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Free PDF Book: Personal Finance and Investments – A Behavioural Finance Perspective

Personal Finance and Investments - A Behavioural Finance Perspective

Personal Finance and Investments

‘The reader should not expect to find unambiguous answers to all the many questions concerning personal finance and investments,’ Keith Redhead argues in the preface to this new textbook, thus underlining the role personal judgement plays in personal finance and investments.

Personal judgement should be informed by many perspectives; hence his interdisciplinary approach to the study of personal finance and investments.

In this book, the author draws from finance, psychology, economics and other disciplines in business and the social sciences, recognising that personal finance and investments are subjects of study in their own right rather than merely branches of another discipline.

Considerable attention is given to some topics, which are either ignored or given very little attention in other texts. These include:

  • the psychology of investment decision-making
  • stock market bubbles and crashes
  • property investment
  • the use of derivatives in investment management
  • regulation of investments business.

More traditional subject areas are also thoroughly covered, including:

  • investment analysis
  • portfolio management
  • capital market theory
  • market efficiency
  • international investing
  • bond markets
  • institutional investments
  • option pricing
  • macroeconomics
  • the interpretation of company accounts.

Packed with over one hundred exercises, examples and exhibits and a helpful glossary of key terms, this book will help the reader to grasp the relevant principles of money management. The book avoids non-essential mathematics and provides a new approach to the study of personal finance and investments. The book will be essential for students and researchers engaged with personal finance, investments, behavioural finance, financial derivatives, and financial economics.

 

Preface

This book approaches personal finance from an investments perspective, and investments from a personal finance perspective. Texts in the area of finance tend to be either on corporate finance or investments. However the appropriate dichotomy may be between corporate finance and personal finance.

Texts on personal finance would cover investments, as the current one does. In the future texts may emerge covering other aspects of personal finance such as saving and debt. The present text pays some attention to saving and debt, but the emphasis is on investments.

This emphasis stems largely from the fact that there is far more academic literature on investing than on saving and borrowing. There are a few texts available specifically on personal finance with coverage of savings and debt, but unfortunately they tend to be at a relatively elementary level of analysis with little reference to the academic literature.

The current text differs from other texts on investments in a number of ways:

  1. It recognises that investing is a behaviour, which can be analysed from the perspectives of a number of disciplines. Many investment texts are based solely on financial economics. When they allow another discipline into the analysis it is typically by means of a separate chapter, or section of a chapter, on behavioural finance. This entails a consideration of the implications of cognitive psychology. The present text does not separate behavioural finance into a separate chapter, but integrates it into many aspects of investing. It also goes beyond cognitive psychology and introduces the significance of a number of other disciplines such as social psychology, sociology, accounting, macroeconomics, politics, demography, gerontology, media studies, and marketing.
  2. It uses less mathematics than most other texts. Although mathematics can provide rigour, it can also be a barrier to communication. Many readers find mathematics impenetrable, and can lose sight of the fundamental principles by being distracted by mathematical methodology. Furthermore mathematics can limit discussion to the measurable dimensions, whereas many important aspects of personal finance and investing are not measurable.
  3. There has been an attempt to integrate the most recent (at the time of writing) literature into the discussion so that readers become acquainted with the most recent ideas and evidence.
  4. The text recognises that personal finance is about money management. Correspondingly the concepts and principles covered are related to the money management problems of individual investors.
  5. Many of the investment theories are illustrated by numerical examples.
  6. The text has a UK orientation. Whilst non-UK residents can use the text to learn about the principles and processes of personal finance and investments, the institutional examples (e.g. savings schemes, pension schemes, and the regulatory framework) are UK-based. However about 95% of the text has universal relevance.
  7. There are chapters dealing with issues that are important but rarely given emphasis in other
    texts. Examples include the psychology of financial decision-making, stock market bubbles and crashes, the significance of institutional investors, the purposes and processes of regulation, property investment and finance, and alternative investments such as structured products and hedge funds.
  8. The text recognises that most investment at the personal level is carried out through
    institutional investors. Consequently there is much more emphasis on institutional investors than is typically the case with other texts.

 

THEORY AND PRACTICE

This book should be useful to practitioners in the fields of personal finance and investments as well as to students. Sometimes practitioners dismiss theory as irrelevant to their needs. However an understanding of relevant theory can be of great assistance to practitioners.

It is worth quoting from Cordell et al. (2006:78): Although academic research is often obtuse and unrealistic, many articles have implications that have relevance to the real world inhabited by practitioners. Plowing through the mathematics and statistics of some articles may be a stretch for most practitioners, but the inferences drawn from articles are often worthy of the financial service professional’s time and effort. Indeed, many of the financial concepts used daily by practitioners . . . were born in academic articles.

This book incorporates the contributions of more than 800 recent articles, which are of relevance to both practitioners and academics. The intention has been to make the concepts and implications of those articles readily accessible to those who lack the time to devote to reading the articles themselves. However, the articles are referenced so the reader is able to refer to the articles where this is desired.

 

THE ONLY THING THAT IS CERTAIN IS UNCERTAINTY

The reader should not expect to find unambiguous answers to all the many questions concerning personal finance and investments. One of the reasons for ambiguity is the existence of differences in opinion. There is, in particular, a dichotomy between two schools of thought. One school is known as the traditional or neoclassical tradition (but which could be referred to as the arbitrage–optimisation tradition). According to this school of thought most people act rationally (or nearly so) and financial markets allow them to do so.

Markets are expected to be accessible and investors should have equal access to information. Arbitrage and optimisation are important concepts in this tradition. The returns from investments are expected to be no more, nor less, than fair compensation for delaying expenditure and accepting risk. This is probably the dominant school of thought amongst academics.

The main alternative school of thought is referred to as behavioural. According to this approach people are frequently irrational and financial markets do not always provide conditions that permit rational investors to fully achieve their objectives. Sentiment plays a large part in this tradition. Practitioners are often more comfortable with this school of thought.

The reader may find that there are different answers to the same questions. This is to be expected, particularly when there are radically different ways of thinking about problems. The debates continue. It should not be assumed that one perspective is correct for all times and in all markets.

According to the efficient market hypothesis all investments are correctly priced since they reflect all relevant information (or are sufficiently accurately priced to preclude the possibility of profiting from mispricing). The debate about the efficient market hypothesis may seem arcane but it is central to the debate between the two main schools of thought. Traditional finance theory is largely premised on market efficiency. If financial markets were not efficient, the case for traditional finance theory would be weakened. It may be expected that degrees of efficiency vary from time to time and from market to market.

There are many financial market adages. One is: ‘ The only thing that is certain is uncertainty’. This applies not only to financial markets but also to the analysis and understanding of those markets.

 

Introduction

People save and invest for various purposes: for holidays, home improvements, cars, deposits for house purchase, children’s education, old age, and general security. Some of these are short- term objectives and others long term. The single biggest long-term objective is usually the provision of a retirement income. The time horizon of the investment will influence the nature of the investment. Savings for a holiday are unlikely to be put into a risky investment such as shares. Saving for a pension is unlikely to be in low return investments such as bank or building society accounts.

The largest investment item for many people is their pension fund. At an annuity rate of 8% per annum (p.a.), a pension of £20,000 a year requires a pension fund of £250,000. Whether a pension is being provided by an employer or being funded by the employee, a substantial sum of money needs to be accumulated. So successful investing is vital.

The need to invest for retirement is becoming increasingly important as governments progressively back away from promising adequate state pensions. In Europe and North America, as well as elsewhere in the world, the proportion of retired people in the population is rapidly increasing. This is often called the demographic time bomb. In the United Kingdom (UK), for children born in 1901, the average life expectancy was 45 for males and 49 for females (Harrison 2005). Those born in 2002 had average life expectancies of 76 for males and 81 for females.

Life expectancy is steadily increasing, and with it the average period of life in retirement. The result is a rising ratio of pensioners to workers. It is often seen to be unrealistic to expect those of working age to pay the increasingly high taxes needed to pay good pensions to members of the retired population. One answer is to encourage people to provide for their own pensions by accumulating pension funds during their working lives (another approach is to raise the retirement age).

personal finance
Percentage of the population that is 65 or older

According to a World Bank publication (Palacios and Pallares-Miralles 2000) the percentages of the populations of the UK, Germany, and France over 60 in 2000 were 20.7%, 20.6%, and 20.2% respectively. The expected percentages for 2030 were 30.1%, 36.35%, and 30.0% respectively. According to the US Census Bureau (1999), in Western Europe (the members of the European Union as of 1999) the ratio of people of retirement age (65?) to those of working age (20–64) was about 0.15 in 1950.

By 2000 it had nearly doubled to 0.29. It is projected to approximately double again, to about 0.64, by 2050. The ratio of pensioners to people of working age would have risen from about 1 to 6 in 1950, to around 4 to 6 in 2050. It is clearly unrealistic to expect those of working age to be able, and willing, to pay sufficient taxation to provide so many retirees with adequate pensions. Table 1.1 shows some Organisation for Economic Cooperation and Development (OECD) figures that illustrate the ageing populations in a number of countries (derived from OECD population pyramids).

There is also the issue of how to invest. Stock market investments, particularly shares, are seen by many people to be too risky. However, historically shares have massively outperformed other forms of investment such as bank deposits. The issue of relative risk needs to be seen in relation to an investor’s time horizon. The picture from a 40-year perspective is very different from that of a one-month perspective.

Investments in shares can benefit from time diversification; over a long time span good periods can balance out bad periods. Also from a long-term perspective, the accumulated income from investments becomes more important in determining the final sum accumulated. For example £1,000 invested at 4% over 40 years will grow to £4,801, whereas at 8% it would grow to £21,725. The income receipts from stock market investments may be more stable than the interest receipts on bank or building society deposits.

According to the Barclays Capital Equity Gilt Study (1999; the study is updated annually on the Barclays Capital website), £100 invested in a balanced portfolio of UK shares in 1918 would have grown to nearly £420,000 by 1998 (with dividends, net of basic rate tax, being reinvested). An investment of £100 in Treasury bills over the same period would have grown to less than £2,500 (the Treasury bill rate of return is roughly equivalent to premium bank or building society deposits).

These represent rates of return of approximately 11% p.a. and 4% p.a. respectively. When allowance is made for the effects of inflation on the purchasing power of money, the average rate of return from bank and building society deposits has not been far above zero. The message seems to be that the accumulation of wealth over long time periods, such as the periods typically required for the accumulation of pension funds, requires investments to be made in stock markets.

 

FUNCTIONS OF FINANCIAL SYSTEMS

A financial system can be looked upon as a combination of financial markets, institutions, and regulations that aim to perform a set of economic functions. Most of those functions have a direct bearing on investment decisions and behaviour. The functions might be regarded as the provision of means of:

  1. Settling payments.
  2. Investing surplus funds.
  3. Raising capital.
  4. Transferring funds from surplus units (savers) to deficit units (borrowers).
  5. Managing financial risk.
  6. Pooling resources.
  7. Dividing ownership.
  8. Producing information.
  9. Dealing with incentive problems.

1. Settling payments.

This refer s to the mechanisms for making payments. Mechanisms include cash, cheques, credit cards, and so forth. This relates to investment only in so far as there needs to be a mechanism of paying for investments.

2. Investing surplus funds.

This is the investment process. Investors have varied needs and wishes concerning risk, return, liquidity, and other characteristics of investments. A financial system should provide a wide range of investment choices so that individuals can satisfy their investment objectives.

3. Raising capital.

Some people or organisations have expenditure that exceeds their income. They would need to raise capital by borrowing or selling shares. A financial system should provide suitable financial instruments for obtaining funds. Such instruments would include bank loans, various forms of bond, and various types of share.

4. Transferring funds from sur plus units to deficit units.

This brings functions 2 and 3 together. Not only should there be suitable financial instruments for investors and those raising capital, but there should be markets or intermediaries for bringing them together. For example banks are intermediaries that transfer money from investors who deposit money to borrowers who receive loans. Stock markets transfer money from investors, who buy shares or bonds, to the firms that issue the shares and bonds.

5. Managing financial risk.

Most people or organisations that invest or raise funds face risks from price movements. For example an investor in shares will lose in the event of a fall in share prices. Financial systems should provide instruments for managing such risks. Risk management instruments include derivatives such as forwards, futures, swaps, and options. There are also other risks that need to be managed, such as default risk. Financial systems generate credit rating agencies that inform investors of the levels of such risks.

6. Pooling resources.

When businesses and governments borrow they want to raise large sums of money. Individuals normally have small sums to invest. By pooling the small sums of a large number of individuals, large sums are made available to businesses and governments. The pooling of large numbers of small amounts is carried out by intermediaries such as banks, pension funds, and unit trusts.

7. Dividing ownership.

When an investor buys shares in a company, the investor becomes part owner of the company. Share issuance is a means of dividing the ownership of a company among a large number of investors. The transfer of ownership to investors entails the transfer of risks as well as prospective profits.

8. Producing information.

The most common for m of information produced by financial systems is information about prices. This would include prices of shares, bonds, and money (interest rates are prices of money). Information about prices allows investors to measure their wealth, and helps them to take decisions about how to allocate their wealth between different types of investment. Interest rates are likely to influence decisions about saving and borrowing.

9. Dealing with incentive problems.

Incentive problems include principal-agent, moral hazard, and adverse selection problems. It is in relation to such matters that regulation can be particularly important.

Principal-agent problems can arise when investors allow others to take decisions for them, or follow the advice of others. For example an investor may allow a financial adviser to choose investments. There is a risk that the adviser chooses the investments that pay the highest commission to the adviser, rather than the investments that are best for the investor.

This would be a case of the adviser exploiting the situation of having more information than the investor. The investor is referred to as the principal, the adviser as the agent, and the inequality of information as asymmetric information.

The principal-agent situation can lead to moral hazard. Moral hazard can arise when the agent takes the decisions but the principal bears the risks arising from those decisions. For example a fund manager may make investments that are riskier than the investors would like. This could be possible as a result of the fund manager (the agent) having more information (asymmetric information) than the investor (the principal).

Adverse selection can be another consequence of asymmetric information. Consider the case of annuities. Annuities are incomes for life sold by insurance companies. In exchange for a lump sum the insurance company guarantees a monthly income for the rest of the life of the person buying the annuity. Individuals know more about their health and prospective lifespans than insurance companies can know (asymmetric information).

People with short life expectancy are less likely to buy annuities than those who expect to live for a long time (adverse selection). Those who expect long lives stand to benefit most from annuities. If insurance companies price annuities according to average lifespans, they will lose money because people buying them will tend to have longer than average lives. Women tend to live longer than men. If annuities are priced to match average life expectancy (average of men and women together), women will buy annuities to a greater extent than men.

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