. The passive investors concentrate on long-term appreciation of the stock as they invest in securities after conducting rigorous research on its past performance (Black, Jensen and Schloes, 1972). The main evidence of passive investing that relates to EMH and modern finance is that this closely matches with performance of index. This does not require the managers to rigorously plan investments since investors are aware of the analysis of future stock price. Passive investment does not beat the market since performance of the stock indicates underlying index and the investor has to be satisfied with its performance. The managers of the investment plans are unable to take any action on behalf of the investors, if overall performance of the market declines or the individual securities are not sold. 4 (p2) The evidences and arguments held by behavioural finance are not feasible in case of passive investing. There are no strategies for the passive investors, which will endow them with the ability to beat overall performance of the market over a long-term. The passive investors perform rigorous research for tracking past performances of the stock and then predict the future performance of the concerned stock. Behavioural finance does not believe in extensive research on past performance of the stock; instead, it puts emphasis on ongoing purchasing and selling of the stocks (Mills, 1927). Question 5 Beating the market refers to making effort for earning a return that is greater than the prevalent market index indicating the stock performance. One can beat the market by undertaking huge risk in the investment pattern. Risk is undertaken by the investors in case where they want to earn greater returns. The risk associated with the stock can fetch good return or even generate loss for the investor. Thus, beating the market is a dynamic concept, which is practiced by the arbitrageurs (Shiller, 1989). Question 6 No, active investor does not indicate that the investor is trying to beat the market. Such activities are undertaken by the arbitrageurs, who purchase stock when the market is rising and sells them off when it is declining (Mehra & Prescott, 1985). The active investor in fact can beat the market if the stocks outperform the market index. They invest without examining the future value of stock and rely on the short-term profit. However, if they achieve more than the predicted short-term return, then they are predicted to beat the market (Fama, 1991). Question 7 The investors become conservative after attaining 60 years of age since they do not want to invest aggressively in the stocks. Investment in stocks is associated with risk and thus, whenever they do so, they thoroughly examine the stock price movement in the past (Mandelbrot & Hudson, 2004). If such an investor desires to beat the market, the individual needs to believe in the behavioural finance that indicates that market is inefficient. As an investor, I should invest in those funds or schemes which will provide me security during the specific period of investment. Opening fixed deposit in banks is very safe since it provides us with a fixed rate in interest after a period of time no matter what happens to the market. A particular amount is invested in banks to receive a definite return from it. The stock market is very risky to invest in as its activities are dependent on the state of the market. Noise trading is lucrative but it is accompanied by higher amount of risk. This, I will not prefer that. I will like to a passive investor as abrupt decisions are dangerous where cash is concerned. Investment is likely to be made after extensive research of the movement of the stock prices of particular organisations. References Black, F. (1986). Noise. Journal of Finance, 41, 529 – 543. Black, F., Jensen, M. and Schloes, M. (1972). The Capital Asset Pricing Model: Some Empirical Tests. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=908569 Cootner, P. (1964). The random character of stock market prices. Cambridge: Massachusetts Institute of Technology Press. De Bondt, W. & Thaler, R. (1985). Does the stock market overreact? Journal of Finance, 40, 793-805. Retrieved from http://home.business.utah.edu/finmll/fin787/papers/debondtthaler1985.pdf Fama, E. F. (1965). The Behaviour of Stock Market Prices. Journal of Business, (38), 34-105. Retrieved from http://stevereads.com/papers_to_read/the_behavior_of_stock_market_prices.pdf Fama, E. F. (1991). Efficient capital market. Journal of Finance, 46, 1575-1617. Retrieved from http://thefinanceworks.net/Workshop/1002/private/2_Market%20efficiency/Articles/Fama%20on%20efficient%20capital%20markets%20II%20JF%201991.pdf Friedman, M. (1953). The Case for Flexible Exchange Rates. Chicago: University of Chicago Press. Jegadeesh, N. & Titman, S. (1993). Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, 48(1), 65–91. Retrieved from http://fi.qu.edu.az/~faliyev/ibdia/capm.pdf Kahneman, D. & Riepe, M. (1998). Aspects of investor psychology. Journal of Portfolio Management, 24(4), 32-65. Retrieved from http://www.rsj.com/files/Aspects_of_Investor_Psychology.pdf Malkiel, B. (2003). The Efficient Market Hypothesis and Its Critics. Retrieved from http://www.vixek.com/Efficient%20Market%20Hypothesis%20and%20its%20Critics%20-%20Malkiel.pdf Malkiel, B. G. (1973). A random walk down Wall Street. New York: Norton. Mandelbrot, B. B. & Hudson, R. L. (2004). The (mis)behaviour of markets: A fractal view of risk, ruin, and reward. London: Profile Books. Mehra, R. & Prescott, E. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15, 145- 161. Retrieved from http://www.dklevine.com/archive/refs41401.pdf Mills, F. C. (1927). The Behaviour of Prices. New York: National Bureau of Economic Research. Shiller, R. J. (1989). Market Volatility. Cambridge : The MIT Press. Shleifer, A. (2000). Inefficient markets: An introduction to behavioural finance. New York: Oxford University Press. Read More