Behavioural Investment Strategies - Assignment Example

BEHAVIOURAL INVESTMENT STRATEGIES Your name Subject Date INTRODUCTION Financial markets refers to an elaborate system of the financial institution and intermediaries and arrangement put in place and developed to facilitate the transfer of funds from surplus economic units (savers) to deficit economic units (investors). Savers include individuals, small businesses, family units’ savings through institutions such as SACCOs, banks, insurance firms, pension schemes etc. Investors include government, companies, family units etc. BEHAVIOURAL INVESTMENT STRATEGIES This is a report addressing the questions from a behavioral finance perspective on the market or stocks to avoid or invest in and if it is worthy to follow the recommendations on business television hence the report covers certain segments that would cover an initial and in-depth outlook on the investment decisions based on the behavioral finance perspective. Behavioral finance perspective involves the study of psychology on the behavior of financial practitioners on the subsequent effects on markets (Maloney 2008). It opens up to the reasons as to why markets can be both efficient and inefficient. However there are behavioral perspectives that go against the theory of decision making in investing as they involve the psychological aspect of buyers and not on the influence of supply and demand. One of the behavioral aspects is when a buyer focuses on the face value gain than probability gain. The buyer tends to look rewarding value of a stock disregarding the probability aspect of the stock. A buyer may also be influenced by a crowd in making decisions since the he is human and would like to belong somewhere. This also goes against the principle of demand and supply. Another perspective is when an investor prefers predicting events as well as looking for pattern in investment choices ignoring their random nature. This explains the gambling nature of buyer even though he has the knowledge of the risks involved Before making any investment decisions in stocks, one first need to categorize him/ herself in the three major groups of investors i.e. averse, neutral or a risk taker. A risk adverse investor is one who avoids volatile stocks embracing the ones that are less risky even though they reward low returns; while a neutral investors takes more risk than adverse investor and less than a risk taker. Finally a risk taker as the name suggests engages in high risks which can have the greatest rewards or losses. Financial Markets/Institutions functions in the Economy In any economy, financial markets or an institution helps in the distribution of financial resources to the most productive units: Savings are transferred to economic units that have channels of alternative investments; making them the link between buyers and sellers. They help in the allocation of savings to real investment, in achieving real output in the economy by mobilizing capital for investment and in enabling companies make short term and long term investments decisions and hence increasing the liquidity of shares. According to Saunders & Million (n.d.), ffinancial markets provide provision of investment advice to individuals through financial experts, enables companies to raise short term and long term capital/funds; they act as means of pricing of securities for example Stock Exchange index shares by indicating changes in share prices. In addition, they are providing investment opportunities to various groups and savers can hold financial instrument for investment made. Financial markets are broadly classified into two categories namely; the capital Markets and the Money Market. Capital markets These are markets for long term funds with maturity period of more than one year. For example in capital markets, the financial instruments used here are debentures, terms, loans, bonds, warrants, preference shares, ordinary shares etc. The capital market serves as a way of allocating the available capital to the most efficient users. Capital market financial institution includes: Stock exchange, Development bank, Hire purchase companies, Building societies and Leasing firms. Capital markets are sub-divided into two namely Security markets and the Non-security/instrument. Security markets; these are the stock exchange dealing with instruments such as shares and debentures. Security market is further sub-divided into two; Primary market which enable organisations to raise new finance by issuing new shares or bonds, and the Secondary market which enables existing investors to sell their investments, should they wish to do so. Secondary market enhances the marketability of securities. The second type of Capital markets is the Non-security/instrument markets which involve mortgages and the capital leases. In both types, they provide long term funds which are necessary for investment decisions, help in giving advice to investors to make wise investments decisions and to make viable investments, they make long term investments to be made liquid as the transfer between shareholders is facilitated, facilitates the international capital inflow. In addition, capital markets facilitate the liquidation and marketing of a long term investor and also act as a channel through which foreign investments find their way into the market. Money/discount markets This is a market for Short Term funds maturing in a period of one year. Money market works through financial institutions as they facilitate transfer of capital between savers and users. The transfer can be direct (from saver to investor) and indirectly through an intermediary. Foreign exchange market is also part of money market. The money market or discount market is the market for short term loans. Financial Instruments in Money market include: Commercial paper, Treasury bills, Bills of exchange, Promissory notes, Bank overdrafts and Bankers certificate of deposit. These instruments are sold by commercial banks, merchant banks, discounting houses, acceptance houses, and government. The stock exchange market The Stock Markets also known as the equity markets are hubs where shares are issued and traded either through exchanges or over-the-counter markets. These markets are the most vital areas of a market economy in the manner that they provide companies with access to capital and investors with a part of ownership in the company and the potential of gains based on the company's future performance (profitability). Modern finance depends on the following key assumptions: a rational and a fair price being determined by financial market (Krantz 2010). Behavioral finance does not seek to contradict these tenets, but complements them by emphasizing the importance of human psychology and groupthink in financial markets. Behavioral finance points to the existence of market bubbles and manias as examples of cases where human behavior may be the missing link that explains such market anomalies. A majority of people assume that they can easily outperform the market simply by replicating the strategies used by successful professionals and or alternatively taking the opposite position held by the losers. On the other hand, the behavior of the "losers" or the "crowd" can be easily observed by taking note of certain leading behavioral indicators. These indicators show that the "crowd" can be reliably wrong at important market junctures as people fall prey to the collective emotions of fear (at market bottoms) and greed (at market tops). Stock exchange Stock exchange is special market places where already held stocks and bonds are bought and sold. They are, in effect, a financial institution, which provides the facilities and regulations needed to carry out such transactions quickly, conveniently and lawfully. There are several types of stock markets. Organized Exchange This is where the buying and selling of securities is done by buyers and sellers are not present but only the agents or brokers internet. Over the Counter Market (OTC) This type of stock exchange provides an opportunity for unlisted or unquoted firms to sell their security. OTC is usually organized by the dealers or stock brokers who buy securities themselves and then sell them. There are several benefits that a stock market can bring to an investor. Extra Cash Flow; by trading or selling options in the market one can extra monthly cash flow. The investor can use some extra cash here and there and the stock market gives you a great way to be able to get it, even if it’s just through dividends. Long Term Growth; The real benefit of trading or investing in the stock market is not the short term cash flow but the long term growth. It is a great place to keep ones money and to let it grow over years and years until it can finally start paying out a great income. Better returns than banking: when you deposit your money in the bank you only get small amounts of interest compared to what you would have got if you invested in the stocks. Furthermore, banks take the money they get from central deposits and pay you back a small percentage of the profit the made. The money markets on the other hand have the following benefits to an investor: High annual percentage yields; compared to the rates of return of regular savings, money markets rates of return are far higher. Liquidity; money markets are very liquid. You can easily convert your money market account into cash. Being a first timer in the stock market dealings, the following factors should be considered before investing. Beware of the Financial Expert: Advice in this modern world from all quotas is easily accessible i.e. TV, internet, Newspapers, Consultants, and Magazines and lately from social media. Should not blindly follow tips or get sucked into buying expert advice through e-books or other sources. Learn Everything You Can: Before she starts learning about stocks, one should have a basic understanding of: accounting, economics, personal & corporate finance and taxation. This vast knowledge lies in local libraries and media spots. Practice First: Before starting with real money, one should learn the ropes and gain experience by virtual trading. This can be accomplished simply by writing down a few stocks one would like to invest in, and keeping track of how they do over time. The stocks good to invest in The stock which are moving on an upward trend gently but not fast as the logic behind this is that the prices of stocks should not increase abnormally as this might bring in a sharp decline in the price. Rather prices should rise moderately as this assures sustainability of future increments. A Share whose rising market price is in conformity with the rise in the volume of traded shares should be preferred because it shows that investors have an interest in the shares (Dodd & Buffet 2009). Another quality to look for in a stock is it’s stability in market price. A large fluctuation implies high risk while a small fluctuation means low risk. It is also worthwhile to invest in company that neither experiences financial or management crisis as this implies a good image translating to improve stock prices. Factors to consider before making a decision in investing in a good stock Week Range: A stock is considered a good value if it is trading near its 52-week low. Stocks that are trading closer to the 52-week low than the high also have upward momentum. Earnings per Share (EPS) and Cash Flow per Share (CPS):   Investors should look for positive earnings as well as consecutive growth over each quarter. Earnings and cash flow per share should both be positive with positive growth over each quarter. EPS is determined by the following formula:  Net Income – Dividends on Preferred Stock Average Number of Outstanding shares EPS breaks down the profit, or earnings of a company in terms of individual shares Dividends: When investing in a company, it is good to look for stocks that offer dividends. Dividends are usually a sign of good financial health. Check to see if they are currently paying a dividend. If a company has money to pay, then they are performing well in the market. The companies that pay the highest dividends often have steady growth Insider Activity: The insiders know the company better than any analyst.  If the number of shares bought by individuals inside the company has been increasing, it may be a good time to buy. Always consider the amount of shares CEOs and other executives are buying and selling, to get an accurate picture of what is happening on the inside. In addition, one should try to choose stocks that are not the victim of newspaper publicity and television headlines, and there’ll be much smoother sailing. The markets or stock an investor should avoid Stocks having high level of risk in prices for a long period of time should be avoided since they fluctuate greatly in prices resulting to uncertainty implying that they have a high chance of leading to losses (Kirk, 2010). Secondly stocks of companies whose earnings are lower than the annual dividend rate should also be avoided since there is a possibility that the dividends may be reduced plummeting the share price. Also avoid buying stocks of companies whose source of income will be depleted in a short period of time. Lastly shares of companies experiencing financial and management challenges should be avoided as financial crisis places doubt on going concern of a company. Recommendations Television is an important form of communication and has been for many years. Television brings important historical events, both positive and negative, directly to investors. For instance, Stocks can become vulnerable to fluctuations beyond the investors control as a result of too much publicity and demand. On the other hand, TV recommendations on stock markets gives traded shares a greater potential for acquiring better prices, as a result of many investors taking part in their trading thus increases profitability and eventually high returns. It is worthwhile to follow recommendation on business television in making investment decisions. Media plays a vital role in marketing stocks of companies a fact that cannot be ignored. However an investor should not over rely on the media for information regarding investments instead he should seek knowledge about investment to make prudent decisions (Graham & Zweig 2003). This is because sometimes media hype creates over reaction amongst investors leading to panic for no reason. If the T.V advert gives an advice in investing in the stock market then the following factors should be considered before buying shares in the advertised company: Economic conditions of the country and other non-economic factors for example unfavourable climatic conditions and diseases which may lead to low productivity and poor earnings. State of management of the company for instance the key management strategies for the company. Is the company honest and successful? The nature of the company’s product dealt in and its market share. For instance, is the product vulnerable to weather conditions or are the products subject to restrictions? Marketability of the shares is also another factor to consider. One should ask how fast or slow can the shares of the firm be sold? Diversification i.e. does the company have a variety of operations for example multi-products so that if one line of business declines, the other increases and the overall position is profitable. Company’s trading partners both in local and abroad and its competitors. Prospects of growth of the firm due to expected growth in demand of products of the firm. Conclusion In conclusion, the Capital and Money markets are both profitable to invest in; it all depends on whether the investor has short term goals or long term goals. If the investor has long term he/she should invest in the capital markets (securities and non-securities). On the other hand, if he/she has short term goals he/she should invest in the money markets. References Dodd, D. & Buffet, W. 2009 Security Analysis 6th ed. New York: McGraw Hill. Graham, G. & Zweig, J. 2003 The Intelligent Investor Revised ed. New York: HarperCollins Publishers Krantz, M. 2010. Fundamental Analysis zfor Dummies, Kindle. New Jersey: Wiley Publishing Inc. Kirk, C.E. 2010. Fire Your Stock Analyst. 2nd ed. New Jersey: Pearson Education, Inc. Maloney, M. 2008. Guides to Investing in Gold and Silver, 1st ed. New York: Hachette Book Group USA. Saunders, A., & Million, M. (n.d.). Financial Markets and Institutions:A modern perspective. Read More