Behavioral Finance Nowadays - Essay Example

Behavioral Finance- FIN 645 QUESTION The following quotation appeared in the Fortune magazine “I have never asked to serve ona corporate board, never even hinted at wanting to be on one. And I have never asked to be on a compensation committee. I suspect that the reason I’ve been put on so many is that word gets around that I believe in paying people very, very well… I cannot sit and say to you what the right compensation number is. That’s the judgment call, the business judgment call. That’s what a board of directors does… What I know most of all is that when I see extraordinary effort and results out of a CEO, you can’t pay him enough.” Evaluate the comments made by this particular director. Make sure your responses are well organized and documented, using references/examples from any of the assigned readings on the topic for this class. Be well organized in your writing. Maximum pages: four pages, double-space, size 12 Grade: 25 The extract herein depicts a conversation. The conversation seems to be anchored around organizational management. A keen look at the extract avails the exact relationship between the communicator and the context. Here, the communicator seems to be a successful management guru who gets to be interviewed by a journalist. The first statement justifies the success that the communicator has had in management. In the sentence, the communicator is quoted as saying how he has never been in need to work for any organization at the corporate level. At this point, the reader is made to understand that the speaker has been working at the corporate level of organizations courtesy of the success he/she has enjoyed. Further, the speaker seems to have vast knowledge on the different aspects of management. This experience might have been the platform through which he/she has won attraction from many organizations. The basic aspect of the organization that the speaker seems to have met success is motivation of employees. In more than one occasion in the extract, the speaker is seen as mentioning the word “compensation.” The repetition at one point may mean emphasis; basically showing which aspect of the organization is more important to the speaker. The repetition may also stand to mean the point of interest. The speaker sounds to be very interested on the wellbeing of the employees, not only when such employees are with the organization, but even after such employees leave the organization. Apparently, the many times the speaker has been forced to boards of directors, he/she has always noticed that managerial production is very much anchored on how best organizations motivate such office holders. In an illustration, the speaker gives an example of how good it would be for an organization to motivate their top performing CEOs. To the speaker, money apart from money which is considered the epicenter of motivation, he/she cannot explain any more aspects of motivation. One factor that stands out from this extract is that motivation does not only mean focus on money strands. Based on the use of words, one can evaluate the speaker as one individual who really believes in himself. Each and every statement out of the speaker seems to be very firm. The speaker as well seems aware of what they are saying. There are no unnecessary repetitions. He/she is a critical thinker. Who would not wish such an individual to be on their board of directors? QUESTION 2. Given the new economic and market realities prevailing since the 2008 great recession – including employment opportunities for yourself as a business executive – first list, and then explain in needed details the top four (4) Behavioral Finance lessons that you learned in this class that can be of value to you going forward. I emphasize going forward because my goal in this question is to see how you can apply the lessons learned in this course to make decisions that may face you at work now or in the future. This also means you must answer this question from the perspective of your job; your present job or a job that you envision you may have later on. Make sure you answer this question in light of the post-2008 economic and financial realities. Don’t be afraid to “take risk” in answering this question; it may pay off in both grading and your future experiences! :-) Maximum pages: three pages, double-space, size 12; reference page(s) does not count in the maximum page limit. Grade: 25 Since the year 2008 that saw the genesis of great recession, a lot has changed in the world of economic trends. Basically, nations do not look at their economies as they used to be. This zest has been instigated by the effects of the great recession that to date can be seen. Individually, the aspect of economic recession that has kept my head up is the effects that this depression has had on Greece. When one studied the economic trends of Greece before 2007, no one could default their economists. Does the same happen today? Not really. The problem might have arisen from how well such economists perceived the concept of behavioral finance. Basically, the economic periods to any economist should be like bubbles. Bubbles swell, but no one ever knows when they are going to burst. The first lesson I have learnt in behavioral finance is the concept of anchoring. In my profession and in many others, people are obsessed with the short term value. Contemporarily, people would go for substitutes that that would satisfy the same needs. In economics however, I have noticed that people should go for the hard rock decisions that have long term solutions. Any country would sustain their job market with critical analysis of the concept of anchoring. The second lesson is on hindsight bias. In most cases, people tend to overrate their aptitude to predict trends. Not one individual understands that trends are in constant evolution. One trend today mutates to a very different trend tomorrow. To stay adept to these trends, I have learnt flexibility as the trick. Always stay informed and be ready to learn, it will make you grow with growth and create contingencies with ease. My third lesson on behavioral finance is the on the threats of confirmation biases. We live in a world with much diversified opinions. Any question that we ask seems to be having an answer already. The theories that surround people have made it so easy for such people to make continuous mistakes. The future depends on originality, my knowledge in this field has taught me to give little reference to what already exists but rather to what is yet to come. My final lesson in the behavioral finance is anchored around the herd behavior. World innovation trends reveal how people tend to be thinking in herds. Individualism is gradually becoming a word of the past. My opinion is that much as we need groupings to put our ideas in place, we do not need groups in making decisions that we know are life changing. Manipulation of the status quo to me is the core of future developments both for individuals and groups and nations. QUESTION 3. Say the level of the market as measured by the Dow Jones Industrial Average is currently at 12,000. A forecaster has made a prediction of 13,300 for the level of the market in one year, along with a 95% confidence interval whose lower bound is 12,500 and whose upper bound is 14,500. You know from experience that this particular forecaster tends to be both excessively optimistic and miscalibrated. Describe how you might debias this individual. Give a numerical example (making up relevant numbers as appropriate). Grade: 20. Predilection gain is; 13,300 – 12,000 = 1,300 The range for the predilection is; 12,500 to 14,500 With 12,500 gain is; 12,500 – 12,000 = 500 With 14,500 gain is; 14,500 – 12,000 = 2,500 Range is 14,500 – 12,000 = 2,500 As the forecaster is excessively optimistic, the proposed upper range of 14,500 is most likely overestimated. QUESTION 4. Lou Donaldson and his neighbor, both U.S. residents, are meeting at a local restaurant. During lunch, they discuss investing and Donaldson, age 45, makes the following statements: 1. “My father was a buy-and-hold investor but I am an active trader. To keep trading costs low, I use an online brokerage firm. I have done well investing in technology companies because I know the industry.” 2. “I am holding a large position in Omega Corporation with a large unrealized loss. Omega’s stock price declined last year when reported sales and earnings failed to meet analyst expectations. I took advantage of the decline to increase my position. Omega sales growth has continued to slow over the last year, but I believe the stock is still a good investment.” 3. “I read a newspaper article reporting that commercial property values in the city have increased 14 percent annually since 2000. According to the article, the average commercial property in the city sold for $1.5 million last year. This makes me very happy because I just purchased a piece of commercial property last month. There is no doubt that it will be a good investment.” Select the behavioral finance concept best exhibited in each of Donaldson’s three statements. Explain how the behavioral finance concept you selected affects Donaldson’s investment decision making. Note: No behavioral finance concept can be used more than once. Grade: 15. 1. Overconfidence, Donaldson exhibits overconfident in this one. He trades actively rather than holding, uses online brokerage firms despite the risks due to low costs and overly relies on his knowledge of technology companies to pick stock. As observed by Terrence Odean, traders that conducted most trades tended on average to receive lower yields than the market. 2. Loss aversion and disposition effect; in this case, Lou Donaldson has made a bad investment and regardless of all indication of further looming loss, he hopes. He holds a large position in Omega Corporation which has a large unrealized loss. The previous year, when sales and earnings did not meet expectations, a bad indication also, Donaldson, respite of all rational indications, took the opportunity to increase position in Omega Corporation. 3. Confirmation bias; In this case Lou Donaldson, 45 is trying to support his commercial property investment purchase by actively looking for information that supports his reason for the investment decision (Akers & Deaves, 2010) . In this case Donaldson sites a newspaper article that purports that commercial property prices have increased annually by 14% since 2000. First there is need to make sure that what the newspaper is purporting is true by cross referencing with bureau of statistics figures and other sources of information. Secondly even if the rate of price increase is true other factors may affect how future commercial property prices may look like. QUESTION 5. Joyce Siosan is a 42-year-old lawyer at a prestigious law firm. She is meeting with Joel Murray, a financial advisor, to organize her finances. During the interview process, Siosan tells Murray that she has been purchasing short-term, out-of-the-money call and put options. Siosan acknowledges these options have a low probability of paying off and that the expected return from her options trading is negative. However, she states that she is attracted by the possibility of high returns when she can exercise in-the-money options. At the same time, Murray notes that Siosan has been purchasing low-payoff earthquake insurance on her home, which is located in a low-probability earthquake zone. A. Describe Siosan’s utility function. Contrast her utility function with that assumed in traditional finance theory. A utility function specifies utility of a consumer for all combinations goods received. In this case, Joyce Siosan has been purchasing short-term, out of the money call and put options, although this have low probability of paying off. Traditional finance theory attempts to maximize on possible returns by diversification in investing with aim of collecting investment assets with low risk. Therefore, the traditional finance theory would have more of the high return in the money options with less or no of the out of the money call and put options and no earthquake insurance. Siosan purchases a new luxury vehicle every two years and takes expensive annual vacations. She has a reputation for paying the entire bill at the upscale restaurants where she dines regularly with her friends. Siosan’s annual consumption, options trading, and housing expenditures are paid for entirely out of her salary income and half of her modest sources of income into her relatively small retirement account, which excludes her options trading (Yan, 2011). Siosan is reluctant to incur debt and has only a small mortgage on her home, despite the fact that she will soon be made a partner in her firm and will have much higher earnings. Murray believes that Siosan exhibits behavioral biases that interfere with an optimal savings and consumption allocation. In particular, he thinks that she is not saving enough for retirement. B. Discuss how Siosan’s behavior reflects the bias of: i. self-control. ii. mental accounting. Explain how a rational economic individual in traditional finance would behave differently with respect to each bias. In the above case, Siosan can exercise self control by increasing the yearly gap before she purchases new luxury vehicles or she takes expensive annual vacations. She also can regulate the number of times she pays the entire restaurant bill for her friends by letting them pay at other times (Ian, 2011). Siosan assumes mental accounting by using her salary income to pay for her annual consumption, options trading and housing expenditure. She puts half of her modest sources of income into small retirement account. Siosan’s retirement portfolio is allocated 50% to money-market securities and 50% to a few speculative stocks that she read about in an investment newsletter. Murray observes that Siosan’s retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean–variance framework. C. Determine whether Murray’s observation about Siosan’s retirement portfolio allocation is correct. Justify your response with two reasons. Grade: 15. First, Soisan diversification is viable as she can diversify into other securities. Also, having 50% investment in money markets is not advisable as money markets are highly volatile with short term returns. 50% investment on short term speculative stocks is not advisable. Soisan’s retirement portfolio is entirely based on short term high risk investments. For retirement portfolio, she can invest her money in long low risk stable return investments like bonds and stocks which she expects to perform well in the future. References Akers & Deaves Cengage (2010) Behavioral Finance: Psychology, Decision-Making, and Markets) by Ian, K. (2011). Deformation of the organization of Ownership in Ukraine and tribulations: Constructing an Efficient proprietor in an incompetent State: Journal on Problems of Economic Transition, 53, 12, 78-90. Wako, W. (2011). Prudential policy and Banking performance in Japan: Elsevier Publication. Journal on Japanese Economy, 38, 3, 30-70. Yan, X. (2011). The Democratizing authority of Economic restructuring: Journal on Problems of Post-Communism, 58, 3, 39-52 Read More