Behavioral Finance: Apple and UK Banks Shares - Coursework Example

Behavioral finance: Apple and UK banks shares Name Course Tutor Date Behavioral finance: Apple and UK banks shares Introduction One of the major assumptions in the current economic and finance world is that investors are rational in their choice of investment options; they tend to seek ways to increase their wealth In other words, they are wealth maximizers because they resort to options that seem to be profitable to them and non-complicated (Shefrin 2002).From the conventional economics perspective, investors’ emotions and other extraneous factors do not have an influence on the decision of investment options or economic choices. However, this assumption does not hold water since it does not reflect on how investors behave in the real world. The plain fact is that individuals often behave irrationally when choosing investment options. The difference between the real world and the principles in economics prompted scholars to study cognitive psychology to answer the question of irrationality and illogical behaviors the convention economics and finance did not explain. This is now where behavioral finance comes in; it seeks to explain the ordinary man’s behaviors when it comes in choosing between two options (Shefrin 2002). Cognitive psychologists such as Daniel Kahnemen and Amos Tversky who are considered as fathers of behavioral finance conceived the concept of biasness and heuristic approaches. These psychologists focused their study on cognitive biases and the heuristic approaches of problem solving to shade more light on the understanding of the peoples irrationality behavior. They later blended the economics and finance concepts with those of cognitive psychology hence behavioral finance. This paper focuses on the concepts of behavioral finance; it shows how these concepts affect the investors’ behavior on the markets. Overview of UK banks and Apple Company report Trading in the UK banks’ shares has become a lot more uncertain due to the slow economic growth rate in western economies. Moreover, the banking industry is struggling with the impact of low interest rate; this has slowed down investment banking from the investors (Michael, Sayer &Harman 2011). At such uncertainty times, banks resort to delivering innovative solutions to their customers, this is a necessary and important to maintain long-term profitability. The normal tendency in uncertain conditions is that bank may hunker down wait until the conditions improves. However, one problem with banks is that they cannot afford to wait for conditions to improve. This is because of the following innovation drivers First, technology is changing rapidly; smart phones developments and new internet applications are coming down stream (Michael, Sayer &Harman 2011). Thus, the ever-changing technology can aid the banks to continue operating even if when the conditions for trading are proving to be tough. Another innovative driver is that consumers’ behaviors are often changing. The consumers are now adopting new types of interactive technologies in their daily lives hence they expect the banks to adopt too (Michael, Sayer &Harman 2011). Thirdly, new entrants in the industry brings competition on the available market, therefore, banks are forced to look for innovative means to curb this competition. Finally, the changing business model is also a factor that is forcing UK banks to look for more innovative ways to improve their performance. In regards to Sewell, Martin. (2010).Apple is the most valuable technology company in the world; its new shares on the market are always high. Investors run for the shares of the new product of this company knowing very well that they will make a good amount of profit. The value of shares of this company starts reducing when the product has stayed on the market for a long period. Unlike in UK bank shares where the conditions are often uncertainty, the conditions are certainty for new products in Apple Company. Thus, investors are likely to run for the Apple shares other than going for UK bank shares. Apple Company manufactures smart phones; these kinds of phones have attracted many consumers around the world because of their convenience. This fact alone has put Apple shares at a better place to compete with other companies for the limited investors who want to invest in shares. Reports reveal that Apple Company would continue growing since its new products have high demand all over the world. The growth rate will reach at a plateau phase when the products have reached and saturated all the market. The fact of continued growth depicts that the company’s shares will How investors’ sentiments impacts decision making report Factors to consider in making investment decision Choosing one investment share option among other options is one big challenging task to the investors. In most cases, investors often have little knowledge on which shares options can earn them good reputation in case they make a decision of investing in them (Cartwright, 2011). Here are some of the factors an investor should put in mind to enable him to choose the best share option. First, the investor should study the volume of the number of the stock bought and sold in a single day of trading (Whitaker, 2012). If the volume of a particular shares stock is low, them it means that the liquidity of these shares is low. When the liquidity of a share is low it implies that it is hard to buy and sell such shares since the buyers and sellers are few on the market (Levy, 2002). Low liquidity of shares tends to create unnecessary volatility that many investors try to evade. This investor should observe carefully the volume of both Apple shares and UK bank shares sold every day. It is advisable for him to opt for those shares that have high volume of sales on daily basis. This will enable him to sell them or convert them to cash at any time of his convenience. The second factor this investor should consider is the price or earnings ratio (P/E) per share. This is the ratio of price per share to earnings per share of stock. If the P/E of a certain share stock is high, it means that the price per share stock has been overvalued, on other hand, the prices per share is more than the earnings per share (Whitaker, 2012). When the P/E is low, then the price per share must have been undervalued or the price per share is lower that the earnings per share. For investors, it is advisable for them to settle on companies that have low P/E; here they will be able to earn good profit in form of dividends. P/E is a critical measure of evaluating the profitability of the stock thus; most companies strive to maintain their P/E as low as possible to attract the investors who want to buy their shares (Sewell, 2010). This investor should compare the P/E of Apple Company and that of UK bank shares and choose the shares that have low P/E. This will enable him to reap more profit other than depending on the friend’s advice on choosing on UK bank shares. The third factor the investor should put into consideration is the earnings per share (EPS) and the cash flow per share (CPS) (Whitaker, 2012). EPS is found by the formula (Net income - dividends on preferred stock divide by the average number of outstanding shares. EPS breaks down the profit or the earnings of a particular firm in terms of individual shares. Cash flow per share (CPS) accounts for how much a particular company really has at hand and determines the effectiveness of that company. CPS aid in determining if the company has enough cash at hand to pay off all the debts and carry on future operation that contribute to stock price increases (Levy, 2002).) Any investor who is contemplating on which shares to choose when making investment decision should go for the shares of that company that has a positive EPS and CPS. Therefore, the investor who is seeking advice between UK bank shares and Apple shares is supposed to choose the option that has positive EPS and CPS. Market cap is another factor the investor seeking to find a better option should consider. Market cap is the overall price to buy out the whole company (Whitaker, 2012:1). Companies are classified as micro, small, medium, large and mega, a mega company means is that one that is well established and has a large capital base. The financial base of such a company reads in terms of billions, while micro companies are those that have small financial base that reads in terms of few millions. A mega company has a large market cap while a micro company has a small market cap. When a company has a large market cap, it means that it is more stable and safe to invest in. Experienced investors always go for shares of mega companies that have a large market cap (Shleifer, 2000: 27). This is because the investors know that such companies are more stable. Hence, they are safe to invest in unlike in smaller companies that can easily collapse. The investor seeking advice should compare the market cap of Apple Company and that of UK bank for him to choose the company that has a large market cap. This will help him in choosing an option that is secure to invest in. Any investor seeking a better investment option should also find out if the companies offering their share options are paying dividends to their shareholders (Whitaker, 2012). Dividends are cash paid per share by particular company as a reward to its shareholders for holding its stock. If a company is in a position to pay out some money to the shareholders dividends it means that the company must be performing well. This is because dividend is part of the profits earned by the company hence it is a proof to show that a certain company is profitable when one does some investment in it. Often, the companies that pay dividends to the shareholders have steady growth because it attracts more investors to buy its shares thus increase in stock (Shleifer, 2000). The investor should find out between UK bank and Apple Company, which one pays highest dividends to the shareholders. He should by the shares of that company that always pays higher dividends to the shareholders. Volatility of the shares of any given company is also another factor an investor can use when reconsidering to invest his money in a particular stock. Volatility (Beta) is the standard deviation of any given stock (Whitaker, 2012). It is sometimes difficult to calculate but when one knows how it applies, it can be a good measure to deduce if he is going to make good returns in the invested shares. Normally, an investor can make quickest and big profit when the stock is at high volatility, however, the investor could also loose greatly when the market of the stock underperforms (Shleifer, 2000: 24). For an investor who want to play it safe and preserve his money, it is advisable him to opt for low volatility stock to avoid big losses. Therefore, the investor should consider the volatility of Apple shares and that of UK bank and decide which one fit him as per his desires. Another simple factor an investor can consider when making a decision on investment option is that he/she should look at the news popularity (Cartwright, 20112). In most cases, news affects the expectations and decisions of the investors, these expectations tend to determine the stock prices. Some famous companies such as Apple are often in news, sometimes-the media exaggerate such companies’ prices. Investors should be vigilant and try to choose stocks that are not victims of media publicity. Such companies try to lower the prices a bit to attract the buyers. As mentioned earlier Apple Company is a victim of media popularity because of its brilliant performance, hence its prices are high. Therefore, the investor should consider comparing the Apple popularity and UK bank popularity in media so that he can determine which company is not exaggerated by the advertisement of the media. Sources of biasness Experienced investors always believe that they are logical decision makers. This inmate assumptions cause irrational decision making especially when they are making investment decisions. Moreover, human minds are inherently susceptible to many forms of biasness (Montier 2007:1). This biasness falls under four sources. The first source of biasness is self-deception; under this, we have over-optimism where individuals tend to overestimate their ability. In real sense, an individuals’ ability can be less but to him he feels that he can perform more than that. This form of self-deception often leads to biasness when it comes to decision making. Overconfidence is the second form of self-deception (Montier 2007). Sometimes individual investors can feel to be overconfident that they would manage to accomplish a particular task when in real sense they cannot. Being overconfidence in something always mislead individuals especially the investors to make irrational decisions. Lastly, on self-deception, we have self attribution, this is where people are fond of crediting their skills to good results but tend to blame bad luck for poor results (Shleifer, 2000).Therefore, self-deception attributes are the main causes of irrational decision making among the investors. The second source of biasness is simplification. Under this source, we have anchoring. Anchoring states that, people grasp non-relevant information always believing that they are making good decision Sewell, Martin. (2010).This is a good example applicable to the investor who has gotten information from a friend to chose UK bank shares other than Apple’s shares. He has anchored to the irrelevant information provided by a friend and probably it would affect his decision-making. Representation is another form of simplification source of biasness. Under representation, individuals judge the situation by appearance rather than likelihood Montier (2007) argues that individuals often like good stories regardless whether they are true or false rather than bitter facts of reality. Thus, representativeness later on leads to making awkward decisions that end up haunting them. Loss aversion is also under simplification (Singh 2012: 118). Here people usually give more weight to loses they incur other than the gains they get in a certain investment. They look just one side of the coin this behavior lead them to making irrational decisions. Other sources of biasness are emotion and social interaction (Montier 2007:2). Under emotion, we have the regret theory where an individual fear making a particular decision knowing that he may suffer a great loss. The fear in individuals sometimes makes them to opt for wrong decision especially when they are looking for investment options. Social interaction is also a source of biasness in decision-making. Individual are influenced by other people around them to take a certain action, these actions in most cases are irrational since he based his decision to the views of other people (Montier 2007:2). Normally, human beings are social beings, people like interacting with others sharing ideas and even helping each other. In the process of socialization, people learn from one another and they want to do things as other people have done. This greatly influences their decisions in their endeavors Decision making strategies to avoid biasness As we can see, the investor who is seeking investment advice has suffered from the effect of biasness in deciding on what option to settle on. We can find he is coming for advice but in his mind, he is already decided to buy UK bank shares. Biasness is a normal behavior most investors tend to show when it comes to investment decision making. They rely on rumors, false advice and even the attitude they already have towards the particular companies. Biasness later leads to wrong decision-making (Levy, 2002: 1). Strategies that would benefit the individual investors’ decision-making skills require self-awareness and discipline. Actually, investors can immunize themselves from being biased by applying the following strategies. First, a disciplined investor should understand biases; an investor ought to recognize biasness in case he is thinking on which investment option is appropriate for him (Singh 2012: 121). Once he is able to recognize it, he will be able to avoid it when making his decision. The second strategy is that the investor should be aware of his reasons for investing. When an investor has, vague reasons why he wants to invest often provide little investment direction and can lead to loss. One should not want to invest with a reason such he want to retire when he is rich or he want to get a lot of profit within the shortest time possible. Such reasons will mislead him in his decision-making. An investor who is looking for investment advice he should be having tangible reasons why he wants to invest (Shleifer, 2000) this will make him more focused to his objectives and probably, he may achieve them. The third strategy an investor can avoid biasness in his decision making is quantifying the investment criteria. Quantification of the investment objectives guides someone not to act on rumors, emotions and other unnecessary biasness; one should ensure that his criteria for investment should meet the quantitative benchmarks. Moreover, the criteria should be supplemented with other qualitative information for example the recognition of the company as producer of quality products or has best management team. Another strategy is diversification of the investment projects. Singh, Sudhir. (2012). suggest that investors should learn diversify their investment across various industries and different investment options such as real estates, bonds, precious metals and stocks is very health to any investor. Diversification limit an investor to be tied on one company’s stock, thus, one spreads the risks when he invests in different options. In case that company performs badly, he cannot suffer a great loss since some of his investments are elsewhere hence they are not affected. This is unlike when he has heaped all his funds in the stock of one company. Controlling investment environment is also another strategy that the investors can use to make credible decision to avoid biasness. This strategy entails checking the stock regularly and reviewing the portfolio annually. This is done to ensure that investments are meeting the desired strategies. Regular checking of the stock will guide the shareholder whether to sell them off or buy additional shares. Finally, Singh, Sudhir. (2012).also advices that investors should understand that slight underperformance should not be a discouragement to them. He notes that in most cases, strategies for earning abnormal profits usually exaggerate cognitive biasness hence they lead to lower returns. However, investment strategies based on the indexing avoids bad effects of biases thus they are deemed more favorable. Conclusion In conclusion, behavioral finance is a new concept in the economic world in that it encompasses both the conventional economics and psychological concepts. Behavioral finance concepts came into existence when the convention economic concepts failed to answer the question of irrational behavior in consumers in choosing the right options among others. The conventional economics holds that people are rational when it comes to making investment decision. However, the fact on the ground is that people tend to irrational due to biasness. This biasness emanates from different sources, therefore the form of biasness an individual attributes to a particular option tend to affect his decision. Scholars have tried to give some of the strategies investors can use to avoid biasness when making investment decisions. Majorly, these strategies depend on the self-awareness and the goals of the investor in the investment project. Moreover, scholars have identified some factors a serious investor should put in mind before making any investment decision especially when he wants to buy shares from a company. These factors act as measuring indicators investors can use to choose the best share option especially when many companies are offering on the market. An investor such as that one seeking more advise on which option to settle on between UK bank shares and the Apple shares should consider the mentioned factors and take note of the sources of biasness in order for him to come up with a credible decision that would not harm him in future. Bibliography Cartwright, Edward. (2011).Behavioral economics. Routledge. London Levy, Haim. (2002).Fundamentals of investments. Harlow: Financial Times. Prentice Hall. Michael, Bill. Sayer, David. &Harman, Nigel. (2011). UK banks: Performing benchmarking report. Accessed on 21st Aug 2012. Retrieved from http://www.kpmg.com/dutchcaribbean/en/Documents/Financial%20Service%20UK%20 Banks%20Performance%20Benchmarking%20Report%20HY%20Results%202011.pdf. KPMG. LLP Inc. UK. Montier, James, 2007. Behavioural Investing: A Practioner’s Guide to Applying Behavioural Finance. Chichester: Wiley Finance Sewell, Martin. (2010). Behavioral finance. Accessed on 21st Aug 2012. 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