Personal Investment in the UK - Is It a Science or a Matter of Good Fortune - Essay Example

? Personal Investment in UK – Is It a Science or a Matter of Good Fortune Table of Contents Introduction 4 Evaluation: It is a Science 5 Modern Portfolio Theory (MPT) 5 Capital Asset Pricing Model (CAPM) 6 Arbitrage Pricing Theory (APT) 7 Black-Scholes (BS) Model 7 Rough Set Theory (RST) 8 Financial Services Authority (FSA) 9 Matter of Good Fortune 10 Different Types of UK Investment 10 Individual Saving Accounts Allowance 10 Investment Trusts 11 Unit Trusts 12 Open Ended Investment Companies 12 Stocks and Shares 13 Fixed Income Securities 13 Property 13 Liquidity Funds 14 Balanced Portfolio 14 Portfolio Management 15 Difficulties Associated with Portfolio Management 16 Transaction cost 16 Taxes 17 Statutory Stipulation 17 Time Constraint 17 Conclusion 17 Personal Development Reflection 18 Reference 22 Bibliography 25 Introduction The London Stock Exchange is considered as one of the oldest stock exchange of the world and can draw its history back more than 300 years. Participation by the people in the investment activity of United Kingdom is a long history. Personal investment is done by the individual. Personal investing constitutes an important part in personal financial investment. Personal investment is done for future expenditure plans such as to buy real estate, pay for family expenses and also to pay off outstanding loans. Now, the question is how an individual invest. He may begin to build up his financial assets in order to pay for long term financial goals. He may want assets accessible to make down payments on housing and may also want to guarantee that human capital is low risk by buying disability insurance and term insurance (Schewart, 1999, pp.1-2). Personal Investment is done in order to create a safe financial cushion which will be used in after years. The cushion includes various types of investment such as participating in pension plans, individual saving accounts, investment trusts, unit trusts, open ended investment companies, endowment policies, annuities and other transaction of gilts and bonds, shares, property, liquidity funds and other options (Nestpensions, pp.1-2). Personal investor should create an investment portfolio in order to better manage their investment which in turn helps them to improve their standard of living. In personal investment, portfolio plays very important role. Markowitz’s theory indicates that successful combination of a portfolio present a given level of risk with maximum expected return, or a given expected return with low level of risk (Ou, 2005, pp.31-39). If personal investor will be able to manage their portfolio in a well manner, then market will be defeated by them and they will get good return. However, it is impossible for everyone to get good return in investment in the United Kingdom. For this particular reason, there can be a debate that “the personal investment in UK – is it a science or a matter of good fortune”? Evaluation: It is a Science If personal investors in UK want to get higher return and to decrease investment risk, then they should learn and use some principles, theories and approaches in order to manage their portfolio in a significant manner and to make predictions on the trend of investment to achieve their goals. With the growth of investment theory, more principles, theories and approaches are coming up with the experts, scholars and investors. Modern Portfolio Theory (MPT) Modern portfolio theory (MPT) is published by Harry Markowitz in 1952. It offers a framework for the systematic selection of portfolios which are based on expected return and risk principles. MPT principles are used by the financial advisors in advising their individual investor client and MPT terms are used by the financial commentators in discussing the current investing environment. The theory focuses on how risk averse investors can build a portfolio to formulate the best on expected return in view of a given level of risk. Markowitz was the first to develop the portfolio diversification concept. He showed quantitatively, how portfolio diversification reduces the risk of a portfolio when individual risks are correlated. He also showed that the investor should account for the interrelationships between security returns to calculate portfolio risk and also to reduce portfolio risk to its lowest level for any given level of return. Markowitz had created a formulation known as mean variance and efficient frontier in order to calculate how one can get the better expected return (Jones, 2009, pp.168-169). The basic for the portfolio management’s modern theory was provided by the Markowitz model. The investors may gain minimum risk of portfolio under the same expected return, if they will use the modern portfolio theory in order to optimize their portfolio. So, it is a science. Capital Asset Pricing Model (CAPM) It was introduced by Jack Treynor (1961, 1962), Jan Mossin (1966), John Linter (1965) and William Sharpe (1964) independently, depending on the tentative work of Harry Markowitz on modern portfolio theory. The capital asset pricing model classifies risk factor into two types. One is the risk factors that cannot be diversified away by the use of Markowitz framework irrespective of the face that what the investors does, they cannot eliminate these risk factors. These risk factors are known as systematic risk factor. Second are the risk factors that can be eradicated by means of diversification. These risk factors are known as unsystematic risk factors and they are unique to the asset. According to CAPM, it has only one systematic risk factor i.e. market risk – the risk of the whole movement of the market. This is the risk related with holding a portfolio which consists of all assets, known as the “market portfolio” (Focardi and Fabozzi, 2004, p.86). CAPM is a model for measure of the value on an individual portfolio. Security market line is used for individual securities. It shows the relationship between systematic risk and expected return to disclose how market can make a price to individual securities by means of the relation to their security risk level. Capital asset pricing model provides a method for dealing with risk for both firms’ investment and portfolio investors. With subsequent earnings for both individuals and economy as a whole, if properly used, this will improve the capability of decision making inside and outside the firm. Therefore, Capital asset pricing model is scientific for the personal investors in order to develop their decision-making. Arbitrage Pricing Theory (APT) Arbitrage pricing theory is a theory proposed by Ross (1976) which was extended from Capital asset pricing model. It is a theory of asset pricing that states that expected return of a financial capital can be replicate as a linear function of different macroeconomic element. It is susceptible to changes in each element characterized by a factor-specific beta coefficient. To price the asset accurately, the return’s model-derived rate can be used. If the price deviates, then it can be brought back into the line by the arbitrage. It is expected that APT is excellent than CAPM, because it need more subsistent assumptions and also the explanation power of arbitrage pricing theory is better than capital asset pricing model because the APT model is multifactor. The two fundamental principles of arbitrage pricing theory are linear k-factor model and absence of arbitrage. The assumptions of arbitrage pricing theory are: the two fundamental principles stated above, financial markets are frictionless and competitive; and investors have identical expectations about the return generating process and they are risk averse and also the risk aversion and expectations are bounded (Koch, 2009, pp.18-19). One cannot imagine any particular asset pricing to entirely describe reality. If an asset pricing model improves the understanding of security market return of an investor then it is a success. As discussed earlier, arbitrage pricing theory has no gaps and weakness (Jarrow, 1995 p.136). Therefore, it is a success and a scientific asset pricing model for personal investor. Black-Scholes (BS) Model It was first expressed by Black and Scholes (1973), published in the journal of Political Economy. It is a mathematical model generally used by options market investors. The equation of black – schools explains the option’s price over time in the form of a partial differential equation. The key idea behind the equation is that investor can buy and sell the underlying asset to hedge the option in the correct way and eliminate risk accordingly. After the model was published in the journal of political economic for the first time, immediately, the Chicago board options exchange dealer realized its importance. Sooner, it was programmed into computer and used in the Chicago board options exchange. Today, the black – Scholes model and some of its deformation is broadly used by financial managers, options investors, investment banks and underwriter. It is viewed that Merton, Black and Scholes’ work are a modulation point in the study. Their method gives evidence that it is very useful for investors trading in options market. This approach is very dynamic for extending the option pricing theory in many respects on another side. Hence, today this model is widely used in finance. Moreover, the black – Scholes model is used by the investors to calculate and then price the financial derivatives. It is also applied for the pricing of corporate bonds, interest-rate derivatives and real options (Balakrishnan, 2010, p.660). Above, the basic and widely used theories and models in investments have been discussed. Definitely, the personal investors in UK can use other approach, theories and principles in order to manage their portfolio and predict the markets and thus make their investment decisions. Rough Set Theory (RST) Rough set theory is a rule-based decision making technique, developed by Pawlak (1981). The various applications of rough set theory are existed in different scientific fields. It is a helpful method for those people who use to make investment decision. Gain-loss portfolio theory is significant for those investors who are looking for high expected return compared to expected loss. The unmatched return and losses abolish equal amount of wastage and portfolio return, but cancel a great percentage of portfolio waste than portfolio return (Abraham, Falcon and Bello, 2009, p.6). It was mentioned in a paper wrote by Mouselli and Hussainey (2009) to re-examine the effect of corporate related reporting in developing investors ability to better expect future earnings change in UK. Their result shows that disclosure quality factor is significant to pricing surplus gains of UK portfolios. Another study extended the research on the predictability of stock returns in the British equity capital market. It examines the macroeconomic variables like term structure of interest rates and fundamentals predictive power like dividend yields. Some studies have also found that stock returns are discovered from the term structure of interest rates and from a set of general stock market variables. There are number of evidence that signifies that long and short-horizon stock returns could be forecasted by fundamental variables such as dividend yields. To the investors’ predictability, joint bond stock model is a very helpful model. Financial Services Authority (FSA) With the exception of principles, theories and approach, the regulation plays a crucial role in personal investment in the United Kingdom. Regulation is executive legislation that distributed responsibilities and composes rights. The Financial Services Authority is an independent no-government body in UK which is accountable for the financial services industry’s regulation. They are an open organization which provides full information for firms, consumers and others about their objectives, plans, policies and rules. They control exchanges, firms and financial services markets. Financial services, exchanges and firms must meet the FSA standards. If the exchanges, firms and financial services markets are ineligible to meet the required standards, then Financial Services Authority can take action against them. The Financial Services and Market Act (2000) present four statutory objectives and they are: financial stability, reduction of financial crime, market confidence and consumer protection. Overall, Financial Services Authority implements the regulation to provide an immense investment environment for personal investors in United Kingdom. Without regulations, the investment environment in the UK might be anarchic and out of control. Therefore, the regulations provided by Financial Services Authority makes the investment environment controlled and well organized in UK. So, the personal investors can invest in a rational and scientific market (Buckle and Thompson, 2004, p.345). Matter of Good Fortune As discussed above, it was clear that approach, principles and theories can help the personal investors in improving their ability in order to predict markets and control the portfolio. Regulations also provide an accurate investment system to the personal investors. But, it is also true that sometimes luck decides whether investors will get profit or not from the market. Kumar (2005) in his paper describes that the gambling preferences of individual investors are revealed in their decisions of stock investment. He believed that individual investors use to prefer lottery type stocks and the necessity for the stocks with lottery characteristics mature during economic downturns. Some recent studies have shown that nearly every mutual fund that surpasses the market is a matter of good fortune. Different Types of UK Investment Individual Saving Accounts Allowance The easiest way to save tax free is through Individual Saving Account. It enables to invest from cash to stock and shares to government bonds. Individual Saving Accounts are accessible from range of sources such as banks, supermarkets, building societies, investment firms, national savings, financial advisors, stockbrokers and insurers (Glasgow, 2011). To simplify the Individual Saving Account structure, the difference between mini and maxi Individual Saving Accounts has disappeared. Nowadays, there is only a difference between a Cash Individual Saving Account and a Shares and Stocks Individual Saving Account. This means that an Individual Saving Account can now include up to two different types of investment i.e. one is stocks and shares and the other is cash (Sutherland, 2003, p.280). Individual Saving Account investment growth does not usually incur a tax liability. It is flexible because it allows both regular fixed contributions and lump sum investments. In UK, Individual Saving Account is a tax efficient method of saving (Glasgow, 2011). Following latest changes in government legislation, the limit of future Individual Saving Account are tied to the Retail Prices Index. It is now possible for the people to transfer money which are held in a Cash Individual Saving Account to Stocks and Shares Individual Saving Account without affecting yearly allowance or the tax status of the investment. Investment Trusts Investment Trusts buy and sell shares in other companies. When someone invests in an investment trust companies, then they become a shareholder of that company. Their shares will rise and fall according to the demand and supply of the shares. Investment trusts facilitate to spread risk by investing in several other companies without bothering about buying, selling and monitoring shares individually. There are about more than 350 UK listed investment trusts. They offer income, capital growth and specialist situations for example investment in a particular sector or a country. The lifespan of some investment trust are short, usually ten years. The idea behind this is to give the investors a date, of selling all the assets by the trust and returning the cash to shareholders. Split-Capital, which is sometimes called split-level investment trusts offer two types of shares: one has the right towards all capital growth and other has the right towards all income from the trust. All splits usually have seven to ten years wind-up date from their launch. The income shareholders are capable of receiving all the incomes in the form of dividends, from the trust. They will receive dividends with a fixed or nominal amount at the time of wind-up. At the end of split’s life, capital shareholders are capable of receiving their paybacks, when they get the value of all the assets after the repayment of income shareholders (Leach, 2012). Unit Trusts A unit trust minimizes the risk of investing in stock market through diversification by scattering the money across different types of investments or a wide range of shares. Companies and individuals may contribute in unit trust which is a fund, to obtain a share in the returns which is generated by the fund. It is a cost effective and the usefulness of this trust is that the professional fund managers are engaged to look after the investor’s money. A unit trust spreads the risk by diversifying the investment of investors. Therefore, they can gain from stock market returns without restricting their investment to a small number of companies (Buckle and Thompson, 2004, p.136). Open Ended Investment Companies Open ended investment companies are hybrid investment vehicles composing some of the features of a unit trust and some of a company. It is flexible as compared to unit trust. It is more elastic in establishing an umbrella fund with several sub-funds. Each sub-fund can issue different types of share classes, ranging from currency denominations to distribution and accumulating shares (Viitala, 2004, p.35). Open-ended means that the shares which are in the fund will be created as investors invest and cancelled as the investors’ cash in. Open-ended investment companies are anticipated as a medium to long term investment. As this investment may go up as well as down in value, the investors may not get back the amount invested. It can issue bearer shares or registered shares or indeed both. The share register of the open-ended investment companies must be updated daily (Loader, 2011, p.46). It was developed to make cross-border investing easier (Davidson, 2008, p.159). Stocks and Shares Stocks and shares are also known as equities which is an individual unit signifying ownership of a company. Companies issues shares to raise money for business investment. Shares do not have fixed price, it fluctuates according to the macroeconomic factors. Announcement regarding potential takeover, employment, merger bid or manufacturing can influence the movement of the market. If the performance of the company is good, shareholders may be able to receive a dividend paid on each share held by them or may be able to sell their shares at profit. However, it is also true that, if the company does not perform well, they may lose out on their investment (Nestpensions, p.1). Fixed Income Securities It is a type of loan which includes gilts and bonds. It is used by companies and governments to raise money. UK government bonds are known as gilt-edged securities and the bonds which are issued by companies are known as corporate bonds. Bonds are useful for the investment fund’s managers in order to control income within the fund because it pay regular interest and are also repaid in full on the repayment date (Nestpensions, p.1). Property Investing in property is a profitable type of investment but direct property investment can be risky and may also hard to cash in if the property market falls. Funds managers also invest in properties. They don’t invest directly but invest in companies that manage properties. Fund managers may also invest in other funds that concentrate in property investing and these funds are known as real-estate investment trusts (Nestpensions, p.1). Liquidity Funds Liquidity funds are easy to convert into cash when it is required by fund manager. Here liquidity means how easily a particular asset can be sold. Liquidity funds carry little investment risk because they always pay a set amount but there is inflation risk associated with them. There are two uses of liquidity funds in investment funds: firstly, it is used to protect the value of money when shares and bonds are behaving in an irregular way. During these times, a larger portion of money will be put by the manager into investments which have a guaranteed return. Secondly, the liquidity funds form a reserve from which other types of assets can be bought by manager in order to pay to the investors when they want their money back (Nestpensions, p.1). Balanced Portfolio A balanced portfolio is a combination of bonds and stock. For investors, investing in bonds and stocks plays important role in order to maintain balanced portfolio. They invest in stocks for investment growth and in bonds for income generation. Establishing a balanced portfolio by investors enables them to hedge against the ups and downs prevailing in the financial markets. By combining definite portion of equities in a bond portfolio, one can get a low risk profile and a better return. If the investors have more knowledge about the stock market and how it works and about what actually diversification is, they have more appetite for risk. There is a rule; if one is forty years old, then he should have 40% in bonds and 60% in equities, and if one is sixty years old, then he should have 60% in bonds and 40% in equities (Bennett, 1995, pp.68-72). Portfolio Management Portfolio management is the fundamental work of investment management. It can be done by minimizing the risk through diversification. In order to manage an investment portfolio, three steps are considered by portfolio manager i.e. planning to execution to feedback. In the planning step, the objectives and policies of investment are formulated, strategic asset allocations are ascertained and capital market expectations are formed. In the execution step, a portfolio is constructed by portfolio manager. And, in the feedback step, the portfolio manager examines and assesses the portfolio compared with the plan (Villanova, p.5). The steps discussed here were in the short form. Taking in account the large form, the portfolio manager have to consider the following steps in order to manage his investment portfolio. The steps are as follows: Specification of investment objectives: In order to manage an investment portfolio, the usual objectives sought by investors are capital appreciation, current income and safety of principals. Choice of asset mix: Asset mix decision is the most important decision in the portfolio management. This is concerned with the proportions of bonds and stocks in the portfolio. The stock-bond mix mainly depends on the investment horizon and risk tolerance of the investor. Formulation of portfolio strategy: An active portfolio strategy attempt to earn better risk-adjusted returns by resorting to market timing, or security selection, or sector rotation, or some combination of these. A passive portfolio strategy involves maintaining a fixed level of risk exposure and holding a diversified portfolio. Selection of securities: For perfect portfolio management, in order to do stock selection, the investors usually go by technical analysis and fundamental analysis. Portfolio execution: The portfolio manager implements the portfolio plan by buying and selling particular securities in given amounts. Portfolio revision: Fluctuation in stock prices is a common factor. So, in order to manage the portfolio, the portfolio manager needs to do the portfolio rebalancing. It includes a shift from bonds to stocks or stocks to bonds. It may also call for security switches as well as sector rotation. Performance evaluation: The portfolio manager needs to evaluate the performance of a portfolio periodically. The key dimensions are risk and return and the main issue is whether the return of portfolio is proportionate with its risk exposure. These types of review provide positive feedback in order to improve the quality of portfolio management on a regular basis (Chandra, 2008, pp.13-14). Difficulties Associated with Portfolio Management The portfolio manager has to face certain difficulties in rebalancing the portfolio. The difficulties associated with portfolio management are as follows: Transaction cost Regularly buying and selling of securities for portfolio rebalancing may increase the transaction cost thereby minimizing the gains from portfolio rebalancing. Therefore, the transaction cost involved may act as a limitation towards timely revision of portfolio. Taxes Taxes are payable on capital gains which are arising from sale of securities. Generally, short-term capital gains are taxed at a higher rate than long-term capital gains. Therefore, higher tax on short term capital gains works as a constraint. Statutory Stipulation In every country, the largest portfolios are managed by mutual funds and investment companies. The institutional investors are governed by statutory stipulations in relation to their investment activities. These stipulations sometimes act as constraints. Time Constraint Management of portfolio through portfolio revision is a time consuming activity because it involves different approaches and techniques (Kevin, 2006, p.211). Conclusion This essay focuses on the history of stock exchange in the UK and explains the meaning of personal investment. It also evaluates and discusses some approach, theories and principles such as modern portfolio theory, capital asset pricing model, arbitrage pricing theory, black-Scholes model, rough set theory and the regulations which are established by financial services authority. All these theories, approaches and principles signify that personal investment in the UK is a science. After that, it was also estimated that investments have the relation to luck. Good fortune sometimes happens in investment, but in real, skill is the main factor in investment. Therefore, this essay considers that “Personal investment in UK has an aspect of good fortune, but as a whole, is a science”. At last, this paper also explains the characteristics of different types of investment and their combination in balanced portfolio along with investment portfolio management and the constraints associated with it. Personal Development Reflection As a student of MBA Finance, “Personal development, finance and portfolio management” is a core component for me. We were divided into various groups of seven or eight students in each team. After about eight weeks of study on the module, we got to know about various types of investment in UK and tried our level best to manage our portfolio. Each one needs to manage its own portfolio, as it is a personal development. We invest in shares, gilts and open-ended investment companies. All together, we made a profit and our capital increased from 300,000 to approx 307,000. In our team, no one has investment experience before, except me. So, they chose me as a team leader but I too don’t have an experience about investment in UK. Behavioural finance is considered as an important factor for analysing market trends and take investment decisions. Good fortune sometimes happens in investment, but in real, skill is the main factor in investment. Investors should take good decisions using queues and signals sent from the market otherwise they can miss the good opportunities to invest. For instance, regular updates regarding the market movements, how news affects the stock price movements, regular updates on interest rates, government policies, industry trends, stock specific news, etc. should be followed. In case of the team’s portfolio management event, team working is also very important. It helps to learn from other and enables to take better decision in investment. Therefore, it makes me uncomfortable. But, after eight weeks of study, I have good as well as bad experience as regards to this module. The good experience was that: first of all I improve my capability to evaluate investment whatever technical or fundamental analysis and improved my ability of making decision in investment through the simulation fund. I also discussed the problems that I faced related to investment and shared my investment experience with other members. I have been chosen a team leader and a good team leader is one who can make their team members to reach a common goal. In this module investment awareness also played a crucial role. Moreover, we cannot disregard the importance of planning. Our portfolio is not doing well because of lack of planning. So, I toughen the leadership by categorizing the team members to manage portfolio. For technical analysis our team members decided among each other regarding who would monitor which websites in order to analyse and understand the latest trends in market. Our technical analysis was conducted on authorised and legitimate websites including London Stock Exchange and Bloomberg. Our team members individually focused at particular investment stocks, market price movements, news related to government policies, sovereign debt crisis, and so on. The fundamental analysis was conducted on individual stocks by observing the performance of the companies during last five years. Various tools of performance analysis such as ratio analysis, trend analysis, cross-section analysis with key competitors in the same industry was done individually by all members in the teams. Discussion facilities are also taking place online. Regular debates were conducted on a particular topic set by a faculty so that students can contribute their views. But this activity takes place within a definite time period. If the students have certain queries regarding some topics then they can clear it with the help of their faculty members through online chat. The merit of online discussion facilities is that it can take place anytime i.e. there is no need to go to the class specially for solving the queries or for any other type of discussion. The bad experience was that most often I lack in sensitivity to market news thereby resulting in losing good investment opportunities. Since we worked as a team, the biggest advantage that I got was that I could assign the task to my class mate for analysing stock related news so that our team don’t miss good investment opportunity. Thus, as a team we shared our weaknesses and strengths. Our team ensured that individual weakness do not result into team failure. The capability of planning must be strong, because it was not good whatever we have done in diversity of investment. Above all this, I learnt lots of things from the event. Psychology is considered very important in investment. Investors should take good decisions using their psychology; otherwise they can miss the good opportunities to invest. In this event, team working is also very important. It helps to learn from other and enables to take better decision in investment. Leadership also plays vital role in a team. Moreover, we had played a “portfolio game”. I was responsible for managing trading activities of portfolio and for applying a portfolio’s investing strategy. A good leader is one who can make their team members to reach a common goal. In this module investment awareness also played a crucial role. Moreover, we cannot disregard the importance of planning. Our portfolio is not doing well because of lack of planning. If we had done planning in the beginning of the game then we might have enough cash to do other investment also (Jasper, 2003, pp.77-81). Our portfolio performance was barely satisfactory. In addition, I should do more diversification to minimize risk. I should focus more on the fundamental analysis, in order to make decision in investment through market news. If “portfolio game” happens again, then we will make investment plan at the beginning only. From the above discussion it can be said that if personal investors manage their portfolio in a well manner, he or she can understand the market in a better way but in no case can they outsmart the market. After doing the study of this module, a number of employability capabilities have been improved for me. It helps me to take actions and make decisions without hesitation. Team working builds good relationships with colleagues, customers, staff and suppliers within the organization. Leadership quality helped to take responsibility of the team. Efficient planning set up a course of action to achieve definite goals and also plan proper distribution of resources (Kubler and Forbes, 2006). The above competences will improve my employability. 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