Investors, Investment Strategies and Regulation

Question 1

Previous theories and models took as assumptions that investors thought alike. Is that realistic?

Answer 1

No. People behave differently, are very heterogeneous, even if they look like they might think the same

Question 2

Studies about investors’ decisions classify the investors into two categories. Which are them?

Answer 2

-individual investors
-institutional investors

Question 3

What are the main reasons for individual investors to trade?

Answer 3

1) information reasons -> when the benefit of doing so is greater than its costs - information migh be a major motivation
2) rebalancing reasons - may need to trade to rebalance their portfolio
3) life cycle hypothesis - in the initial period of life people essentially tend to borrow, and over time the situation changes
4) tax motivations - at the end of the year taxes become more important. Investors tend to delay the sell of winning stocks to pay taxes later. Also, by the end of the year investors tend to sell losing stocks ‘cause it will compensate previous wins
5) behavioral explanations - like overconfidence hypothesis or social reasons, like the participatios of their peers

Question 4

Regarding behavioral explanations for individual investors to trade, what are the main conclusions of the overconfidence hypothesis?

Answer 4

Investors may trade too much because they are overconfident about their skills;
-investors that trade more tendo to have lower returns -> more fees and comissions
-women tendo to outperform men because they are less overconfident

Question 5

Regarding behavioral explanations for individual investors to trade, what are the main conclusions of the salience hypothesis?

Answer 5

Investors tend to buy stocks that grab their attention, due to hard surch among thousands of stocks

Question 6

Regarding behavioral explanations for individual investors to trade, what are the main conclusions of the flawed information hypothesis?

Answer 6

investors misinterpret information making more significant mistakes that influence prices

Question 7

What patterns in individual investor’s decisions were presented?

Answer 7

1) disposition effect
2) home bias
3) ability to learn by trading
4) cross-sectional variation in performance

Question 8

Regarding patterns in individual investor’s decisions, what is the disposition effect about?

Answer 8

The tendency to hold on to losing stocks for too long while selling winning stocks too early - don’t like to admit mistakes - effect motivated by behavioral reasons; doesn’t only affect individuals

Question 9

How does the disposition effect vary?

Answer 9

-It decreases with experience and trading frequency and increases with social interactions
-Stronger among stocks that are more difficult to value - i.e. stronger with high idiosyncratic risk
- Effect is reverse in case of a loss under high volatility

Question 10

Regarding patterns in individual investor’s decisions, what is the home bias about?

Answer 10

Individuals tend to invest in companies geographically and culturally closer to them - probably due to having more information which may help get higher returns; this also migh be partially due to currency risk and turnover rates

Question 11

What seem to be the main reasons for home bias?

Answer 11

1) information reasons - have better knowledge about domestic companies
2) asymmetric news coverage - local media might focus a lot on local companies and in a favorable way, helping attract investors
3) behavioral reasons - more positive attitudes towards familiar stocks

Question 12

Regarding patterns in individual investor’s decisions, what is the learning by trading about?

Answer 12

If investors are capable of learning, maybe they’ll improve their performance. Although, they learn from their experience, so stronger individuals will over all better their perormance

Question 13

What are some counter arguments about learning by trading?

Answer 13

-there are always new investors entering the markets
-mistakes and lack of feedback prevent learning

Question 14

Regarding patterns in individual investor’s decisions, what is the cross-sectional variation in performance about?

Answer 14

individual investor trading results in systematic and economically large losses - this is predictable and can be traced to investment skills, education, etc

Question 15

What is the difference between dumb investors and smart investors?

Answer 15

Portfolio distortions of smart investors reflect informational advantage generating high-risk adjusted returns, while portfolio distortions of dumb investors arise from psychological biases because those investors have a low risk-adjusted performance - although either dumb or smart they ahve the same behavior (just for different reasons)

Question 16

What are institutional investors?

Answer 16

Organizations that collect funds from individual investors and invest it in a potentially wide range of securities and other assets

Question 17

What important functions can institutional investors do for their investors?

Answer 17

-diversification and divisibility - investors may hold fractional shares of different securities
-professional management
-lower transaction costs, since they trade large volumes of securities

Question 18

What are the teo main differences between individual investors and institutional investors?

Answer 18

the level of wealth controlled by institutional investors per capita is higher and they take decisions in a structure fashion to mitigate mistakes

Question 19

What are the two kinds of mutual funds we can find?

Answer 19

1) Open-end funds - issue shares any time and the individual investor purchases directly from the fund itself
2) Closed-end funds - has shares tradable between investors (price can differ from the net value)

Question 20

What are exchange-traded funds (EFT)?

Answer 20

investment funds traded on stock exchanges - have low costs and stock like features but price can differ net value due to demand and supply

Question 21

Why is it important to study institutional investors?

Answer 21

Because they’ll work like arbitrageurs - individual investors may make mistakes and bring inefficiency to the market, and institutional investors will correct them

Question 22

Regarding the performance of institutional investors in mutual funds, what main conclusions can we take?

Answer 22

-funds with high past returns over short-term periods continue to outperform in the subsequent period
-have significant time ability and good picking
-do well informed decisions

Question 23

Regarding the performance of institutional investors in hedge funds, what main conclusions can we take?

Answer 23

since they have less trading restrictions, we might expect this to be an example of an arbitrageur

Question 24

In what can portfolio strategies be classified?

Answer 24

• Active portfolio strategy - investors use info to forecast and seek a better performance - want to beat the market
  -Passive portfolio strategy - diversifies to match market index - don’t believe it’s possible to beat the market, since they assume it is efficient - don’t care about ifo-> market even more ineffiecient
  -Mixed strategies

Question 25

What are the two schools of active investing?

Answer 25

Value investing - buying stocks believing that the current value is higher relative to the current price
Growth investing - buying stocks they believe will growfast enough to produce appreciation

Question 26

How do financial markets impact real economy?

Answer 26

-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 27

What are the 5 areas in which financial regulators intervene?

Answer 27

1) Mandatory securities disclosure - due to asymetry of information, wrong information, uncertainty
2)Insider trading - because of incentives to manipulate information and profit from certain news
3) Market manipulation - transactions that give misleading signals as to the supply and demand of financial assets - if investors think there is manipulation, they’ll leave the market
4) Short selling - can be used to manipulate the stock market, although it enhances efficiency and if forbiden we’ll have an asymetric market
5) Speculative bubbles - needed to increase info available, mitigate positive feedback (give time for investors to understand what is going on), to remove limits of arbitrage (short sell restrictions), policy measures, mitigate pro-cyclical nature of regulation, enhance the resilience of economies to speculative bubble

Question 28

What does the instability hypothesis say?

Answer 28

There is an endogenous tendency to move from robust finance to fragile finance because of the impact of debt on the economy - tendency to create instability.

Question 29

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

Answer 29

1) hedge finance units - enough anticipated income to pay interest and reduct indebtedness
2) speculative finance units - can pay interest but must use cash from new loans to repay the amounts due to maturing loans
3) ponzi finance units - can’t pay interest with income on the schedule dates, must contract debt or sell assets - unstable

Question 30

Regarding the economic units: hedge finance, speculative finance and ponzi finance units, how do economies tend to move over prolonged periods of prosperity (FIH)?

Answer 30

From a structure dominated by gedge finance to a one dominated by speculative and ponzi finance.

Question 31

What happens in an expansion phase?

Answer 31

-Investors become more optimistic about the future, revise their estimates and become more eager to borrow -> lenders assessment of the risk declines and they are more willing to make loans
The increased demand makes prices increase and attract more investment (may lead do a difficult period if investors can’t pay their debt)

Question 32

What is the Minsky Moment?

Answer 32

When investors realise they wre being too optimistic and a lot of them try to reduce their debt selling securities, which will lead to a decrease in prices, less wealth and less consumption

Question 33

What happens in a slowdown phase?

Answer 33

The balance between investor’s cash commitments and cash flows worsens. Investors become less optimistic and more cautious, as well as lenders, since their losses increase. This leads to an increase in the interest rates.