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How Recent Economic Downturn Affected Investors Decisions Finance Essay

The recent economic downturn has spurred many to comment on the role of risk in the current financial crisis. Many financial commentators consider that the financial sector did not sufficiently consider or wage risk, particularly in mortgage lending in the USA. The commentators assume that not only the financial sector which have been identified and assessed these risks, but they also known how to communicate with them to their stakeholders and the investors who bought into those securities. Equally, the commentators assume that these stakeholders would have to understand what was being communicated with them. But for that to be the case, a shared common knowledge of risk management practice would have been needed, which currently does not exist.

http://www.iso.org/iso/risk_focus_09-07.pdf

3) INTRODUCTION

In economics, a recession is a business cycle reduction, a general slowdown in economic activity over a period of time. During recessions, many macroeconomic indicators vary in a similar way. Production as measured by Gross Domestic Product (GDP), employment, investment spending, capacity utilization, household incomes, business profits and inflation all fall during recessions; while bankruptcies and the unemployment rate rise.

Recessions are generally believed to be caused by a widespread drop in spending. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.

http://en.wikipedia.org/wiki/Recession

In a 1975 New York Times article, economic statistician Julius Shiskin suggested several rules of thumb for defining a recession, one of which was "two down quarters of GDP". In time, the other rules of thumb were forgotten, and a recession is now often defined simply as a period when GDP falls (negative real economic growth) for at least two quarters. Some economists prefer a definition of a 1.5% rise in unemployment within 12 months.

http://en.wikipedia.org/wiki/Recession

4) RATIONAL

In the recent years the equity markets have shown increasing volatility and fluctuations. For a common investor the fluctuations and volatility of the stock market has increased the uncertainty and unpredictability, as market cannot always be judged by the standard financial measures and tools. Market investors have relied upon efficient markets and rational behavior while making financial decisions. In the past years the efficient market hypothesis have been seen in the form of anomalies and irrational investor behavior and therefore the concept of fully rational investors who always maximizes the profit and demonstrate self control is becoming inadequate.

Equity market is based on the assumption of accurate predictions, elastic prices and complete knowledge of market participants, but nowadays this assumption is becoming impractical. The assumption that investors are believed to be rational decision makers whose motive is to maximise profit and minimise loss, is also becoming impractical as more and more investors are showing irrational behaviour at times. Behavioural finance is new hypothesis of finance theory, which seeks to understand and predict systematic financial markets implications of psychological decisions making (Olsen, 1998). Behavioural finance, which is also known as Standard finance, has developed concepts, which studies human behaviour and psychological mechanisms involved in investment decision-making process.

5) AIMS AND OBJECTIVES

Influence of priming is explored to the financial decisions by reinforcing subjects' risk-seeking behaviour under indecision and behaviour in control groups is compared.  Professionals focused on: commercial banks' investment advisors and accountants in CPA firms. Results indicate that priming affects subjects' risk attitudes and investment decisions. Professionals' decisions were affected more undergraduates', suggesting they employ a more intuitive and less analytic approach in making their decisions. The work is related to field-data investigate documenting correlations between returns (investors' decisions) and situational factors, (i.e., weather) by suggesting controlled tests of professionals' behaviour via the difficult intrinsic in field data. http://rof.oxfordjournals.org/cgi/content/abstract/12/3/567

http://vocuspr.vocus.com/vocuspr30/newsroom/ViewAttachment.aspx?SiteName=vanguardnew&Entity=PRAsset&AttachmentType=F&EntityID=436809&AttachmentID=0fa8f2ec-42b1-4297-ac87-7aadabf0dde2

http://ewds.strath.ac.uk/work-with-it/PESTLE/Economic.aspx (ecomonic factor)

LITERATURE REVIEW

Some recessions have been anticipated by stock market declines. In Stocks for the Long Run, Siegel mentions that since 1948, ten recessions were preceded by a stock market decline, by a lead time of 0 to 13 months (average 5.7 months), while ten stock market declines of greater than 10% in the DJIA were not followed by a recession.

Since the business cycle is very hard to predict, Siegel argues that it is not possible to take advantage of economic cycles for timing investments. Even the National Bureau of Economic Research (NBER) takes a few months to determine if a peak or trough has occurred in the US.

During an economic decline, high yield stocks such as fast moving consumer goods, pharmaceuticals, and tobacco tend to hold up better. There is significant disagreement about how health care and utilities tend to recover. Diversifying one's portfolio into international stocks may provide some safety.

There is a view termed the halfway rule according to which investors start discounting an economic recovery about halfway through a recession. In the 16 U.S. recessions since 1919, the average length has been 13 months, although the recent recessions have been shorter. Thus if the 2008 recession followed the average, the downturn in the stock market would have bottomed around November 2008. The actual US stock market bottom of the 2008 recession was in March 2009.

(Source- Recession-“http://en.wikipedia.org/wiki/Recession”-cited on 17th june 2010)

The causes of the sharp economic downturn in 2008 are:

Falling House prices (why house prices are falling) (problems with Housing Market)

Credit crunch (see: mortgage crisis explained)

Contraction of Credit following demise of Lehman Brothers and general credit crunch

Fall in Confidence affecting consumer spending and investment

Global downturn in economic growth (financial crisis explained)

Cost Push inflation of early 2008, causing a squeeze in living standards

http://www.economicshelp.org/blog/economics/causes-of-economic-downturn/

The global economic crisis

Simply stated, a process that started in July 2007 with the US subprime mortgage crisis, and continued through the subsequent collapse of the housing bubble and a decline in the capital of many banks, has led to a global credit crunch. This economic crisis has had a strong effect on exchange rates and prices in several ways:

•    Central banks have adjusted their interest rates, influencing rates on loans and deposits.

•    Currency speculation has intensified.

•    Demand for certain currencies has dwindled. For example, China is hardly buying commodities from Australia anymore, which has caused the Australian Dollar to fall.

•    Lower demand for commodities has triggered changes in prices.

•    Import/export prices have fluctuated.

•    Governmental policies have been in flux.

In turn, exchange rates have a strong effect on expat pay. Expats transfer money between their home and host locations, their allowances vary due to exchange rate change and they mentally convert host currency to home currency on a daily basis. Higher prices at home or in the host country also lead to an immediate change in the Cost of Living Allowance  (COLA). Note: A COLA is also called a Goods & Services (G&S) Differential or Commodities & Services (C&S) Differential or Host Country Allowance (HCA) etc.

 Change in Euro/local currency

Source: www.oanda.com

Factors Affecting Individual Investors’ Asset Allocation Decisions:

Individual and professional investors face several critical factors that affect their asset- allocation decisions. It can be influenced by each other and can be grouped into three broad categories. Each of these broad categories affects individual investor behaviour and they collectively correspond to the detail Assets Allocation Worksheets.

Investors Profile: (1) the ultimate length of the time horizon for the portfolio s a whole; (2) the degree of volatility or value impairment the investor can withstand, in the aggregate and for specific investment categories.

Investment outlook: (1) the degree of conviction that the investor can maintain in the face of significant under or outperformance, by the portfolio as a whole or by selected assets classes, (2) the investors’ confidence level in the specific return, risk and correlation projections on which asset allocation decisions are based.

Investment universe (1) the desired extent of principal protection versus purchasing power protection; (2)the role and the amount of core and non core asset classes i the portfolio.

The noble prize winner Harry Markowitz developed the concept of mean variance in 1950’s. Markowitz work revolutionized the way the markets work and what the implications of the knowledge might be for the design and diversification of investment portfolios. Also, before the concept of mean-variance optimisation came along, our idea was to hold five stocks when one might have seemed to suffice. Markowitz pointed out that it isn’t simply the number of securities we own that matters; it is the correlation of those securities that matters. Thus if we own stock of two companies in same sector, we are far, far less diversified than if we own stocks of two companies of two different sectors, simply because the factors that affect those two sectors are quite different. Mean variance theory was also called as Modern Portfolio Theory. Modern portfolio theory was generally accepted theory of how markets work, asset classes and styles interrelate; Modern portfolio theory is based on the premise of efficient markets. Several assumptions of the Modern portfolio theory were:

1. All investors are rationale-that is, they all want efficient portfolio’s that balance risk and return.

2. All investors have the option to borrow and lend at the rate earned by risk free asset. Thus every investor has the ability to earn at least the return paid on risk free asset.

3. All investors have the same risk and return expectations over the same time horizon.

4. Capital markets are in equilibrium, with no changes in inflation and interest rate.

5. Investors are risk averse- they prefer higher expected returns to lower returns for the same level of expected risk, and they prefer lower risk to higher risk for a given level of expected return. ( Harry M. Markowitz (July/August 1999), “The early history of portfolio theory.” Financial analyst’s journal, Volume 55, Issue 4, Page5-16.)

According to the efficient market hypothesis theory the prices are considered to be the true value of the stock and financial prices demonstrates all the necessary information about the investment. The efficient market hypothesis is based on the notion that people behave rationally i.e.; they maximise expected utility accurately and process all information (Shiller, 1998). In simple words according to him the prices of the financial assets are always correct, so it is impossible to beat the market as all information is given in the stock price. (Shiller, Robert (1990), market volatility and Investment behaviour, American economic review, Vol 80, no 2, p 58-62.)

But when in 2002, Daniel Kahneman won the noble prize for his work in Behavioural finance; suddenly investors everywhere started looking at behavioural finance techniques to improve their risk adjusted portfolio performance. The concept of risk and return lies at the heart of finance; Kahneman and Tversky’s work provides fundamental insights into the psychology associated with both. Their work is composed with two strands, Prospects theory, heuristics and biases. Prospect theory is an alternative to Mean-Variance theory, the theory that underlines modern portfolio theory. Prospect theory like its mean variance counterpart, focuses on the way people choose among alternatives. It describes how people make decisions when facing risky alternatives, while heuristic and biases describe the major psychological underpinnings for the behavioural approach to asset pricing.

With regard to the prospects theory and its counterpart, mean variance/Modern portfolio theory, several features distinguish prospects theory from mean variance theory: Firstly people choose among alternatives based on the effect on the changes on their wealth in modern portfolio theory and people in prospect theory choose on the effects on the outcomes on the changes in their wealth, which is relative to their reference point.

Secondly, people are risk averse in their choices in Modern portfolio theory, where as people in prospect theory are generally risks averse when all of their wealth are observed in as gains, but they are risk seeking when all changes in wealth are observed as losses. Third, people in modern portfolio theory treat risk independently, by its prospect. Whereas people in prospect theory overweigh small prospects which may lead people to be risk seeking.

Fourthly, people in modern portfolio theory absolutely assume that the framing of alternatives does not affect choices, where as people in prospect theory accentuate that frames affects choices.

In context with the portfolio construction, Kahnenam and Tversky’s findings imply that people do not choose well-diversified portfolios. In particular, people ignore covariance among the security returns and therefore, choose stochastically dominated portfolios that lie below the efficient frontier.

A new hypothesis in the field of finance is behavioural finance. Behavioural finance explains the decision making process. Contrary to the Markowitz approach behavioural finance explains how investors get information and how they use this information in their investment decision-making process. Behavioural finance understands and evaluates the psychological decision making process, it describes the financial and psychological principles of financial decision-making process (Olsen, 1998).

The modern theory of decision-making under risk was not based upon psychological analysis of risk and vale rather it was derived from a rational analysis. The modern theory of decision-making was not considered as an explanation of human behaviour but as a normative model of a perfect decision maker.

But when in 2002, Daniel Kahneman won the noble prize for his work in Behavioural finance; suddenly investors everywhere started looking at behavioural finance techniques to improve their risk adjusted portfolio performance. The concept of risk and return lies at the heart of finance; Kahneman and Tversky’s work provides fundamental insights into the psychology associated with both. Their work is composed with two strands, Prospects theory, heuristics and biases. Prospect theory is an alternative to Mean-Variance theory, the theory that underlines modern portfolio theory. Prospect theory like its mean variance counterpart, focuses on the way people choose among alternatives. It describes how people make decisions when facing risky alternatives, while heuristic and biases describe the major psychological underpinnings for the behavioural approach to asset pricing.

With regard to the prospects theory and its counterpart, mean variance/Modern portfolio theory, several features distinguish prospects theory from mean variance theory: Firstly people choose among alternatives based on the effect on the changes on their wealth in modern portfolio theory and people in prospect theory choose on the effects on the outcomes on the changes in their wealth, which is relative to their reference point.Secondly, people are risk averse in their choices in Modern portfolio theory, where as people in prospect theory are generally risks averse when all of their wealth are observed in as gains, but they are risk seeking when all changes in wealth are observed as losses. Third, people in modern portfolio theory treat risk independently, by its prospect. Whereas people in prospect theory overweigh small prospects which may lead people to be risk seeking.Fourthly, people in modern portfolio theory absolutely assume that the framing of alternatives does not affect choices, where as people in prospect theory accentuate that frames affects choices.

In context with the portfolio construction, Kahnenam and Tversky’s findings imply that people do not choose well-diversified portfolios. In particular, people ignore covariance among the security returns and therefore, choose stochastically dominated portfolios that lie below the efficient frontier.

A new hypothesis in the field of finance is behavioural finance. Behavioural finance explains the decision making process. Contrary to the Markowitz approach behavioural finance explains how investors get information and how they use this information in their investment decision-making process. Behavioural finance understands and evaluates the psychological decision making process, it describes the financial and psychological principles of financial decision-making process (Olsen, 1998).

The modern theory of decision-making under risk was not based upon psychological analysis of risk and vale rather it was derived from a rational analysis. The modern theory of decision-making was not considered as an explanation of human behaviour but as a normative model of a perfect decision maker.

RESEARCH METHODOLOGY

The definition of research is “Original investigation undertaken in order to gain knowledge and understanding

[http://www.rgu.ac.uk/credo/staff/page.cfm? page=9471]

This research tends to be qualitative and quantitative in nature. The quantitative method is based on the numerical observations and aims to under the concept through chosen data where statistical data plays an important role. Qualitative method is not a method used to test whether the information is valid or not, this phenomenon is mostly applies by the use of verbal descriptions instead of Numerical data. The use of this data is generally aimed towards creating a common understanding of the subject.

Quantitative research is also known as positivist research. Quantitative Positivist Research is a set of methods and techniques that allow researchers to answer research questions about the interaction of humans and computers. There are two stages in this approach to research. The first stage is the emphasis on quantitative data. The second stage is the emphasis on positivist philosophy. Regarding the first stage, these methods and techniques tend to specialize in quantities in the sense that numbers come to represent values and levels of theoretical constructs and concepts and the interpretation of the numbers is viewed as strong scientific evidence of how a phenomenon works. The presence of quantities is so predominant in Quantitative Positivist Research that statistical tools and packages are an essential element in the researcher's toolkit. Sources of data are of less concern in identifying an approach as being Quantitative Positivist Research than the fact that empirically derived numbers lie at the core of the scientific evidence assembled. A Quantitative Positivist Research researcher may use archival data or gather it through structured interviews. In both cases, the researcher is motivated by the numerical outputs and how to derive meaning from them. This emphasis on numerical analysis is also a key to the second cornerstone, positivism, which defines a scientific theory as one that can be falsified.

(http://dstraub.cis.gsu.edu:88/quant/)

The study of various empirical research and theories of finance is done by qualitative research. Qualitative research is done in the literature review by criticizing the various theories of finance. Then the questionnaires are distributed to active stock market investors in India and UK. The data received is then tested against the theory of finance and conclusions are made has the economic downturn affected the investor’s decision and attitude. Also at the end of the research the data received examines whether investors are influenced by psychological biases and whether they behave rationally while making investment decision.

This hypothesis is supported by empirical research and data received from active investors.

Ethnography is research which focuses on the sociology of meaning through close field observation of socio-cultural phenomena. The ethnographer is required to focus on a community selecting informants who are known to have an overview of the activities of the community. Such informants are asked to identify other informants representative of the community, using chain sampling to obtain a saturation of informants in all empirical areas of investigation. Informants are interviewed multiple times, using information from previous informants to elicit clarification and deeper responses upon re-interview.

(Ethnographic Research, www2.chass.ncsu.edu/garson/PA765/ethno.htm)

LIMITATIONS

The limitation of using Ethnography, as a research method is that it assumes that the researcher is capable of understanding the cultural mores of the population under study, has mastered the language or technical jargon of the culture, and has based findings on comprehensive knowledge of the culture. There is a danger that the researcher may introduce bias toward perspectives of own culture.

(Ethnographic Research, www2.chass.ncsu.edu/garson/PA765/ethno.htm)

DATA COLLECTION

In this research the main data is collected through survey in the form of questionnaire as well as exploring various existing theories of behavioural finance and traditional finance.

Primary data: The first hand data, which is collected for a specific purpose is known as primary data. In this research the survey method used in the form of questionnaire for active investors is the primary data. As the questionnaire is sent to the investors were contacted personally through email and telephone. When completed the questionnaire were sent to the researcher by email. Also interviews are done with investors in UK in order to collect data.

The questionnaire consists of 6 questions concerning various factors affecting financial decision-making and investor behaviour. The researcher chose to study the stock market participants because researcher has got his own shareholding account with this broker and have got contacts with other investors with the same company.

Secondary data: Secondary data refers to the second hand data. It is the existing data summarized collected and summarized about the particular subject. Usually these data is collected through various sources such as database, journals, literature, Internet and so on. The secondary data collected in this research is gathered through exploring various theories of investment and behavioural finance.

http://www.expatica.co.uk/hr/story/How-the-economic-downturn-is-affecting-expat-pay.html

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