The Effect of the Recent Financial Crises on the UK Investors Psyche - Literature review Example

?The effect of the recent financial crises on the UK investors psyche? Objective To examine the effect of UK investors purchasing power and explore how the individual investors behaviour has transformed post 2007/08 financial crisis. Abstract The paper examines the effect of the recent stock market crash of 2007 among individual investors in UK. In this study, we examine the effect of the financial crisis on the investors at a large. The discussion involved how the investors take decisions before investing in the stock market. Their behaviours are studied in order to get a real picture of the stock market investment during and after the period of financial crisis. Theories are provided to guide the behaviours and investment strategies of the investors. The theories give emphasis on the psyche of the investors and their way of thinking and reacting to the financial market changes. The individual decisions are cognitive while investments are made. The paper also highlights on the risk measurement capacity of the investors. The risk is associated with the changes that are brought in the stock prices by the companies during the crisis period. Key Words: financial behaviour, financial crisis, Investment psyche, decision making Critical Review (Background) It is quite understandable when people ask how the crises could have happened after the disaster had struck, but given that market players are irrational, it can be said that people, including experts and laymen alike, play a psychological role in financial decision making. According to Sahi and Arora (2012) it is hardly ever heard that investors make wrong decisions who buy when they have to sell and vice-versa, despite possessing the correct information. This is in complete non-conformity with the efficient market hypothesis theory, which states that people behave rationally and maximize their utility by accurately processing all the available information. This highlights that prices remain at true values of the stock and reflect all essential information about investment (Phansatana et al., 2013). However, Shiller (2013) argues that the behavioural finance disproves the theory stating that individuals are impacted by more factors than just objective figures, including all kinds of subjective factors like, human biases and inconsistency in behaviour, thought and irrationality, when they are faced by market uncertainties. The paper analyses how the recent financial crisis has supported the idea that investors behave irrationally when faced with the financial meltdown and offers interesting observations on post crisis behaviour of investors. Investigations of the recent financial meltdown in 2007 reveal that the lessons to be learnt are plentiful. The crisis investigations done by (Adrian and Shin, 2009; Taylor, 2008; Greenlaw et al., 2008) give general view of the affairs proceeding the crises and they all to some extent agree it was due to a conglomerate of macroeconomic factors like, interest rates, high market liquidity and booming rates of securities market and household. This market crisis also emphasized on the fact that financial sector was unable to predict risk specifically in US mortgage lending segment (Ferguson, 2013). This is the reason why the communication between financial sector and stakeholders was faulty and that the stakeholders had made investments without proper investigation. Ulkua and Weber (2013) firmly believe when recession occurs at the business cycle it brings in a general slowdown in the economy. A general trend of reduced spending is observed. Governments play their role by adopting policies that have an expansionary impact on the economy like, increasing supply of money and reducing taxes. As a result of the financial crisis, Mehl (2013) examined that the equity markets had also shown a lot of volatility and this had instilled unpredictability among the investors. Investors rely on the efficient markets and expect rational behaviour, but this efficient market hypothesis had seen anomalies in the recent past. According to Firat and Fettahoglu (2011), the assumptions for efficiency in inequity markets are the complete knowledge about equities and prices, accurate predicating power and elastic prices. Then again, with the dismantling of efficient market hypothesis, these assumptions also seem unrelated. This is where the scope of behavioural finance comes into play by identifying psychological decision making which affects markets and help in predicting the financial market performance (Prorokowski, 2011). Review Questions 1. How the investor’s purchasing power (behaviour) of UK is affected in the post financial crisis period? 2. How the investors have reacted to the post financial crisis period? How the individual investor’s purchasing power (behaviour) of UK is affected in the post financial crisis period? The post financial crisis in 2007 has threatened the collapse of many large financial institutions, which have made the investors anxious regarding safeguarding their money that they have invested in (Banerjee, 2011). Research done by (Rizzi, 2009) analysed that after the credit crunch individual investors became more conservative, there was seen a reversal from risky asserts (common stocks) to safer liquid investment i.e. government bonds. In an annual report of ICI (2012) finding revealed a massive drop in stock mutual funds owned by households, a colossal drop of more than 45% since 2008 - 2011, which is the second lowest since 1997 the Asian financial crises (ICI, 2012). According to Sharma and Panday (2010) purchasing power of investors in closely linked with risk the investors are willing to take and on the disposable income of the investor (Gervais and Odean, 2001). Therefore, the purchasing power of the investors has reduced as the crises has crunched the income of the common people, which have made them conscious regarding the investment plans in the financial institutions especially after the worst crises since 1930’s. However, Bailey et al., (2011) argues that many individual investors at the present time look at this as an opportunity to enter the stock market. There is innumerable assessment done on the individual investors to understand if the risk taking behaviour and disposable income plays a major part in their purchasing behaviour. Tests vary from as basic as asking investors about what they think of investment risk (Chater & Stewart, 2009) to psychometric testing’s i.e. by exploring and examining their risk perception (Koonce et al., 2005) to actually inquiring the individual to participate in hypothetical investment (Veld et al, 2008). Despite the fact that countless tests and different approaches have been carried out yet no result shows a common pattern, different trial and tryouts determines conflicting results, mainly because the human behaviour cannot be predicted. However, the only conclusive outcome, which keeps on materializing, is of investor’s previous financial experience (either good or bad) and the knowledge about the stocks (their confidence level/ worrying behaviour) etc. Many too still today believe without any empirical evidence that the crises has had a negative effect on investors purchasing power, just based on previous studies as Kaheneman and Tversky (1972) in their study expressed that extreme factors like Great Depression of the 1930’s (also financial crises of 2007/2008 can be categorized in that same sequence of events) can have a gigantic impact on individual investors as they are most noticeable and vulnerable to which Barberis (2013) further claims that consecutive losses can effect individual investor confidence. However, Hoffman (2013) argues that the financial crisis has not affected individual investors in a negative way. As the surveys done by Hoffmann during the period of April 2008 - March 2009 on investors purchasing behaviours and their presumptions on the returns of stock markets (which included the period when stock markets were hit the hardest, September and October 2008 collapse of Lehman brothers and when AIG were bailed out) the results showed that markets were relatively calm and the crises only temporary reduced investors risk tolerance and return expectations and increase their risk perception but that recovered quickly. In today’s world, investors seek for an efficient market where there is huge number of players and concentrates on profit maximization (Shleifer, 2000). According to (Morch et al., 1990; Avery et al., 2009; Shao and Rennie, 2007) the investors try to predict the future performance of the market with their rational thinking procedure and adequate available information about the market. The investors thus assume that with the future analysis of the stock prices they will arrive at a much profitable place (Palan, 2004). The price predicted by them will be closer to the intrinsic value of the stock. With the increase in competition in the market among the different players, there has been a tendency among the investors to check and tally the prices of the stock and evaluate the difference to get sufficient profit. However, (Patev, Kanaryan and Lyroudi, 2006) plight it is impossible to get a perfect market which can be predicted by gathering all the information regarding their performance. Thus, the market hypothesis does not hold true because of the market imperfections. The main drawbacks of the efficient market hypothesis are that it does not account for the value creation by the investment professionals who would have otherwise not existed, if information was available for free. It also does not recognise cognitive biases inherent among individuals. Hence, (Brunnerrneier, 2001) concludes that the investors cannot predict the stock prices to its best as stock prices keeps on fluctuating according to the market condition. In the post-financial crisis period, the investors have lost confidence in the investment plans since their purchasing power has been reduced. These confidence was further lost when the actual period of financial crisis was encountered and they lost their precious money due to the Great Depression and closure of the financial institutions. Thus, the investors found it difficult to gain the confidence in the stock market after they lost their money (Ben-David, 2008). According to Palan (2004) it can be inferred that the imperfect market can be the main reason of losing the confidence of the investors and the reduction in their purchasing power How the investors have reacted to the post financial crisis period? According to some literature (Entrop et al, 2012; Kramer and Lensink, 2012; Nicolosi, 2008) there is a belief that the individual investors have lost confidence after they encountered the huge loss post crises and furthermore lost faith in regulatory bodies (Acharya, 2009). The same regulatory bodies that were assigned with the task of controlling, monitoring and overseeing the markets and protecting the rights and interests of the investors and now some investors view the stock market as rigged. Furthermore, the present market scenario in the European Union does not offer any cushion against such lack of investor trust and this lack of confidence shall have long-term repercussion on investor behaviour (Springford, 2011; Pennathur, Smith and Subhramanyam, 2013). Survey done by CNBC in 2010 of 1035 investors upon which 86% of them were of a view that market was not fair to small individual investors as compared to professional traders and big investment banks (CNBC, 2010). However, Sivy (2012) in his article ‘why the market is not stacked against the little guy’ argues that the market is fair, testifying if individual investors stay away from uneven areas they have the most advantage of succeeding post 2007/08 crises as they respond quicker, can keep a continuous eye on the market, best source of information is available to them and most importantly the trading cost are much lower. Furthermore, on January 31, 2013 according to the Ministry of National Planning and Economic Development a new regulation under the foreign investment law was updated which strengthens the rights of investors (Myanmar, 2013) which should in essence build the confidence back of the investors. After the financial crisis, investor’s reactions seem to have become more cautious regarding management of their finances. They now manage their personal investment in person and seek expert advice on certain matters. They choose products that appear simpler and more transparent in order to build a portfolio that has risk within their scope of management (Adair et al., 2009). Investors have moved on from risk bearing investment to those investments with a consistent inflow of cash like, certain fixed income bearing investments, such pattern shows that investors are now safeguarding themselves from downside risks. There is a preference shift from high risk with high returns to fixed and safe returns; the portfolio asset allocation has become less risk seeking (Jankewicz, 2011). However O’Neill and Xiao (2012) empirical study on investors behaviour after the crises acquaints a different anecdote. An online self-assessment apparatus was used to assemble the data of 20 financial investors during the period of January 2005 - December 2010. The sample of 10,661 investors was divided in to two different groups; before 31 December 2007 and after 31 December 2007, to get a true understanding of investor’s behaviour pre and post financial crises. Following the assessment, it was concluded that all three behaviour categories (savings, budgeting and spending) continued at an extraordinary high level even after the financial crises. This therefore demonstrates that not all investors were being wary of the market and regulators; through saving and budgeting but also there was a noticeable increase in the spending (O’Neill and Xiao, 2012). Further research done by KK (2009) on investors reaction post crises demonstrated that companies also play an integral part in the lost and gain of investors. An empirical study done on management students to contemplate the behaviour of market players during the crises. It was observed that companies were to some extent unhelpful in giving out information and the structure of investments amended as a result of market crash, as compared to after the crises where information available from companies was significantly high thus all investors again a lot. Thus, according to KK there is a positive reaction among investors post financial crises as more information is readily available from companies (KK, 2009). On analyzing the reaction of investor behaviour post 2007 crisis, Holman (2010) observe that behaviour like herding, anchoring, loss aversion had impacted the post crisis thoughts of investors as well. Certain behaviour patterns that had arisen out of the crisis had caused investment dilemma among investors in UK. Figure: Post Crisis expectations between Investor Mood and Time frame of Crisis (Source: Holman, 2010) The figure explains the phenomenon of investor expectations in UK. The prices of stocks went up right before the crisis due to herd behaviour, all stocks were overvalued. The crisis had caused a sharp decline in prices and investor sentiments ran low. After the crisis, investor sentiments had gradually revived, showing a cautious and careful approach in investment pattern. Capgemini (2010) further states investor psyche post financial crisis is guided by emotional factors than objective ones. The needs and aims of the client need to incorporate those emotional factors while building a portfolio that has sufficient strength and risk bearing capabilities (Marston and Straker, 2001). A financial analysis can be executed in order to figure out the harmony between cognitive psychology of the investors and the movement of the market (Hoffman, Post and Pennings, 2013). It shows that there are many wrong decisions that are taken by the investors which are based on some subjective assumptions about the market performance. The assumptions that are identified are: the financial instruments have their own intrinsic value and it has some perceived value that is predicted by the investors. Thus, it is important to know the link between the two values so as to recognize the gap and impact of the same on the investors (Hoffman, Post and Pennings, 2013). Conclusion It can be concluded that the post crisis period has a great influence on the investment pattern of the investors. The investors found it rather difficult to trust on the performance of the stock and thus are affected by the financial crisis that hit in 2007. The behavioural theories are explained to depict the exact behavioural pattern of the investors. The theories however failed to elaborate the behavioural pattern clearly since it depends on the fluctuations in the stock market which affects the performance of the stock. It adds on the human aspect to the theories by acknowledging the layout of the theories (Ashby, Peters and Devlin, 2013). Precis The financial crisis has affected the US economy to a great extent. The financial crisis had later spread globally which had a huge impact on the buying and selling behaviour of the investors. The behavioural finance has elaborated the affect of such crisis on the psyche of the investors who lost their money in the financial crisis that affected the investors in UK. The financial crisis has encountered the closure of many firms due to bankruptcy and the investors are losing their money. There was an overall grim scenario in the financial market as the investors are reluctant to invest in the stocks after experiencing the huge fluctuations in the stock prices. The investors who are the main victims of the financial crunch down were not able to demand for their investment as there was a global depression and the financial crunch. The financial system worldwide has been highly affected and thus the investors lost their confidence in the company’s stock. The markets were not efficient and thus the investors failed to predict the exact stock prices. The prices of the stock however did not reflect the correct market value of the stocks which brought in huge losses to the investors. The behavioural finance thus elaborated the behaviour of the markets and the investors. The behavioural finance highlighted the fact that the markets are not efficient and the behviour of the investors are the function of their cognitive decision-making ability and individual perception about market behaviour. Thus, behavioural finance has explained the behaviour of the market by taking the individual perception and sentiments of the investors. The study also portrays the fact the investors are sometimes even irrational in taking any decision. The underlying asset values are predicted by the individuals in their own way and hence the overall decision making is affected. The post crisis, investor sentiments about making investment in risky financial products like, the stock market, had somewhat changed. Investors in UK had found alternate and safer ways to make investments after bearing the brunt of the US financial meltdown. It is also observed that there is a widespread loss of faith in financial regulators and the European crisis at present does not cushion the belief. There is a general trend of shift from risk bearing securities to fixed income investments that offer lesser but a regular and safer income. Investors also seek expert advice prior to making any financial decision. In conclusion, it is clear that investors have become more concerned with matters relating to their own money. Individual psyche does impact investment decisions but now human factors associate emotional reasons with investments than practical ones. Read More