4. Investors, Investment Strategies, and Regulation

Question 1

4.1. Is investor’s diversity relevant to know how prices are formed in the financial markets?

Answer 1

According to Alok Kumar:

• investors are different and the diversity issue is crucial to understand what is going on in the financial markets.

Question 2

4.1. Name the categories used in studies to classify investors’.

Answer 2

Investors are often dividend in:
1. Individual investors
2. Institutional investors

Question 3

4.1. Name 3 reasons why it is important to study individual investors decisions’.

Answer 3

3 reasons to study individual investors’ decisions:
1. We are all individuals.
2. The shift to define contribution pension plans and the growing importance of private retirement accounts.
3. Increase in the range and complexity of credit products available to households.

Question 4

4.1. Why do individual investors trade?

Answer 4

Reasons for individual investors to trade:

1. Information reasons
   - Investors will trade when the marginal benefit is greater than its costs
2. Rebalancing reasons
   - they trade to rebalance their portfolios after stock price changes
   - individuals may need to liquidate their investments for consumption purposes
3. Life cycle hypothesis (Modigliani and Brumberg, 1963): - as the time goes by people will smooth their consumption by investing and borrowing
4. Tax motivations:
   -investors trade in order to take advantage of the tax laws concerning investment returns such as interests, dividends, and capital gains.
5. Investors trade due to behavioral explanations.

Question 5

4.1. What are the main behavioral explanations that justify why individuals’ trade?

Answer 5

Main behavioral explanations:

a) Overconfidence hypothesis
b) Salience hypothesis
c) Flawed information trading hypothesis
d) Social reasons

Question 6

4.1. Explain the overconfidence hypothesis.

Answer 6

a) Overconfidence hypothesis: investors may trade too much because they are overconfident about their investment skills.
- Overconfidence induces more trading but harms investment performance.

Question 7

4.1. Explain the salience hypothesis.

Answer 7

b) Salience hypothesis: investors are net buyers of attention-grabbing stocks.
- In other words, because there are a lot of options available, investors tend to invest in stocks that attract attention.

Question 8

4.1. Explain the flawed information trading hypothesis.

Answer 8

c) Flawed information trading hypothesis: investors misinterpret information, and because of that, they make significant mistakes that influence prices.

Common mistakes:
- price strongly reacts when the same information is published in the same journal at different moments in time (Huberman and Regev)
- the change in the names of corporations alters investor’s demand (Cooper et. all)
- Investors sometimes ignore useful info. in firms’ financial statements, like in footnotes (Teoh and Wong)

Question 9

4.1. Describe the social reasons that impact investors’ decisions.

Answer 9

d) Social Reasons: social interaction induces stock market participation and trading.

Question 10

4.1. Point the main patterns in individual investor’s decisions.

Answer 10

Main patterns in individual investor’s decisions:
1) disposition effect
2) home bias
3) ability to learn by trading
4) cross-sectional variation in performance

Question 11

4.1. What is the disposition effect?

Answer 11

1) Disposition effect (Shefrin and Statman) is the tendency to hold on to losing stocks for too long while selling winning stocks too early, and it is highly noted in different types of markets.

• Some authors think this effect is motivated by behavioral reasons, such as the fact that investors prefer to take the risk of higher loss by holding the investment and waiting for a recovery because they are reluctant to admit errors.
• The disposition effect seems to be stronger among stocks that are more difficult to value.

Question 12

4.1. Describe the home bias pattern.

Answer 12

2) Home bias: individuals tend to invest in companies geographically and culturally closer to them, and more often choose stocks of companies from their region or country (domestic stocks).

Reasons for the home bias pattern:
a) Informational reasons (investors proximity to the firms facilitates the acquisition of more accurate information)
b) Asymmetric news coverage (local media tend to present facts about local firms in a selective/ favorable way)
c) Behavioral reasons (people have more positive attitudes towards familiar stocks)

Question 13

4.1. What is learning by trading?

Answer 13

3) Learning by trading:
lt is important to study if (and how) investors learn by trading because if investors are capable of learning, maybe financial markets could be studied as if there were no investors with bounded rationality.

Question 14

4.1. What are the main points about cross-sectional variation in performance?

Answer 14

4) cross-sectional variation in performance: Individual investor trading results are systematic and economically large losses, but some investors can obtain abnormal returns when risk exposures are controlled.

-Cross-sectional variation in performance is predictable and can be traced to investment skill, cognitive abilities, investment style, education and gender.

Question 15

4.1. Empirical literature has shown that the average investor…

Answer 15

• Trades excessively
• Holds concentrated portfolios
• Exhibits a preference for domestic stocks

Question 16

4.1 Define institutional investors.

Answer 16

Institutional investors are organizations that collect funds from individual investors and invest in a potentially wide range of securities and other assets.

It includes: banks, insurance companies, pension funds, mutual funds, and hedge funds.

Question 17

4.1. What are the functions of institutional investors?

Answer 17

Functions of institutional investors:
a) Diversification and divisibility
- Enable investors to hold fractional shares of many securities
b) Professional management
- Have full-time staff of security analysts and portfolio managers
c) Lower transaction costs
- Since they trade a large number of securities, they can achieve savings on brokerage fees and commissions.

Question 18

4.1. Point the differences between individual investors and institutional investors.

Answer 18

Differences between individual and institutional investors:

• the level of wealth controlled by institutional investors is higher
• decisions are taken in structured mechanisms by institutions

Question 19

4.1. Name the 2 kinds of mutual funds.

Answer 19

2 kinds of mutual funds:

1) Open-end fund: a fund that issues or redeems its shares at any time, the investor will purchase shares directly from the fund.

2) Closed-end fund:
a fund which shares are tradable between investors, its shares can be traded at prices that can differ from net asset.

Question 20

4.1. There are several types of mutual funds according to their investment policy, identify them.

Answer 20

Types of mutual funds:
- Money market funds
- Equity funds
- Bond funds
- Index funds
- Specialized sector funds

Question 21

4.1. What are Exchange-Traded Funds (ETF’s)?

Answer 21

ETF’s: investment funds traded on stock exchanges, much like stocks, most ETF’s track an index.

Advantages:
- low costs and stock-like features
- can be traded throughout the day

Disadvantages:
- since ETF prices can depart from net asset value, investors incur a bid-ask spread

Question 22

4.1. Institutional investors may affect the structure of prices. Why?

Answer 22

Institutional investors may affect the structure of prices because:
1) Funds’ pursuit of styles can account for observed patterns in stock returns
2) They cause mispricings to increase, which may lead to speculative bubbles.

Question 23

4.1. Institutional investors seem to be …

Answer 23

better informed than other investors,
- The securities institutional investors purchase outperform those they sell

Question 24

4.2. Portfolio strategies can be classified as

Answer 24

Portfolio strategies:

a) Active portfolio strategy
- uses available info. and forecasting techniques to seek a better performance

b) Passive portfolio strategy
- relies on diversification to match the performance of some market index
- assumes that the marketplace will efficiently reflect all available information in the price

c) Mixed strategies
- passive core strategy where part of the portfolio is indexed, and the other part is actively managed

Question 25

4.2. Identify and explain the 2 main schools of active investing.

Answer 25

2 main schools of active investing:

a) Value investing
- Buying stocks out of the conviction that the current value is high relative to the current price

b) Growth investing
- Buying stocks because it is believed the value will grow fast enough in the future to produce substantial appreciation

Question 26

4.2. ESG investing is a recent trend, and the implementation of it’s policy may enhance corporate profits, because…

Answer 26

• better working conditions improve productivity
• good governance practices may increase earnings

Question 27

4.3. Financial markets can impact the real economy in different ways such as …

Answer 27

• Capital markets help investors to discriminate between good and bad investment opportunities
• Banks get financing from capital markets
• Speculative bubbles can distort real investments
• Volatility in financial prices can influence consumption

Question 28

4.3. Financial regulators intervene in …

Answer 28

1. Mandatory securities disclosure
2. Insider trading
3. Market manipulation
4. Short selling
5. Speculative bubbles

Question 29

4.3. Name reasons to regulate Mandatory securities disclosure.

Answer 29

Reasons to regulate:
- Conflicts of interest between corporate managers and investors
- Information is a public good
- Development of a market of informed investors

Question 30

4.3. Name reasons to regulate Insider trading.

Answer 30

Reasons to regulate:
- Corporate managers have incentives to manipulate information
- Corporate managers have perverse incentives because they can profit from negative news
- Development of a market of informed investors

Question 31

4.3. Name reasons to regulate Market manipulation.

Answer 31

Reasons to regulate:
- Fairness reasons
- Manipulation hurts investors’ confidence in the financial markets, making them less liquid
- There is a positive relationship between market manipulation and price volatility.

Question 32

4.3. Name reasons to regulate Short selling.

Answer 32

Reasons to regulate:
- Short selling can be used to manipulate the stock market (significant in the case of stocks issued by banks)

BUT…
- Short selling activity seems to enhance market efficiency, which can be important in the case of a speculative bubble

Note: short-selling activities are mainly restricted during crashes.

Question 33

4.3. The Financial Instability Hypothesis (FIH) …

Answer 33

Was proposed by Hyman Minsky, exploring the relationship between financial markets and the real economy

FIH is based on the idea that:
- There is an endogenous tendency to move from robust finance to fragile finance because of the impact of debt on the economy
- The economy generates a financial structure that is susceptible to financial crises

Question 34

4.3. The fragility or robustness in the economy depends on the fragility or robustness at the level of the economic unities.What are the main economic unities ?

Answer 34

Main economic unities:
1) Hedge Fund units
2) Speculative finance units
3) Ponzi finance units

Question 35

4.3. In order to guarantee the robustness of Hedge Finance units It is necessary to …

Answer 35

have enough anticipated operating income to pay interest and scheduled reduction in their indebtedness.

Question 36

4.3. In order to guarantee the robustness of speculative finance units, It is necessary to …

Answer 36

have enough anticipated operating income to pay interest using cash from new loans, to repay the amounts due to maturing loans

Question 37

4.3. Regarding Finance Instability Hypothesis (FIH), over periods of prolonged prosperity, economies tend to …

Answer 37

Move from a structure dominated by hedge finance to a structure dominated by speculative and Ponzi finance.

Question 38

4.3. The supply of credit is pro-cyclical, why?

Answer 38

Supply of credit is pro-cyclical because it…
increases when the economy is booming and decreases during economic slowdowns.

Question 39

4.3. What are the harms of competition among banks?

Answer 39

Increased competition among banks and financial innovations leads to financial fragility and increases the likelihood of a financial crisis.

Question 40

4.3. In expansion phases, investors…

Answer 40

• Become more optimistic about the future and revise their estimates of the profitability of investments upward, thus, become more eager to borrow.
• Additionally, both the lenders’ assessments of the risk of individual investments and their risk averseness decline.

Question 41

4.3. The Minsky Moment is when…

Answer 41

Occurs a sudden major collapse of asset values.

Question 42

4.3. What are the main policy implications that follow from the FIH?

Answer 42

Policy implications from the FIH:

1) Policies that work in one financial regime may not be effective in another regime.

2) There is an unwarranted emphasis on investment as the source of all good things, but in truth, inept investment can deter all that.

3) In order to do better, we have to establish a society where the tendency of businesses and bankers to engage in speculative finance is constrained.

4) The authorities should guide the evolution of financial institutions by discouraging instability-augmenting institutions and practices.