Chapter2: Individual Investors

Question 1

Outline the four main tax advantages of pension schemes.

Answer 1

Four main tax advantages of a pension scheme
1. Contributions are granted tax relief at the investor’s marginal rate (often up to a maximum contribution).
2. There is no tax on income or capital gains within the fund.
3. Part of the fund may be taken as a tax-free lump sum on retirement; and
4. Life insurance can be provided from contributions to the fund.
(The disadvantage is that all payments are classed as earnings when taken by the recipient.)

Question 2

Describe the four main risks that an investor in an ETF (exchange traded fund) would be exposed to, whether or not the ETF is investing directly or indirectly in the underlying assets.

Answer 2

Four main risks

Credit risk:
this is particularly important where the ETF has derivative exposure and may have counterparty exposure through this.

Liquidity risk:
* some ETFs are permitted to borrow in order to fund margin calls.
* If this borrowing is withdrawn the ETF may have to find the cash at short notice;
* liquidity risk also exists (particularly for ETFs investing in illiquid assets) if investors redeem units and the manager is unable to sell underlying assets quickly to satisfy these redemption requests.
* Such risks also arise for stock lending.

Regulatory risk:
changes to the rules governing what investments may be held, reporting requirements etc can be a risk for the manager.

Tax:
Tax changes (including withholding taxes overseas).

Question 3

List the six main types of ETF that are available to individual investors.

Answer 3

Five main types of ETF

1. Index ETFs
2. Commodity ETFs
3. Bond ETFs
4. Currency ETFs (also known as ETCs)
5. Active ETFs
6. Leveraged ETFs.

A property ETF is just a type of Index ETF.

Question 4

State four possible advantages offered by financial intermediaries compared to direct investment (from Subject SP5).

Answer 4

Four advantages offered by financial intermediaries.

1. pool resources and thereby enable small investors to gain access to investments which they could otherwise not do so by themselves
2. diversification
3. expertise
4. lower dealing, administration and management costs.

Question 5

State four possible disadvantages of financial intermediaries compared to direct investment.

Answer 5

Four disadvantages of financial intermediaries

1. additional layer of costs to the investor
2. products offered might not meet the exact requirements of investor
3. products offered may be inflexible
4. investor loses element of control over investment choice

Question 6

List the 16 main behavioural biases (from Subject SP5)
(# FOAM POEM) or (#SAD PROOF FLASH MOB)

Answer 6

SAD PROOF FLASH MOB

**Behavioural biases: SP5
(# FOAM POEM) / (#SAD PROOF FLASH MOB )

Status quo bias
Anchoring
Dislike of negative events

Prospect theory
Representative bias
Options
Overconfidence
Familiarity

Framing
Loss aversion
Availability bias
Self-serving bias
Herd behaviour

Mental accounting
Optimism
Belief preservation

Estimating probabilities

Question 7

Outline (from Subject SP5) the ideas behind:
* framing
* overconfidence

Answer 7

Framing
* Suggests that the way in which a choice is presented or ‘framed’ can have an enormous impact on the answer given or decision made.
* Equally, a response to a question can be influenced by its wording.

Overconfidence
* People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occurring.

May result from: *
* Hindsight bias
– events that happen/don’t happen will be thought of as having been predictable/unlikely prior to event.

• • Confirmation bias
    – people tend to look for evidence that confirms their point of view (and dismiss evidence that does not justify it).

Question 8

Explain (from Subject SP5) what is meant by anchoring.

Answer 8

Anchoring

• When forming estimates people tend to start with an initial value (an ‘anchor’), which may be more or less arbitrary.
• To arrive at a final estimate, they will then adjust away from this value.
• Experimental evidence suggests the adjustments made tend to be too small and so people are said to be anchored too heavily on the initial value.

Question 9

Explain what is meant by the term loss aversion (from Subject SP5).

Answer 9

**Loss aversion

• A person may be much more sensitive to losses than to gains of the same magnitude.
• A related behaviour is **myopic loss aversion ** which considers repeated choices rather than a single gamble.
• Research suggests that investors are **less risk-averse **when faced with a multi-period series of gambles.

Question 10

Explain (from Subject SP5) what is suggested by:
* prospect theory
* mental accounting.

Answer 10

Prospect theory

• Suggests that whilst investors are typically risk-averse when considering gains relative to some benchmark, they are likely to be risk-seeking when facing losses.

Mental accounting

• Suggests people show tendency to separate related events and decisions and find it difficult to aggregate events.
• Rather than netting out all gains and losses, people set up series of ‘mental accounts’ and view individual decisions as relating to one or another of these accounts.

Question 11

Describe how the order of a range of choices may influence choice (Subject SP5).

Give four other influences of the range of options on choice (Subject SP5).

Answer 11

How order of range of choices may influence choice

• Primary effect suggests people are more likely to choose first option presented.
• Recency effect suggests that final option may be preferred.
• Other research suggests people are more likely to choose an intermediate option than one at either end!

Four other influences of range of options on choice

1. greater range of options discourages decision-making
2. status quo bias – people have marked preference for keeping things as they are
3. regret aversion – by retaining existing arrangements, people minimise possibility of regret (pain associated with feeling responsible for loss)
4. ambiguity aversion – people dislike uncertainty and are prepared to pay a premium for rules

Question 12

Outline the eight other behaviours associated with behavioural finance (from Subject SP5).

Answer 12

Other behaviours

1. Optimism – people tend to overestimate their own abilities and skills
2. Representative bias – people often put too much emphasis on particular features of a sample as opposed to likely features of whole population
3. Belief preservation – once people have formed a belief they tend to be overly reluctant to change it even in the face of strong contrary evidence.
4. Availability bias – when estimating probabilities people tend to focus excessively on more recent and more salient events
5. Familiarity
6. Dislike of negative events
7. Self-serving bias
8. Herd behaviour – following the crowd / fear of missing out.