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Behavioral Finance & Passive investment

I would choose a passive investment strategy, investing in a selection of stock market tracker funds. I will not be trying to follow an active strategy, and I will not be attempting to exploit the ideas of behavioral finance. In this essay I will describe my strategy, explain the positive reasons for choosing it, and explain why I think it would be very difficult, or almost impossible, to apply the ideas of behavioral finance to consistently beat the index.
Passive investment strategy
Passive investment refers to investing in broad sectors of the stock market without the use of information about attractive and unattractive securities. This strategy does not forecast the prices for securities or the time markets and sectors of the stock market (Laffer & Canto, 1990). The broad sectors of the stock market focused by the passive investors are known as the asset classes or indexes. Although the main goal of passive investment is to gain profits, the investors also accept the average returns produced by the various classes of assets. Passive investment does not use the information that is used by the active investors in the stock market trading. Assets are allocated depending on the empirical research but not according to the risk level and the returns expected from the stock assets (Dennis & Bernstein, 1998).
Index investing is a type of passive investment where by the indexes for the securities determine the portfolios to invest in. A committee constructs the security indexes and samples the various market sectors for each security index. An example of the security index is the Dow Jones Industrial index. It contains a sample of 30 large companies in US. Many domestic and international markets have their own security indexes (Comiskey & Mulford, 2000).
Passive investment involves the use of low risk investment. Returns in the stock market are directly related to the level of risk of the stocks; the higher the risk the lower the returns. The government gives full support of the passive securities. Examples of some of the passive securities are the bond securities from the government, government guaranteed shares and many others (Fischer & Papaioannou, 1992).
Behavioral finance
Behavioral finance is a branch of economics which deals with the understanding of the economic decisions made by consumers, investors and borrowers and the effect of these decisions to the prices in the market, returns and resource allocation. The field of behavioral finance deals with the public choice and their effects on the markets. For example, the stock market behavior (Grauer & Hakansson, 1995). The structure of information and market characteristics determines the investment decisions and the outcomes of the market. Behavioral finance also deals with the research about the market trends in the stock market and the changing demand by the consumers and investors. Investments in the stock market can be categorized into passive and active investment. Improvement in the market efficiency and the free flow of information has created a shift in demand to the passive investment in the modern stock markets (Fischer & Papaioannou, 1992).
Advantages of passive investment strategy over the active investment strategy
Passive investment is more valid since it is generated by universities within a nation and private research centers. Compared to the active investment where the indexes a generated from the Wall Street organizations, banks, insurance companies, managers or any other party interested in the profits obtained from the active investment (Armstrong, 2004).
Passive investment does not rely on the information generated by active mangers. Active investment involves the use of information from the stock market experts, advisors, money managers among others. This information is based on speculation and no accuracy is involved. Passive investment is relatively more accurate since there is no speculation about the future market trends. Both private and public sector economists forecast the market to predict the trends of the economy and investment patterns in future. Research has found out that economists are inefficient in predicting with accuracy the future economic and investment trends in the market (Dennis & Bernstein, 1998).
The future prices for securities are not predictable. Statistical studies have proved that the behavior pattern of prices for securities cannot be distinguished from that of random numbers. The price pattern for the securities cannot be predicted with accuracy since there is no persistence in the market behavior for the securities. There has been an upward trend in the prices for securities as economies grow and inflation persists. Since inflation cannot be predicted, the prices for the securities also cannot be predicted (Dennis & Bernstein, 1998).
There is a direct correlation between the risk and returns on securities. The higher the returns the higher the risk in the investment. Investments with low risk and high returns do not exist in the stock market (Liaw, 1999). There are many forms of investment risk. Investment risk can be defined as the potential to lose the capital invested and the duration of the loss. Researchers have analyzed long term data to define relationship between risk and returns of all the major assets in the market. A correlation of the different types of investments has been developed to assist the investors. The future risk and returns expected from returns has been predicted. The findings of research by many investment researchers has identified that there exists no high return low risk securities (Dennis & Bernstein, 1998).
Compared to active management, active management is cheaper. Investors in the active investment incur many costs in matching the returns of the passive portfolio. Some of the costs include trade costs, high management fees, and costs by the market impact when the managers influence the prices they pay, taxes, from the high turnover rates, commissions and the dilution to maintain high cash positions compared to the passive management (Dennis & Bernstein, 1998).
Passive management is less risky than the active management. Active management seeks to select securities which outperform the market. This leads to concentration on a few securities. The managers may predict wrongly leading to market losses. Passive investment is diversified and the managers allocate the securities to many categories of investments. Passive investments can be predicted with accuracy. They have risks and returns which can be quantified. Diversification in securities produce high returns and reduces the risks attached to the securities. Investing in one category is more risky and may yield less returns (Claessens & Laeven, 2006).
Passive management has better performance than the active management. This is caused by the high costs and risks attached to the active management (Dennis & Bernstein, 1998). More than three quarters of the active management performs below the passive portfolio in any given year. With time the range increases until almost none performs above the market averages. Passive management exceeds the active management by almost 2 percent in terms of asset type and mix. Active managers must pay capital gains taxes each year. The after tax returns for the active managers are lower by 30 percent compared to the passive management (Papaioannou & Fischer, 1992).
Passive investment strategies are widely used by smart money users. More than half of all institutional monies are presented in passive portfolios. Approximately 4 percent of retail investment use passive strategies. Companies using the passive investment strategies are AT&T, IBM, Pepsi, Stanford University and others (Gallagher & Prashanthi, 2005).
The performance of active managers cannot be identified in advance. The media promotes active managers who have indicated good performance in the past. The success of the active management cannot be predicted by the use of the data from the past. In most cases the results are obtained by luck. Research has found out that the past performance of active money managers is not related to the future performance. Some of the greatest active money mangers, such as Warren Buffet and others have recommended the passive (index) funds (Das, 1993).
Active management investors perform more badly than the advertised numbers. Information about the real returns made by the investors is hard to get. The figures reported by the active mangers do not reflect the true market performance. Brokers and investors have a tendency to move rapidly to pick asset classes which end up losing performance. The mainstream financial press does not report about poor performance by the active investors. In addition Wall Street brokers do not mention bad business. Retail investors should not follow the information from Morningstar, CNBC or any other source when selecting mutual funds (Claessens & Laeven, 2006).
Passive investment strategy makes use of the asset class securities. Asset class explains the group of securities with similar risks and returns. Examples of the asset classes are the treasury bonds, commercial real estates among many others (Wellisch, 2000). The asset class selected by professional money managers determines the performance of the securities. Returns are produced by the markets but not the mangers. Asset class securities have less risk compared to the active investments. Passive investors prefer the asset class securities since they are risk averse. Asset class is supported by the government and they have a guarantee for payment (Anderson, 2005).
Behavioral finance and passive investment strategy
Investment has become a major trend in the today’s’ life. Many investors are concerned about the security and the returns from the money invested. The stock market has become a major investment path for many people. The stock market has been expanding over the years and more people participate in the sale of private and public stocks. The study of behavioral finance attempts to explain the different categories of investments, the risks involved and the returns (Laffer & Canto, 1991).
Passive investment has been encouraged by many researchers especially after the economic crisis which has recently affected the global economies in the recent past. The unpredictable market behavior and world economies have caused many investors result to the use of low risk investments (Claessens & Laeven, 2006).
Information about the pricing and performance of the stocks in the markets is adequate and investors are seeking other aspects to choose the most competitive securities. Economists suggest that stocks have the correct prices all the times. The correct price is the best possible fair value of the securities depending on the available market information (Liddell, 2004). Due to the establishment of market democracy the forces of supply and demand have controlled the stock markets in many countries. The behavior of investors determines the best prices of the stocks in a competitive market. The fair value of the stocks is achieved at the equilibrium when the forces of supply and demand coincide. Market participants are well informed about the actual prices and amount of stocks and they tend to control the prices of all stocks in the market. Security issues about the stock are a major factor affecting the stock market. Investors should consult the professionals in mutual funds as well as stock brokers to acquire adequate information about the stock performance in the market (Anderson, 2005).
Investment mangers should choose the asset class which is most suitable to the investment they prefer. Asset class securities are diversified and have low risks. The use of passive investments is increasing and many people prefer the low risk investments. The active investment has been underperforming and many investors are avoiding such investments due to the high risks attached. Investors are focusing on more predictable securities which have low risks attached. Many economists have been blamed for misleading investors about the market patterns. Active money managers have used the press to improve their image but the reported performance is contrary to the   actual data. Therefore, passive investment management is the most suitable for investors with the need to reduce risk and improve the returns. There are professionals who can accurately predict the future prices of the stocks and the securities are controlled by uncertainty. Active managers speculate the future prices and there is no single person with the ability to provide the certainty about the future market trends. Investors may be attracted by particular stock mangers due to their past performance but this may mislead them. Since stock markets are not efficient many investors have turned to the passive investments. There are many errors which have been identified with the active markets. There are many losses which have been incurred by investors who have entirely relied on the active investment.

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