The Mechanisms Used by Investors in the Share Market - Essay Example

THE NAME OF THE UNIVERSITY BANKING & FINANCE MECHANISMS USED BY INVESTORS IN STOCK MARKET STUDENT NAME ADMISSION CODE LECTURER NAME 8/31/2012 Describe the mechanisms used by investors in the share market to analyse and manage systematic and unsystematic risks. How do these risks affect share prices? Question: Describe the mechanisms used by investors in the share market to analyse and manage systematic and unsystematic risks. How do these risks affect share prices? Introduction The main reason of the investors trading on share market is to secure a way of raising funds for their businesses through the buying and selling of shares. The share market also helps them to evaluate the worth of their businesses in terms of shares and securities traded, because of the latest updates on share prices. The share market behavior will fluctuate time and again (fall and rise), a tendency that is known as volatility. Volatility in most share markets around the world makes it hard for price-setter to clear interpretations, sometimes resulting to erroneous economic signals (Barnett et al, 2010). The investment process is therefore surrounded with a number of risks, for example, systematic and unsystematic risks, which should be well analyzed and managed by investors. These risks sometimes undermines a fundamental maxim of share market that states “buy when price is low and sell when price is high” because one who buy cheaply but risks incorporated in them is high. Assaf and Cavalcante (2005, p.6) asserts that the share market is to some extent multifaceted system which itself is a part of a multifaceted system of the economy. Under this notion, investors employ a number of mechanisms that help them to analyse and manage the risks of the stock market. As such, the mechanisms help to foresee the future of the share market by establishing the underlying discrepancies and improvising models to base their market predictions. Stock market The stock market is an establishment where investors transact their business (stock exchanges), that is, buy and sell securities or equities. These equities are in allotment of shares of different firms. Each share is measured as a unit of possession of a firm’s value or revenues. Stock exchanges are perceived to be parameters geared towards marshalling financial resources to aid a most favorable and lucrative investment. Especially in the case of developing nations, which are in dire need of finances to sponsor their development projects, stock exchanges come in handy. In general, stock market encourages cooperation among investors by creating a neutral ground for investment in respective securities. It also develops a platform for entrepreneurs to mobilize or raise capital through provision of a trading system that ensure easy and accurate business transactions (Kidwell et al, 2010). Share market anomalies The rapid advances in technology have eased the mobility of financial flows around the world. As a result, financial markets find themselves in a catch-22 situation of a severe competition. This development has forced some stock exchanges to double the listing of firms in the market and increase cooperation among them as a response to a competitive environment. Such chinks in the share market have appeared to instigate some anomalies on stock market. According to Barnett et al (2010), the stock market anomalies refer to investment elements that constantly make returns above the expected one beside investment risks involved. For example, research has pointed out that stocks with low price-earnings (P.E) ratios will perform better than those with high price-earnings ratios. Also, those stocks with low market capitalizations perform better than those with high capitalization firms. Other anomalies that features most is the peculiar patterns in the timing of stock returns, as returns of one year could be achieved in one month or in one day or in hours. This implies that investors may use available public information to benchmarks performance of their investment. Risk factor in the Share Market The trading mechanism in the share market is established on business arrangements between a buyer, seller, and a broker who essentially carry out business in a stock exchange. Usually, the trading mechanism is almost the same as it’s the case of an auction, where willing business people make offers on some share or security. If the offer is acknowledged by the seller of the stock or security, the broker completed the transaction. Trading in the share market calls for a certain level of risk and for such risk to be assumed, an investor should be remunerated properly. This remuneration is in the form of a fee known as the risk premium or just premium. The risk factor is thus indispensable in the share markets if investment is to make worthy gains (Barnett et a, 2010). The integral elements that cause risk are price and interest (Kidwell et al, 2010). Risk is as well caused by internal and external factors that surround an investment. In any share market, there is strong connection between risk and return, as the investors saying goes, “the higher the risk, the higher and the return”. Risk management is an economic term referring to a process employed by investors to identify and analyse the financial risks there investment may be associated with, and then develop mechanisms to manage and minimize such risks while they maximize the returns. If the risks on the share market can be described using another term, then it is “volatility”. Majority of the well-known investors in the share market, have used risk management mechanisms to minimize the risk in their investment so as to maximize on their returns. Potential Investment Management Risks Risk factor and uncertainty are the basic parts of any investment, be it in the share market or not. The major investment risks in the share market comprises of systematic and unsystematic. Systematic risk refers to the risk that is linked with market returns. This is the risk on the value of an investment portfolio and is not accredited to any risk of individual investments. Systematic risk results from macroeconomic elements like inflation, currency fluctuations, recessions, insecurity and foreign investment policies (Assaf and Cavalcante, 2005). These are elements that affect the entire market. Whereas unsystematic risk is the kind of risk that is specifically associated with the company or the industry in which it operates in such as pricing of products, marketing strategy and labor union outcomes. This risk is based on a particular investment or on a collection few investments and is not linked to any returns from the share market. Unsystematic risk may sometimes be identified as specific risk or residual risk. The two risks will encompass market risk and inflation risk. According to Kidwell et al (2010), market risk occurs from changes that are experienced in the financial markets whereas inflation risk results from the changes in prices of products. Investors use inflation risk in determining the long term investments while market risk is more important in short term investments, because, the market is easily analyzed and managed to some extend whereas for inflation risk, it is hard to manage and control it. Mechanisms used to analyze and manage systematic and unsystematic risks There are several mechanisms that investors use to analyse and manage the risk in a share market. The mechanisms include: 1. Monitoring the trend of the market: This is the most common mechanism that investors use to minimize the two risks in a share market. The only hitch with this method is the intricacy of figuring out the trends in the market as they change incredibly fast, for example, a market trend may last even for one day (Kidwell et al, 2010). 2. Portfolio Diversification: Diversification of portfolio is perceived to be the best mechanism that investors use to mitigate an unsystematic risk as it’s not linked to any market risk. Investors who own diversified number of share portfolios minimizes the risk exposure to their investments compared to ones that have one share portfolio. Mutual Funds are yet another means to diversify the impact. 3. Asset allocation: It is believed asset allocation can partially mitigate systematic risk. By owning different kind of asset classes, with low correlation, an investor will have low portfolio volatility (risk) for the reason that asset classes act in a different way to macroeconomic elements. While in some cases the portfolio of asset categories could be rising some may be diminishing (Barnett et al, 2010). 4. Stopping Losses: The stoppage of losses is also another mechanism that investors employ to analyse and manage risks. This helps them to make sure that they don’t lose money easily should the securities collapse in the share market. In this mechanism the investor has the choice of walking out of a share market should price fall lower than a preferred specified limit. 5. Self-discipline: This is yet another alternative investors uses to dispose of their stock when there is steep fall in price. This is drawn from Warren Buffet, the ever best investor in stock market who pronounced “don’t lose money” In general, share market presage risk and good enough, there are adequate mechanisms that an astute investor will employ to secure his or her money and ensure good returns. A careful and timely utilization of these mechanisms will help investors analyse the risk associated in their investment and improvise strategy to manage the risk. In dealing with systematic risk, asset allocation is more important whereas unsystematic risk is well managed with diversification a portfolio. In a synopsis, the blend of asset allocation and correct diversification minimizes both types of risk, which are systematic and unsystematic risks (Assaf and Cavalcante, 2005). Therefore in the risk management mechanisms, asset allocation and portfolio diversification are basics of sound investments. Other Risk Management Solutions Sometimes when an investor has identified and evaluated the risk, he or she employs some four main risk management solutions: 1. Avoid: Investors try to minimize, if difficult to bear with the risk they may pull out from investment options. 2. Control: Investors try to undertake mitigation measures within their disposal to minimize the risk. 3. Transfer: Some investors will resort to outsource risk management solutions either through hedging or insurance 4. Accept: Investors will undertake the investment while bearing the risks involved in mind. This is especially when the level of risk is very low and poses small harm to investment. Conclusion Investment risks are key hindrances to any investment. The adoption of effective mechanism to help in analyzing and managing of either systematic risk or unsystematic risk by investors will be a sound investment decision, which will help in realizing good returns. In a financial market, avoiding and accepting risks are rather clear-cut decisions an investor should insinuate, while the other two, control and transfer, calls for a more reflection before a decision is reached. References Antoniou, A., Ergul, N. and Holmes, P. (1997). Market efficiency, thin trading and nonlinear behavior. European Financial Management, vol. 3, pp. 175-190 Assaf, A. and Cavalcante, J. (2005). Long range dependence in the returns and volatility of the Brazilian stock market, European Review of Economic and Finance, vol. 4, pp. 1-19 Atkins, A.B. and Dyl, E.A. (1990). Price reversal, bid ask spreads and market efficiency, Journal of Financial and Quantitative Analysis, vol. 25, pp. 535-547. Bouchaud, J.P., Gefen, Y., Potters, M. and Wyart, M. (2004), “Fluctuations and response in financial markets: the subtle nature of random price change”, Quantitative Finance, vol. 4, pp. 176-190. Barnett, W.A., Geweke, J. and Shell, K. (2010). Managing investment risk: Stock market. Cambridge University Press, New York. Chordia, T., Roll, R. and Subrahmayam, A. (2001) Market liquidity and trading activity, Journal of Finance, vol. 56, pp. 501-530. Famer, J.D. and Joshi, S. (2002). The price dynamics of common trading strategies, Journal of Economic Behaviour and Organization, vol. 49, pp. 149-171. Kaizoji, T. (2002). Speculative price dynamics in a heterogeneous agent model, Nonlinear dynamics, Psychology and Life Science, vol. 6, pp. 217-229. Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbee, D., & Peterson, R. (2010). Financial markets, Institutions and money (2nd Ed.). Milton, Queensland: John Wiley & Sons Australia Los, C.A. (2004). Measuring the degree of financial market efficiency, Kent state University working paper. Mouck, T. (1998). Capital markets research and real world complexity: the emerging challenge of chaos theory, Accounting, Organizations and Society, vol. 23, pp. 189-215. Peters, E. (1996). Chaos and order in the capital markets. A new view of cycles, prices and market volatility, John Wiley and Sons Chichester, pp. 83-105. Sadique, S. and Silvapulle, P. (2001). Long term memory in stock market returns: international evidence, International Journal of Finance and Economics, vol. 6, pp. 59-67. Willinger, W., Taqqu, M.S. and Teverovsky, V. (1999). Stock market prices and long range dependence, Finance and Stochastics, vol. 3, pp. 1-13. Read More