International finance and banking

Title: International finance and banking

Introduction

In the contemporary realities of harsh competition the foundations of financial theory is a subject to serious reconsideration. The tactics of investing into shares and stocks have become vast and various, since investors apply mixed tactics to benefit as far as possible. Under the conditions of free markets and booming globalization, investor behaviour has remarkably changed over the last decade. To sustain competition, the investors are pragmatically driven by investor-related goals more and more focusing on rapid growth and taking risks to create sound portfolio. At that, it is becoming more and more complicated to make any long-term predictions high-growth potential investments in stocks that would ensure steady growth. The global financial crisis alone has devalued numerous expert forecasts regarding the stability of corporate shares, and therefore many companies failed on world stock markets. Therefore, the contemporary situation necessitates the analysis of the recent changes in investor behaviour regarding earnings per share and shareholder wealth.

General discussion

From the conventional viewpoint, inventors have been always driven by the core objective to maximize shareholder wealth either in short-term or long-term perspective. However, the contemporary fluctuations on share and financial markets featured by high risk levels and volatility require additional assessment of the investor’s actions. The highly dynamic situation is largely predetermined by the precepts of contemporary finance. First, portfolio risks reflect the volatility and covariance of individual instruments in the investor’s portfolio. Second, considering high level of current investment risks, investors attempt to select optimal instruments and financial measures to ensure the returns from investments and optimize mean-variance. Third, considering the likelihood of potential losses due to previous returns and risks, value-at risk should be re-estimated. While market volatility increase, investors find it more difficult to secure their investments from risks. The situation is mainly caused by the recent investor behaviours aimed at the investor related goals and oriented towards viewing their past returns as independent and using applicable data and technologies to hunt for the same assets^[1].

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Consequently, the ongoing situation on most investment markets indicates that investment instruments are largely defined on the basis of their returns, past risks, and co-variances to attain value-at-risk and mean-variance optimization. Furthermore, currently it is being stated that investors do not act independently, rather they are responding to the actions of their competitors. Next, it is rather difficult to outline the collection between safety and risk of collection of assets. In addition to this, only diversity is able to ensure investment liquidity. Any patterns of investor behaviour (including positioning data, portfolio flows etc) require timely insights since risk management is often ill-controlled and/or unpredictable. Therefore, to regain previous independence investors should strive for conducting more detailed research of risk-management models. Providing that co-variances and volatilities of the portfolio securities rise, the risks will rise too. Whenever the risk budget is violated, investors are made to reduce own risks through selling highly correlated or volatile securities contained in their portfolios. The core problem, therefore, consists in the investors’ ability to opt for the same portfolio to alter the risk factors particular to their portfolio. Providing that covariances, volatilities, and past returns affect investors’ portfolio assets, their value will reduce in a volatile fashion causing investors to overstep own risk budget. In order to eliminate risk factors, investor should sell their risky assets as well as those contained in the portfolio. Such approach will enable the rising of correlation between the portfolio assets. Ostensibly, whenever market volatility rises, investors are forced to go beyond own risk lim­its by selling the same assets at the same time. Subsequently, such tendency results in further increase in covariances and volatili­ties making investors go beyond own risk limits. The paradoxical situation consists in the fact that investment portfolio featured as safe is actually risky. This paradox is caused by the assumption that modern portfolio theory does not consider the aspects of investor behaviour. Thus it is crucial to understand the contemporary tendencies of investor behaviour to manage the ongoing investment risks. This is to indicate that portfolio positioning and flows necessitate timely insights to alert institutional investors from arising risks that are beyond the agenda of conventional covariances and volatili­ties’ perception^[2].

In 2006 the US research company ‘Dalbar, Inc.’ stated that namely investor behaviour rather than fund performance ensures investment return. Thus, mutual fund investors benefited more from real returns compared to those who opted for timing the market. At that, statistical data indicates that over 1984-2004 the loss of average US market timer investors comprised -3.9% per annum. Considering the fact that average investors seek optimally-performing investments, it is obvious they should primarily attain at least average investment return. However, individual choices depend on the investor behaviour which is not always rational, let alone spontaneous. The contemporary behaviour of investors is featured by overreaction and overexcitement towards either falling or rising markets. The average investors tend to make bargains with investments that are most profitable in the short-term perspective. Meantime, in the short-term perspective, average investors tend to sell the investments characterized by poor performance. Consequently, average investors hold their portfolios prior to market correction, to secure their gains in from the short-term performance. However, upon the market correction this strategic approach will reap no substantial benefits. Thus, stock market correction alone makes most average investors panic, assuming their potential losses, which necessitates cutting the latter. Thus, to win a benefit every investor should carefully analyze own portfolio to determine particular investment holdings that are advantageous and those that are not. At that, investor portfolios should be assessed as a whole, whereas the predictions (gambling) of individual investments will lead investor into failure. Investor behaviour is complicated due to the fact that the short-term reactions and/or responses of stock markets are almost unpredictable. However, such short-term trends particular to stock markets do not influence the investment climate. Thus investors should develop long-term strategies while adjusting their portfolios to further strengthen their position. The portfolio changes should be, therefore, implemented when market is on the rise, or investor is in the profitable position. This indicates that investors should strive to sell certain portion of their profitable investments to realize a pat of their profit. Meanwhile, investors should critically assess own risks and their tolerance prior to making an investment. Namely, the success of long-term investing consists in spending vast amount of time to understand ones risk tolerance. Consequently, investor behaviour lies in the core of successful long-term investment, assuming the development of personal long-term investment strategy considering risk tolerance, as well as long-term investment objectives. Only the establishment of a sound investment portfolio will enable meeting financial goals while making investments. More precisely, the development of a personalized Investment Policy Statement should consider investor’s individual position and particular situation on the market. Finally, the investment decisions guided by the Investment Policy Statement will reap long term benefits, whereas short-term speculations will lead an investor to nowhere^[3].

For the time being, it is evident that the behaviour of most investors lacks stability. This is mainly due permanent fluctuations on the share market which financial consequences are almost unpredictable. Therefore, the decisions of most investors are featured as rather spontaneous and emotional, assuming high level of risk. National share markets have recently fallen down in terms of total return generating, and therefore investors have considerably lost in profits. Hence, long-term returns demand detailed analysis in due circumstances.

Overall, the world of investment is characterized by the ‘loss aversion’ and therefore one could hardly find any rationality herein. In due sense, financial experts claim that ‘behavioural finance’ indicate that the pain of a loss immensely overwhelms the pleasure of gain in the investor behaviour. Such tendency assumes an adverse affect on investors’ actions. Worse than that, the current situation is intensified by the financial crisis, inflation and recession trends in many world economies making investors prone to serious psychological biases. In addition to psychological challenges, there are many other factors that impact investors’ choices. For instance, money illusion makes the majority of investors believe that monetary factors like rates, prices, and currency values are fixed and invariable. To this end, erroneously investors ignore the inflation effects on the value of their assets. Furthermore, the borrowing interest rates are subject to almost uncontrolled fluctuations. Furthermore, the tendency of anchoring indicates that investors tend to consider the most recent price as the ‘right’ one. The stocks purchase over boom periods are becoming undervalued due to financial changes and economic instability, which means that investors lose their added value per stock. Similar to los aversion is the factor of regret bearing a strong emotional load on investors who deny admitting making a mistake by purchasing a ‘poor’ stock, for example. Consequently, investors strive to compound the erroneous decision by deferring selling stocks which had gone down. Such disposition effect indicates that for a comparatively long time lag investors tend to hold on to their ‘losing’ investments, or conversely sell out their most beneficial stocks in a rather quick fashion. All these circumstances allow us to consider the investors’ behaviour as highly emotional and spontaneous wherein decisions lack reasonability. Regarding the traits of overconfidence and attribution expressed by most investors in the contemporary conditions of share market development, investors mistakenly deem that good returns are the direct results of their investment capacity, whereas unsatisfactory outcomes are attributed to bad luck. However, this biased assumption should be crossed out since the today’s vast flows of financial and market information and cutting-edge technologies allow every investor to properly analyze the most recent trends and fluctuations on markets and predict their investment options. One another factor influencing investor behaviour is known as mental accounting, assuming that the mentality of most investors is predetermined by the factors of gain or loss, rather than reasonable assessment of their overall wealth or total portfolio.

The abovementioned biases necessitate sufficient action considering the recent tendencies of falling markets internationally. On the emotional level, the management of such investment biases seems problematic, whereas tailoring ones investment strategies seems as the most optimal solution. For this purpose, it is advised by financial experts that investors should act in unbiased manner emphasizing on diversification benefits. Namely, the development of a well-planned approach towards diversification allows investors to control their most features biases, such as overconfidence. In a reasonable way, diversified investments eliminate the investor’s risks of over-trading and reduce the investor’s proneness to mental accounting. Further on, diversified investment encourages an investor to apply a portfolio-relates instead of stock-oriented approach. Furthermore, investing through well-managed funds allow investors not to overreact to market alterations and get risk-free from the investment via direct equities^[4].

Under the conditions of high market volatility, most investors need the additional help from advisers to discipline their individual investment decisions. To this end either fundamental or technical approaches may be applied. Namely, fundamental analysts state that stocks always return to their intrinsic value (i.e. stock fair price, real value). This indicates that it is optimal to purchase a stock at time when its actual price is lower than its assumed intrinsic value and further sell it out when the actual price exceeds the stock’s intrinsic value. Conversely, technical analysts tend to disagree with such conventional approach claiming that stock’s current price reflects the market’s response to the stock. At that, it is evident that fundamental analysis researches a stock financial portfolio, including company’s financial statements, profit and loss figures, dividends paid, most recent results of corporate management, rivals analysis etc. While determining the right stocks to buy/sell and their most appropriate purchase/selling periods, fundamental stock analysts apply three core ratios: the P/E ratio, the PEG ratio, and earnings per share (EPS).

EPS stands for the amount of a company’s profit which is allocated to every outstanding share within the common stock. At that, EPS ratio indicates a company’s profitability. EPS is designated by dividing the stock’s net income of the last 12 months by the number of outstanding shares. Hence, in practical terms, EPS is applied as an important variable to determine share’s price.Furthermore, EPS makes a core and indispensable component of the P/E ratio.Investors are aware that while generating net income, the company which generates the EPS number withless investment (equity) will be more efficient while using itscapital to generate income. At that, investors’ should take into consideration the so-called ‘earnings manipulation’ which adversely affects the earnings number’ quality. Hence, investment experts warn that it is vital not to bank on a sole financial measure; conversely, financial measures should be applied in optimal conjunction with statement analysis or corporate management, for instance, to ensure the most optimal investment option. While evaluating share price, EPS is applied as an efficient tool relating income to ownership grounded on a per share basis.

The price/earnings ratio (P/E ratio) is considered as a rather important investment tool among the fundamentalists. In other words, P/E ratio is a popular indicator applied by fundamental analysts during the stock market analysis. This particular ratio enables to designate whether a stock is a bargain or overpriced. To determine the P/E ratio one should divide a stock’s price per share by the according earnings. Overall, investment experts consider that the lower is the P/E the better is the stock bargain. Nonetheless, it is worthy to note that P/E may indicate the higher potential of a stock. Thus, P/E exceeding 20 is considered by the majority of fundamental investors as far too expensive. Overall, higher P/E is particular to the solid companies owning safe investments and paying dividends duly. In turn, on sector level, biotechs is featured by the highest P/E, whereas commodities will have the lowest P/E ratio. In turn, PEG ratio is applied as the fundamental tool within the analysis of the stock market determining the future growth potential of a company. To this end, the correlation is as follows: low PEG ratio indicates that stock is an optimal bargain. At that, PEG ratio equalling 1 or lower than that is deemed a good buy option. Overall, PEG ratios are designated by dividing P/E by the assumed growth in earnings in the future. The application of these three fundamental stock market ratios indicates an optimal solution to effectively manage stock amount. In addition to this, financial and investment experts recommend investors to seek stock backed up by solid financial statements, well-balanced management, and resistance against the competitors^[5].

In addition to the abovementioned fundamental ratios, shareholder wealth presents special concern for investors’ consideration. In due context, it should be noted right from scratch that the company’s business is owned by shareholders, whereas company’s operational staff including executive officers CEO, directors and/or presidents only control daily business operations. In case the latter are not a company’s shareholders, they are not entitled to claim any assets or profits. Thus, maximizing shareholder wealth indicates that after liquidation, the value of cash shares will be lower on a per share basis compared to the amount potentially offered by public market for such shares at the given time. To save the situation corporate management will take the measure like driving the price of the stock, and/or reducing the number of outstanding and issued shares. Hence, the maximization of shareholder wealth stresses on the importance of maintaining the corporate position relevant to shareholder concerns. At that, undesirable takeovers are often caused by poor stock price performance provoking proxy to fight for control. Furthermore, management can apply proper stock option incentives to attain the beneficial market value maximization. Next, namely influential institutional investors make company’s management more responsive towards the shareholders^[6].

Overall, shareholders reap financial benefits from their investment in company’s shares as follows: (1) they receive dividends as a result of the distribution of company’s net profit or part thereof to shareholders, assuming that shareholders are the owners of the company. Herewith, in most cases dividends are paid on biannual basis, including tax benefits due to ‘dividend imputation’ system; (2) capital growth indicates the increase of the market value of company’s shares over total cost of such shares, reflecting the increase in the company’s assets and profits. However, various cycles may assume numerous fluctuations on the share market, wherein prices for are designated by supply and demand correlation; (3) new issues of shares are made by a company requiring further funds. At that, new shares are proposed at a discount price to the existing shareholders. Their value is grounded on predetermined ratio which excludes brokerage deductions. The entitlement to the offered shares is indicated as ‘rights’ enabling shareholders to acquire the shares or sell their rights on them on the stock market. At that, annual reports highlight all the relevant details regarding shareholder wealth optimization options^[7].

Considering the abovementioned, corporate management primarily aims to maximize shareholder wealth through the implementation of a plan to ensure the growth of company’s sales assuming profitability as well as dividends for investors. Hence, the announcement of dividend increases by corporate managements is a clear sign for shareholders that a company has ensured corporate prosperity and success. The maintenance of such profitability over long period of time entitles a company to ‘blue chip stocks’ that indicate high level of recognition on the market. Conventional models applied to value equities largely emphasize on the importance of cash dividends. A common stock is therefore valued based on the predication of the discounted value of the assumed dividend streams. To achieve total returns ranked above average one should invest into the Dow Jones Industrial stocks assuming the highest level of cash dividends. Alternatively, institutional investors establish mutual funds on the payment of cash dividends emphasizing on the income of equities as a core investment objective^[8].

Conclusion

The dissertation project on theory and practice of finance discussed the investor behaviour with the emphasis on investor-related goals such as earnings per share and shareholder wealth. At that, fundamental ratios of investment were analysed. The current trends of investment markets and according behaviours of the contemporary investors were well-reasoned and explained.

Reference list

BT Financial Group 2008, Investor behavior: that sinking feeling, [retrieved November 29, 2008 http://www.bt.com.au/Articles/2008-April/200804-BIO-Investor-behaviour.asp

Collison, D & Frankfurter, G. 2000, “Are we really maximizing shareholder wealth? Or: What investors must know when we do”, Journal of Investing. New York: Vol. 9, Iss. 3; pg. 55

Gillespie, C. 2006, Investor Behaviour, The Financialist, Iss 89, retrieved November 29, 2008

http://www.rogersgroup.com/Content/Newsletters/articles/CEG_InvestorBehaviourApr06.pdf

Harris, A., 2007, Three Tools for Every Fundamental Investor- EPS, P/E Ratio, and the PEG Ratio, retrieved November 29, 2008

http://www.associatedcontent.com/article/111253/three_tools_for_every_fundamental_investor.html

Kalirai, H. 2003, Risk and investor behaviour, Canadian Investment Review, retrieved November 29, 2008 http://www.trendfollowing.com/whitepaper/Risk_Kalirai.pdf

Nugent, T. 2002, Stock Dividends A Strategy for Increasing Corporate & Shareholder Wealth, retrieved November 29, 2008 http://www.victoriacapitalus.com/researchpapers/Stock%20Dividends.pdf

Worrell D, Nemec C, Davidson W. 1997. One hat too many: key executive plurality and shareholder wealth. Strategic Management Journal 18(6): 499-507.

1

^[1] H Kalirai 2003, ‘Risk and investor behaviour’, Canadian Investment Review, [Online] Available at: http://www.trendfollowing.com/whitepaper/Risk_Kalirai.pdf

^[2] Kalirai (Ibid.)

^[3] C Gillespie 2006, ‘Investor Behaviour’, The Financialist, Iss 89, retrieved November 29, 2008 http://www.rogersgroup.com/Content/Newsletters/articles/CEG_InvestorBehaviourApr06.pdf

^[4] BT Financial Group 2008, ‘Investor behaviour: that sinking feeling’, retrieved November 29, 2008 http://www.bt.com.au/Articles/2008-April/200804-BIO-Investor-behaviour.asp

^[5] A Harris, 2007, ‘Three Tools for Every Fundamental Investor- EPS, P/E Ratio, and the PEG Ratio’, retrieved November 29, 2008

http://www.associatedcontent.com/article/111253/three_tools_for_every_fundamental_investor.html

^[6] D Worrell D., C Nemec and W Davidson 1997, One hat too many: key executive plurality and shareholder wealth. Strategic Management Journal 18(6): 499-507.

^[7] D Collison & G Frankfurter, 2000, “Are we really maximizing shareholder wealth? Or: What investors must know when we do”, Journal of Investing. New York: Vol. 9, Iss. 3; pg. 55

^[8] T Nugent, 2002, Stock Dividends A Strategy for Increasing Corporate & Shareholder Wealth, retrieved November 29, 2008 http://www.victoriacapitalus.com/researchpapers/Stock%20Dividends.pdf