Chapter 2
Bond is one of the long term debt instruments (IOUs), which issued by corporations and governments. A bondholder has a contractual right to receive a known interest return, plus return of the bond's face value at maturity. Bond investing is the excellent way to earn money, but it is not a short-term return in investment and takes years. Maturity is typically 20 to 40 years. Bond is a safer way to invest because it does not follow market movement.
Ordinary stock also called as common stock. Common stock is an equity investment that represents ownership in a corporation. Each share of common stock represents a fractional ownership interest in the firm. The return on investment in common stock comes from either of two sources: dividends or capital gains. Dividends are periodic payment the corporation makes to its shareholders from its current and past earnings. Capital gains result from selling the stock (Gitman& Joehnk, 2008).Common stock are rely on current market condition; it means when the market is fluctuate, stocks would follow by going up or down.
Preferred stock represents an ownership interest in a corporation. Preferred stock has a stated dividend rate and has no maturity date. Investors typically purchase it for the dividends it pays, but it also provides capital gains (Gitman& Joehnk, 2008).
Unit trust/mutual fund
A mutual fund is an investment company that invests a pool of funds belonging to many individuals in a portfolio of investments (Frank K. Reilly and Edgar A. Norton, 2006).Gitman& Joehnk stated that, mutual fund is a company raise money from sale of its shares and invests in and professionally manages a diversified group of securities. Investors own an interest in the fund collection of securities. The value of the portfolio at the time the transaction made will reflect buy all the mutual funds issue and repurchase shares of the fund at a price. Unit trusts also take the middle ground between high-risk-high-return investment vehicles such as the stock market.
Trustee--The trustee protects investors' rights and interest by ensuring that the fund manager follows regulatory guidelines and the requirements specified in the deed.Figure 1: How the Unit Trust Work
Investor-Invest in the fund by entrusting the fund to the fund manager.
Fund Manager-manages the fund by making professional investment decision and administers the fund operations
Unit Trust Fund
Trust Deed-The Trust Deed is a legal document that specifies the responsibility of the Trustee and the fund manager, together with the rights and liabilities of the investor.
Source: HSBC.com. Unit Trust Available from:
http:// http://www.hsbc.com.my/1/2/personal-banking/investments/unit-trusts/new-to-unit-trusts
Derivatives
Derivative in the financial markets is contract to buy or sell an asset or exchange cash, based on a specified condition, event, occurrence, or another contract (BusinessDictionary.com). A derivative product's value depends upon and is derived from an underlying instrument, such as commodity prices, interest rates, indices, and share prices. This type of investment has high levels of risk, because they usually have uncertain returns or unstable market values. But, because of their above-average risk, they also have high levels of expected return. Derivative instruments can be traded in an organised exchange or over-the-counter (OTC). Derivatives consist of the options and warrants in Malaysia as below:
Futures
A futures contract is an agreement between two parties to buy or sell the underlying instrument at a specific time in the future for a specific price determined today (HSBC).Examples of commodities sold by contact include pork bellies, cocoa, soybeans and platinum. Examples of financial futures are U.S Treasury securities, interest rates, stock indexes, and contracts for Japanese yen. Gitman& Joehnk (2008) said that, trading in commodity and financial futures is generally a highly specialized and high risk proposition.
Options
An option provides the holder/buyer the right, but not the obligation, to purchase or sell a certain quantity of the underlying instrument at a stipulated price within a specific time period by paying a premium (HSBC).Normally, investors purchase option to take advantage of an anticipated change in the price of common stock. However, the purchaser of an option is not guaranteed get a return and even will lose the entire amount invested if the option does not become attractive enough to use. The two common types of options are puts and calls.
Investor Behaviour
Researchers in behaviour finance believe that investors' decisions are affected by a number of beliefs and preferences. They also believe that the resulting biases will cause investors to overreact to certain types of financial information and under react to others. (Gitman&Joehnk, 2008)
Over the past twenty years, psychologists (most notably Daniel Kahneman and Amos Tversky) have found again and again that the usual axioms of fiancé theory (expected utility theory, risk aversion; Bayesian updating, rational expectations) are descriptively false. For example, people display overconfidence in their own judgment, and they make decisions that depend as much on how a problem is "framed" as on its objective payoffs. In other words, agents make rational choices based on rational expectations. This set of assumptions can be citied on two counts: (1) Some assumptions are false, e.g. people violate the substitution axiom of expected utility theory ;(2)The set is incomplete.
In competitive markets, the argument goes; irrational agents lose their wealth and go out of business, or somehow are rendered irrelevant by smart arbitrageurs who jump in to exploit the opportunities created by irrationality.
De Long et al. (1990b, 1991) show that, in some circumstances, noise traders may actually earn higher returns than rational traders. Since they do so by unintentionally bearing more risk, the noise traders have lower expected utility but higher wealth. Also, rational people may have an incentive to join the crowd rather than to go against it. In general, evolutionary forces tend to be slow in their effects, so even if noise traders do earn lower expected returns, they will still affect asset price. (Werner & Richard,1994)
Overconfidence
According to Lichtenstein et al. (1982), the most robust finding in the psychology of judgement is that people are overconfident. It means that people are overestimating the reliability of their knowledge and their abilities. Investors are overconfident in their judgment, which frequently leads them to underestimate the level of risk in an investment. A specific finding of relevance to finance is that the degree of overconfidence varies across domains. Moreover, overconfidence can cause financial analysts and money managers to make predictions that are too bold and giving investors a false sense of security (Gitman&Joehnk, 2008). People are more confident of their predictions in fields where they have self-declared expertise, holding their actual predictive ability constant (Heath & Tversky, 1991).
In the world of investing, confidence levels are driven by the recent market performance. It is easy to overestimate the risk tolerance, particularly when your immediate frame of reference is period of equity market gains. Very often investors who perceive their risk tolerance to be high exhibit much less confidence when faces with market downturns.
Cycle of market emotions
While the ups and downs of equity markets are largely unpredictable, their effect on investor behaviour very often. Figure illustrates the typical cycle of market emotions.
Figure: The Cycle of Market Emotions
Understanding the cycle of market emotions can help manage your reaction to market volatility and keep your long-term financial goals in sight even in times of uncertainty.
Investors who are underestimated the level of risk in an investment is called overconfidence in their judgment. The underestimate seen becomes very important as the length of the investment horizon increases. Besides that, overconfidence can cause financial analysts and money managers to make too bold predictions and giving the investors the false sense of security. One of the mistakes of all the overconfident investors is -they trade too much. By trading frequent in large transaction costs will erode investment returns.]
Biases
Biases can lead a people to emphasize or discount information and lead to strong attachment to an idea or an inability to recognize an opportunity. Bias is also meaning a predisposition to a view that inhibits objective thinking. It can affect availability, representativeness, overconfidence, anchoring and ambiguity aversion of investment decision making.
Availability bias occurs because investors rely on the information to make informed decisions, but not all of the information is readily available. Investors tend to pay more attention to more available information and discount information to draw their attention.
Biased Self-Attribution
Biased Self-Attribution means that people tend to take credit for their successes and blame others for their failures. For example, when Jacky buy a stock, and the stock is earning the profit now, Jacky will say that great stock was a smart move on his part. On the other hand, when the stock is continuing make a loss, Jacky will say that lousy stock was my broker's fault. This propensity obviously distorts reality and can lead to faulty investment decision. The investors will tend to place more value on information that supports their pre-existing beliefs and often disregard contradictory views. (Gitman&Joehnk, 2008)
Belief Perseverance
People are typically ignoring information that causes the conflict to their existing belief. For example, if they believe a stock is good and purchase it, they later tend to discount any signals of trouble. Due to the fear of it will contradict their initial opinion, they even avoid gathering new information.
Prediction
Friedman argues that theories should be judges not on the basis of their assumptions but rather on the validity of their predictions.
Intuition
Markowitz(1952) expresses intuition as who suggested semi-variance might be a better measure of risk than variance and was formally incorporated into Kahneman and Tversky's prospect theory, a descriptive theory of decision making under uncertainty.
Anchoring happens when you cannot integrate new information into your thinking because you are too "anchored" to your existing views. You do not give new information its due, especially if it contradicts your previous views. By devaluing new information, you tend to under react to changes or news and become less likely to act, even when it is in your interest.
Young adulthood
Young adulthood is a critical period on the ages of 22 to 34 years old. There are two most critical development task happen in this age are economic independence and independent decision making. When a young people move from high school or college into the workforce on a full time basis is called economic independent. As this change entails major life changes, young people need to make independent decision making on the new responsibility (Jose…..).
Young adulthood was a stage of identity versus identify confusion(Erikson,1974).Hall and Erikson had define adulthood as reaching maturity, leaving home, and taking on new adult responsibilities.
Young adulthood is an interesting combination of true psychological strength and hazards. They are in the process of achieving their long term goals. When young adulthood is moving toward psychological and economic independence, their decisions have an enormous impact on the trajectory of their functioning (Jose….).
Robert Havighurst (1972) has noted that the young adult period is the most difficult period in life because young adults need to make major decisions such as career and job choices, selecting a mate, extending education, and bearing and rearing children.
Factors that affecting young adulthood in decision making
As a people grow, they need to make many decisions and they involve uncertainty. Decision making skills are especially important during young adulthood, as this is often a time of change, identity development, and educational and career development (Gardner& Steinberg,2005).Some of the decision are involves uncertainties that we do not known, and we are forced to gamble blindly. However, in most of the cases, we are able to make calculated decisions based on the uncertainties encompass known or estimated probabilities. By using the calculated risk taking in decision making will effectively curve the outcome to one's benefit (Itiel, Machelle&Krishna, 1996).Young people are more fear to accept the failure in decision making than elder people. Besides that, decision making which related to the risk taking is rely on the various internal cognitive processes. (Itiel, Machelle&Krishna , 1996).
Adult are less likely than a adolescents (13-16) to drive recklessly, to drive while intoxicated, to use varied illicit substances, to have unprotected sex, and to engage in both minor and more serious antisocial behavior(Arnett, 1992).
These authors have agreed that typical laboratory studies of risky decision making fail to consider the emotional and social contexts on taking actually occurs (Cauffman & Steinberg, 2000; Scott, Reppucci, & Woolard, 1995; Steinberg, 2004; Steinberg & Cauffman, 1996).
Some of the researchers have argued that age differences in psychosocial capacities such as sensation seeking or impulse control play an important role (see Steinberg & Cauffman, 1996). Consistent with this, Cauffman and Steinberg (2000) reported that once differences in psychosocial maturity between adolescents and adults are accounted for, age differences in risky decision making disappear.
Adolescents may engage in more risky behavior than do adults because they are more susceptible to the influence of their similarly risk-prone peers.
Hensley (1977) sought to determine whether the tendency for individuals to take more risks in groups than when alone-a phenomenon known as the risky shift (Vinokur, 1971)-might differ across age groups.
There is some evidence showed that peer influence remains an important predictor of participation in risky behavior even during young adulthood (Andrews,Tildesley, Hopps, & Li, 2002; Horvath & Zuckerman,1993).
Figure:The decision of whether to take an additional card as a function of level of risk.Elderly and young participants,alike,were systematically more and more reluctatnt to take an additional card as the risk level increased.
Figure:The response time needed to make the decisions as a function of the level of risk.Elderly and young participants,alike,required less time for the easy trails(trails with eother low or high levels of risk),and more time for the difficult trails(trails with medium levels of risk).
Source: Itiel,E.D,Machelle,K,Krishna,M.(1996)Age Differences in Decision making:To Take a Risk or Not?Gerontology,44,67-71.
Factors that affecting young adulthood in Investment decision making
Investment Decision Making
According to the earlier research have been done (Wetzel, 1983and Mason& Harrison, 1990)stated that, the informal investor have different decision criteria and they are only partly motivated by financial rewards, which means they may be willing to make more risky investments. Hoffman (1972) has indicated a conclusion on his study that the investment decision is affected by the basis of investor-centered factors, such as previous investment experience, personal preference, and personal biases. Besides that, Shapero(1983)has found that the informal investors' investment decision were highly related to familiarity with the business field, personal knowledge of the entrepreneur ,or a high regard for the third party who brings the investment proposal to the investor for review.
More recently, decision making in a complex environment has been a very active research field notably in interdisciplinary approaches between physics and finance. (Jorgen, 2008)
To date, there have a large number of researcher has begun to identify the psychological and behavioural factors that can impact an investor's decision making process. The factors are called by people as idiosyncrasies, anomalies, or behavioural quirks. These also aptly are described as simply human nature. By knowing more knowledge on these means knowing more about you and how these traits may impact your own decisions and stock market as a whole.
Harris(1998) defines decision making as the study of identifying and choosing alternatives based on values and preferences of the decision makers. Besides that, some of the books define the decision making as the process of choosing among alternative course of actions for the purpose of solving problems or attaining better situations regarding the opportunities that exist.
Harris(1998)emphasize that every decision is made within a decision environment, which is defined as the collection of information, alternatives, values and preferences available at the time of the decision. A good decision is related with the correct and timely information gathered and used.
-conceptual model
-behaviour finance
Behavioral finance is a new paradigm of finance,which seeks to supplement the standard theories of finance by introducing behavioural aspects to the decision making process.Behavioral finance is an individual and the way to gather and use information.Behavioral finance seeks to understand and predict systematic financial market implication of psychological decision processes. Oslen(1998)stated that, behavioural finance focuses on the economic principles and application of psychological for improving the financial decision making.
Behavioural finance-H.A.Simon who introduced the concept on decision making based on bounded rationality.
Factors that influence young adulthood investors' investment decision making
Irrational Behaviour
Decision making became a research topic in the field of psychology in the 1950's by the work of Edwards[15] as well as H. A. Simon who introduced the concept on decision making based on bounded rationality[16]. It was however not until the work of Daniel Kahneman and Amos Tversky (deceased in 1996) that results from cognitive psychology founds its way into economy and finance.
behavioral finance. The emerging field of behavioural finance in turn lead to the more recent theories such as feedback and herding as well as models of interaction between smart money with ordinary investors. (Jorgen,2008)
Nonetheless over the last two decades or so, models of irrational reasoning has led to the appearance of a new field in finance called "Behavioral Finance" (Jorgen, 2008)
The traditional financial literature presumes that the individuals are rational agents maximizing the utility function, regardless their emotional state and previous experience. Kahneman and Tversky(1979)was started the research on the role of attitudes, emotions and behavioural biases in the investors' decisions.
Many of the researchers had spent the time on challenges the assumption by proving that judgements maybe formed not only on the basis of content information but also on the basis of feeling. The feeling include all the positive and negative mood, having positive or negative feeling toward a target, or experiencing ease or difficulty when recalling some piece of information from memory. It is proven that the cognitive feeling can exert powerful influences on judgments, and the recent upsurge in scientific as well as public interest on impact of feeling pays tribute to this seminal scientific advance.
Based on traditional economic theories, the investors make rational decisions and refer to the existing available information in making investment decisions. Behavioural finance counters this notion by suggesting that investors frequently behave irrationally and often against their best interests.
Prospect Theory-introduced by Kahneman and Tversky take in account the fact that people in general are unable to fully analyze situations that involve economic and probabilistic judgements. Specifically prospect theory makes three assumptions which deviates from the standard neoclassical framework of economic rational decision making:
*When investing people are often sensitive to some reference level, an investment decision is likely to influences by the absolute wealth possessed by an investor. The satisfaction/dissatisfaction by a gain/loss if an investor is related to the wealth of an investor and not just the absolute amount gained/loss.
*A rational person would act symmetrically with respect to gain versus losses of same size, that is rational person would be equally pleased/annoyed. People however appear to be more risk adverse to losses than attracted by gains of the same size. This appears to be especially true for small losses/gains: even the slightest loss is conceives very bad whereas a small gain is not considered equally satisfying.
*People have the tendency to overweigh events that occur very rarely and underweight events which occur with large probabilities. E.g. people keep on buying lottery tickets despite the chance of winning is almost nil!
Prospect theory contends that losses have more emotional impact than an equivalent amount of gains. For investors, prospect theory can be exhibited through the disposition effect-the propensity for selling winning investment too early and an unwillingness to part with laggard investments. It is also demonstrated in an innate desire to avoid losses; even if that means choosing not to participate in potential gains.
-emotional/intuition
There are three feature of emotion
Emotions arise when an individual attends to a situation and sees it as relevant to the achievement of his or her goals.
Emotions are multi-faceted, whole-body phenomena that involve loosely-coupled changes in the domains of subjective experience, behaviour, and physiology
The multi-system changes associated with emotion are rarely obligatory, emotions do possess an imperative quality, meaning that they can interrupt what we are doing and force themselves upon our awareness.
Emotions and sentiments have to be considered for decision making process. Thaler(1993) proves that psychological forces play a role in determining asset prices. Damasio(1994)shows how decision making can extremely difficult for people who have lost the use of the emotional part of their brains. Forgas(1995)shows that the computations required for making investment decisions are typically complex ,abstract, and involve risk, which are the attributes that are considered to induce people to rely more heavily on their emotions when making a choice. Emotions have also been used to explain recent financial crises (Tuckett&Taffler, 2008 and Chick, 2008)
Clore(1992)stated that, feelings is divided into three categories: affective, bodily, and cognitive feelings. In this study, we only focus on the affective feelings, because it is suitable for the topic of emotional. Affective feelings are valenced subjective experiences that may or may not be directly related to an object (Frijida, 1994;Schwarz & Clore, 1988).They encompass moods, emotions, and other affective experiences. Affective feelings can be considered as either incidental or integral to target (Bodenhausen, 1993).Incidental feeling is defined as the feelings from a source other then judgemental target, which is objectively and unconnected to the target, such as the positive mood. In opposite, integral feelings are come from the target itself. They can be defined as "elicited by features of the target object, whether these features are real, perceives, or only imagined" (Cohen, Pham, &Andrade, 2008).From the previous studies, affective feelings have been shown to influence a wide variety of judgements, which including life satisfaction(Schwarz & Clore,1983;Strack,Schwarz&Gschneidinger,1985),consumption intention(Pham,1998), risk estimates (Gasper&Clore,2000;Johnson&Tversky,1983), pleasantness of pictures (Isen&Shalker,1982), and attitudes toward political issues (Forgas & Moylan,1987).
According to Loewenstein(2000)and Engel & Singer(2008),the decision are guided by fast and largely unconscious intuition as to feels right. Based on Frith & Singer (****), the intuitive 'emotion'-based decisions incorporate important social insight crucial for cooperative societies. Damasio (1994)had made a conclusion, emotion/intuition is the enemy of reason. The decision which is dictated by reason are not always good, while decision which dictated by emotion are not always bad. In some condition, the lack of guidance by emotions can lead to better decision(Shiv et al.,2005),but in most situation the lack of emotional guidance leads to bad decisions(Bechara & Dasaio,2005)
Damasio (1994),a neuroscientist also agreed that, lack of any emotion in financial decisions are caused the worse result rather than better. Besides that, Damasio also mention "without emotions, we can't and won't decide what is best for our economic future."
Investors are argued by making emotional investment decisions that could positively affect their long term investment goals. Rob Macdonald, head of consulting and institutional business at Nedgroup Investments said that "When it comes to investing, one of the most destructive, yet least talked about, forces is the power of emotion and the devastating effect is has on the ability of investors to make sound investment decisions based on logic and reason". Moreover, emotional will causes investors to panic during economy shock. They become greedy when the market rise, tag along herding behaviour, become irrationally attached to their investments, swift too often between funds and take on too much or too little risk.
-frame of references
****()stated that, agents' preferences are affected by the way of presented prospects. Decision process consists of an editing stage and evaluation stage. Editing stage is coded, categorized and the complex problems are broken down into simpler sub problems. Evaluation stage is when the prospects with the highest value are chosen. As the editing can lead to different representations, so the decision also can change accordingly. Framing is at the basis of mental accounting, being the way a problem s subjectively interpreted.
Researcher has shown that frame of reference is so important to the decision making process that it can lead people to ignore the alternative that is more financially beneficial to them and choose the alternative with the lower payoff (Frank,C.&Brett ,S.,1997).
Figure:Sources of financial information("often"and "very often" responses in percent)
Based on the Milestone 3 Report,there is 30% of the participants used financial advisor,followed by Internet and print media as the references.
Souces: Milestone 3 Report August31,2006,Gender Differences in Investment Behavior
Rational Behaviour
rational decision making has been at the very core of financial models describing how one should deal with a variety of problems in finance such as for example portfolio allocation[1], pricing of financial assets[2, 3], valuation of firms and of capital costs[4], pricing of options[5] and even (somewhat less intuitively) describing how the creation of financial bubbles takes place[6].
Classic examples of rational decision models in finance describe how risk willing investors should react to ensure a certain return and has been formalized in models. The rational decision making is at the cornerstone of the foundation for modern financial thinking.(Jorgen,2008)
From the theories of economics and finance presume that decision makers are rational, which means that decision makers consider all the available information and choices in the decision making process and act to maximize their utility. In comparison, behavioural theorists, Hambrick& Manson(1984) are arguing that complex decisions are largely determine by the result of behaviour factors(irrational behaviour) rather than rational and economic factors. By the way, the processing of information in decision making process in a particular environment is differs from one individual to another which has influence on their decision outcomes.
Environmental scanning is one of the rational processes of decision making. The main focus of the decision maker is on environmental sectors such as economic and financial information. Environmental information is considered a crucial to modern corporate planning, especially in major decision making. According to the rationality theory, the decision making process is a goal oriented and structured is categorized as rational. Rational decision making is where the consequences of pursuing different alternatives are calculated, and these consequences are evaluated in terms of how close they are to the goals(Simom,1987 and Dalkman,2001)Environmental scanning is an element of rational decision making process(Daft & Weick,1984;Venkatraman,1989).There have many studies have been conducted in the area of decision making in conjunction with environmental scanning. It has a main purpose to help the decision maker in making better decision in complex and uncertain environment.
Based on the relationship of environmental scanning and performance, it is proposed that the impact of environmental scanning leads to quality investment decisions.
-environmental analysis
-economic analysis
Economic analysis is including the general study of the prevailing economic environment-often on both a global and domestic basis. The analysis help investors gain insight into the underlying condition of the economy and the potential impact it might have on the behaviour of the share price (Gitman& Joehnk, 2008). Normally, stock prices are influence heavily by the state of the economy and by economic events. By rule, stock prices tend to move up when the economy is strong, and they retreat when the economy starts to soften. The overall performance of the economy has a significant bearing on the performance and profitability of the companies that issues common stock. The fortunes of the issuing firms and the prices of stock are change with economic conditions. The food retailing is less affected by the economy, but construction and auto industries are often hard hit when the times get rough. All the behaviour of economy is showed in the business cycle, which is an indication of the current state of the economy and reflecting the changes in total economic activity over time. The two widely used to measure the business cycle are gross domestic product and industrial production. Gross domestic product (GDP) represents the market value of all goods and services produced in a country over the period of a year. Industrial production is a measure of the activity/output in the industrial or productive segment of the economy. Basically, the key factors that affecting the economic is government fiscal policy, monetary policy and other factors.For following is the example of each factor:
Government fiscal policy:
Taxes
Government spending
Debt management
Monetary policy:
Money supply
Interest rates
Other factors:
Inflation
Consumer spending
Business investments
Foreign trade and foreign exchange rates
-financial analysis
FGP (Financial Genetic Programming) is a genetic programming based on forecasting system, which is designed to help users evaluate impact of factors and explore their interactions in relation to future prices. Individual believe that FGP factors such as fundamental factors are relevant to the prediction.FGP is using the power if genetic programming to generate decision tress through combination of technical rules with self-adjusted thresholds(Jin Li,1999).
Milne(1999) stated that, the narrative social disclosures in the annual report had more than 15% impact on the behaviour of how investors allocate their investment funds.
