Is Investment a Matter of Evaluating Risk or Simply Luck - Essay Example

Personal Investment- Is it Just a Matter of Evaluating Risk and Return or Simply Luck? Griliches and Cockburn (2009) define personal investment as a financial investment done by an individual rather than a financial institution or business with the expectation of earning of dividends, interests, and capital appreciation. Gallery and Gallery (2009) and Harrison, Waite, and White (2009) affirm that various investors, both institution and individuals are moved by the actions and performance of the increasing stock by exposing it during bull market periods and reducing it during bear market periods. “Buying high and selling low” behavior is shown during mutual cash flows that reflects what appears to depict emotional response or fear or greed, rather than depicting a rational investment behavior. Most goals in personal investment are straightforward, in that individuals may be preserving their assets, saving for his or her retirement, funding his or her pension plan, or he or she is meeting a university spending requirement (Finke & Huston, 2003). Harrison et al., (2009), Bajtelsmit and Bernasek (2007), and Finke and Huston (2003) emphasize that personal investment constraints can be simple or complex depending on the individual and the current investment situation. The primary constraint which, an individual experiences is the tolerance level that an individual has for the market risk. Potential return and the market risks are related, in that the desire of an individual to experience a greater return will need his or her exposure to higher market risks (Papke, 2008). In most investment cases, time horizon is another fundamental constraint. A good example is a university endowment that has an infinite horizon has risks which are unwise for an investor who is looking to invest in his or her child’s education (Duflo & Saez, 2009). Other investment constraints include liquidity requirements, exposure to taxes, legal issues, and other factors such as avoiding some investments. Constraints in personal investments change with time and an individual must carefully study and research on these constraints before deciding on investing in any investment plan. The review provides a discussion on the technical analysis concepts. It reviews on the module showing how it works, depicting two advantages and two disadvantages. The literature reviews on the fundamental analysis, showing how the module works. The research shows two advantages and disadvantages of the analysis. Part two of the research entails the working of the random walk theory, showing and explains how it works. The research then explains two advantages and disadvantages of the theory. The second part will also entail the literature on the efficient market hypotheses, showing how it works and showing its two advantages and disadvantages. I will conclude the paper showing what the paper entails and how the theories work on personal investment. Part 1: Technical Analysis Lepper and Iyengar (2006) and Kamich (2002) define technical analysis as a method that is used to evaluate securities through the analysis of statistics that are generated by various market activities such as volume and past prices. Murphy (2007) asserts that analysts do not measure the intrinsic value of securities, but instead they use charts and other recommended tools to identify patterns, which suggest future activities in the market. Technical analysts have a belief that the historical performance of markets and stocks are indicators of future performance of the market. Technical analysis bases its assumption on one major factor: history repeats itself (Bajtelsmit & Bernasek, 2007). Analysts use tools and charts to display changes and historical security prices. Prices are plotted over a given period of time. The charts display volume of activities and prices within the security; however, at times analysts display only the price action (Lepper & Iyengar, 2006). It is proven that the price changes in the security represent a shift in supply against demand (Sodelind, Suden, & Palme, 2005). But this is a new form of saying that they represent the interaction between greed and fear. Technical analysis is similar to a probability of hurricane cone. When the price action can be determined, it means that the price of a particular target is yet to be attained. When the price is further away, then the greater is the risk of that commodity in impacting the target. The price shifts away from the particular target. When the price is much closer to the intended target, then the price increases its accuracy. Technical analysis anticipates the probable direction that a price 87.\\\\of a commodity moves and traces the amount of losses (Weisbenner & Liang, 2009). Advantages of technical analysis Technical data generated from the technical analysis procedures can be used to predict future prices and trends of the market (Weisbenner & Liang, 2009). Analysts use various technical formulas and data to predict trends, potential duration, and extents of such market trends. An investor will study the trends and know when and when not to invest. The provided data will enable investors to have the correct predictions on the future trends in the market. With this information, investors can know when to put their assets and plan for investment (Thaler & Benartzi, 2007). When investors do not have the right information during investment, they can experience huge loses in terms of capital investment. They need to know the risks involved before investing in any venture. The aim of investing is to increase return and save for the future, but when the risk of investing is higher than the returns, therefore, it is unwise to invest. The technical data generated from the analysis helps in predicting the future prices and controls investment patterns (Harrison et al., 2009). Technical analysis is the best precursor to developing a good and effective strategy (Shwiff & Bernasek, 2008). The adoption of an effective strategy will enable an investor know the best investment strategy he or she is supposed to use in the process. The effective strategies will provide technical triggers and indicators that will help investors track and figure out various historical volumes and prices of stock, proving the theory of history repeating itself (Finke & Huston, 2003). This enables an investor know trading patterns presenting investors with the ability to know the present and potential movement of prices for the future. The strategy focuses on better success of an investor. For instance, traders can systematically know strategically and systematically to know how to choose their positions. Disadvantages of technical analysis Majority of technical investors rely heavily on the indicators that were created in the 1970s (Griliches & Cockburn, 2009). The investment tools have gone through a lot of transformation due to competitive market structure. Relying on the technical indicators will give a false or ineffective data that cannot be used to successfully predict the future prices (Finke & Huston, 2003). This has resulted to the overuse of these indicators, and the market has readjusted rendering them less effective. When traders invest in these indicators without adjusting to the current prices and competitive nature of the prices, then, investors risk going at a loss. Majority of investors attempt to use the trend-following technique to portray and predict their future market (Dulebohn, 2007). It is true that trend-following technique can make a lot of money over time; the technique has the lowest rate of accuracy and draws the greatest loss to an investor. Weisbenner and Liang (2009), griliches and Cockburn (2009), and Kamich (2002) confirm that investors aim at maximizing returns and increasing their capital, therefore, most traders will use trend-following because it maximizes returns. However, the technique can lead to huge loses in terms of capital and return reduction. Most investors cannot handle psychological loss and may make them withdraw from investments. Traders end up counting their losses and this may discourage further investment. Investors can avoid experiencing huge losses by adopting up-to-date techniques and technical strategies that will help them maximize on their profits without exposing them to huge financial and technical risks. Fundamental analysis Duflo and Saez (2009) and Thaler and Benartzi (2007) define fundamental analysis as a method that evaluates a security measure that attempts to measure the intrinsic value through related financial, economic, and quantitative and qualitative concepts. Murphy (2007) affirms that the fundamental analysis attempts to find out everything affecting the value of the security, including various macroeconomics factors such as industrial and economic conditions, and company factors such as management and financial conditions. The analysis aims at producing a value that an investor can use in comparing the price of the security, and the decision to take at the current situation. The investor is supposed to buy when the security prices are underpriced, and he or she should sell when the prices are overpriced (Papke, 2008). Many investors are familiar with fundamental analysis as a method to analyze the market. The level of fundamental analysis entails examining financial aspects of a company such as its net revenue and earnings (Harrison et al., 2009). The analysis relies heavily on the ability of the investor to analyze a company’s financial report, and since the analysis aims at applying a projected value basing it on the analysis, it focuses primarily on the longer term outlook (Griliches & Cockburn, 2009). The biggest part of the analysis involves checking a company’s financial statements through qualitative analysis. The analyst looks into expenses, liabilities, revenue, assets and other aspects of the company. The analysts perform these analyses to gain insight and know the company’s operations (Kamich, 2002). The insight will show the cash flow statements, income statements, balance sheet, and how they fit and operate. Advantages of fundamental analysis Shwiff and Bernasek (2008), Gallery and Gallery (2009), and Kamich (2002) attribute that a fundamental analysis increases the understanding of an investor. Research conducted into various fundamentals provides an individual with enhanced and improved understanding of a company or a firm and how it conducts its business. An investor will know what he or she needs before investing in a company. The analysis provides him or her with the requirements, which he or she uses to investigate and know the current and future operations of the business. These fundamental tools are vital in decision making, because, without these tools an investor will not be able to make a comprehensive decision on certain business or company (Finke & Huston, 2003). He or she will experience loses that will affect his or her investment decisions. Loses may be due to lack of adequate analysis on the company and how it transacts its business. Sodelind et al., (2005) and Papke (2008) affirm that fundamental analysis aims at focusing on the long time progress of investments. Markets are driven by fundamental forces for a long time, and fundamental analysis looks at long time demographic, economic, consumer, and technologic trend (Griliches & Cockburn, 2009). An investor will determine the business concept for his or her business. The investor will not be worried of the ever changing business world because the trend he or she has chosen will be long term and it involves improving his investments using fundamental analysis tools. The analysis helps the investor to know the trends of his or her business. Disadvantages of fundamental analysis Lepper and Iyengar (2006) and Baltelsmit and Bernasek (2007) emphasize that fundamental analysis is time consuming, hard work and complicated. It has difficult constraints and time acts as one of the factors making it difficult to get an edge in business (Finke & Huston, 2003). The analysis is complicated and takes a lot of time constructing the analysis. It is not an easy task determining the revenue, assets, and liabilities of a company. This requires the services of a professional, who might also take a longer time determining all these factors in a business (Gallery & Gallery, 2009). The process is also complicated because it entails a lot of processes and procedures in determining the financial position of a business an investor wants to invest in and carry out his or her operations. Finke and Huston (2003) asserts that a fundamental analysis that is for the future estimated price is only based on various assumptions that will lead to the creation of a valuation model that caters for the best and worst scenarios in investment. There is no valuation framework that can accept to include negative political or economic changes. We have to consider political and economic changes in all investment activities, but in this assumption, these two factors are eliminated. We cannot get a true picture of the market when these factors are eliminated. Again, the model assumes that the company produces correct and accurate information. However, most companies will not produce accurate information concerning their company. Part II The Random Walk Theory Lepper and Iyengar (2006) define the Random Walk Theory as a financial theory that states that the stock market prices will evolve according to or depicting a random walk, meaning that the stock prices cannot be predicted. The main idea behind this theory is the randomness of prices rendering futile attempts to find a pattern in the stock prices of take advantage of new information (Duflo & Saez, 2009). The theory claims that the stock market prices are independent. Thaler and Bernartzi (2007), Weisbenner and Liang (2009), and Griliches and Cockburn (2009) affirm that momentum does not exist in this theory and that the past calculations concerning growth and earnings do not predict the future growth of a company. Griliches and Cockburn (2009) state that most investors believe that most stock prices are correlated in events in the theory, come in streaks and clusters, but this is not the case because the prices are independent of each other. The theory proves that various methods that are used to predict future prices are futile. Kamich (2002) calls on the intrinsic value notion as undependable because the notion depends on estimates of future incomes using tools such as expected dividend payouts, growth rates, interest rates, and estimated risks. The theory considers technical analysis as being undependable. According to Murphy chartists will only buy when price trends have been established, and then sell when the price trends break (2007). Ideally chartists sell and buy when it is already late. The theory proves this by affirming that stock prices reflect the required information before analysts move on the stock. Advantage of Random Walk Theory Weisbenner and Liang (2009) affirm that the model is simple to use. The model entails simple and straightforward concepts that the investor finds it easy to understand. Duflo and Saez (2009) show that investors can use the models to construct his or her invest pattern and predict the how the market moves. The theory has no designed pattern making the stock prices fluctuate. The investor can easily view the trend in the market because the theory states that there is no given pattern in the stock prices (Harrison et al., 2009). The theory depicts that the stock prices are independent of each other; therefore, the stock prices are easily determined because each price is treated separately. The stock prices in the market will reflect the data that an investor might need to predict the economic conditions. The theory provides an investor with the skills in determining the future market prices and he or she can decide to invest at given period. Dulebohn (2007) and Grilinches and Cockburn (2009) say that the theory can handle various flows around different boundaries. The theory is simple to understand and at the same time it can flow over different boundaries. This means that, the theory is flexible and it can be put in place to represent different economic activities. The stock prices in the market can range depending on the business in the economy. The theory can be used to explain all conditions in the market (Duflo & Saez, 2009). Its flexibility has enabled its use to explain different investment concepts. Disadvantages of random walk theory Random walk theory does not conserve or maintain the mean position of difficulties in free space (Papke, 2008). The theory does not provide sufficient information on when in free space. An investor will find a difficult time trying to predict on his or her investment position when using the random walk theory. A good and effective model provides an investor with the right investment information that will help him or her invest wisely. However, in free space conditions, the model cannot provide an investor with the required information. When an investor choses a wrong investment theory, he or she is likely to experience huge loses in his or her capital returns and increased business risks (Gallery & Gallery, 2009). Thaler and Bernartizi (2007) and Sodelind et al., (2005) confirm that the computed solutions are not exact because of statistical errors. The theory involves various statistical calculations depicting the position of the company; however, some of these calculations provide statistical errors which might cause an investor to experience immense loss (Lepper & Iyengar, 2006). An investor may at times not see the statistical errors in the theory, but it will cause an effect on the control parameters in the model. Control parameters in any model are very crucial, because a single misinterpretation of any parameter will lead to an ineffective investment practices. Business will use a wrong model to interpret future plans and trend. With wrong information, he or she will not represent the true picture of the economy (Sodelind, et al., 2005). The Efficient Market Hypotheses (EMH) Shwiff and Bernasek (2008) define efficient market hypothesis as an investment model, which states that we cannot beat the market. This is because the efficiency of the market stock causing the existing prices to reflect and incorporate relevant information (Weisbenner & Liang, 2009). According to the theory, stocks often trade at fair prices on stock exchanges. This will make it impossible for various investors to purchase undervalued stocks or selling stocks at inflated prices (Murphy, 2007). EMH emphasizes that financial markets are informational efficient, meaning that an investor cannot achieve excess returning an average market on a risk-adjusted basis with the available information when an investment is done. It is not possible to outperform the general market through selection of expert market or market timing. The only way an investor the get higher return is purchasing more risky investments. The EMH existed in three different degrees, strong, semi-strong, and weak degrees (Dulebohn, 2007). The degrees address the inclusion of non-public data and information in the prices of the market. EMH theory says that current prices and markets reflect all investment information, and attempts to prove that markets involve a game of chance (Kamich, 2002). The weak degree of EMH shows that current prices of stock reflect the available security market information. Kamich (2002) emphasizes that the degree has no relationship between volume data, past prices with the future security prices. Technical analysis cannot be used to achieve excess returns. The semi-strong degree assumes that the prices of stock adjust to all public released information (Murphy, 2007). Security prices factor in the available market and non-market information, and prove that fundamental analysis cannot be used to achieve excess returns. The strong degree assumes that the prices of the stock reflect public and private information (Thaler & Benartzi, 2007). The degree contends that inside information, market, and non-market are factored in the security prices and no business has a monopolistic access to all relevant information (Shwiff & Bernasek, 2008). The degree assumes a perfect market and it shows that excess returns cannot be achieved all the time.   Advantages of EMH Bajtelsmit and Bernasek (2007) show that if the applied EMH is correct, then the investors do not have to pay the high charge fees levied by analysts, fund managers, investment managers, and researchers. The investors can just put their investment money in index funds or tracker that will reflect the performance of the market. An investor would never want to incur additional costs during investment, and they would take measures that would minimize their investment costs (Finke & Huston, 2003). An effective EMH framework will reduce these costs and eliminate the extra charges that managers charge for investment. The theory provides an effective and cheaper way for investing. This will maximize the capital returns of the investor by reducing the transaction costs that are charged by managers. Murphy (2007), Dulebohn (2007), and Griliches and Cockburn (2009) emphasize that investing in an index fund and tracker reduces the risks that the investor are exposed to in the market. The factors will also reduce the chances of investing in the wrong investment or making a wrong decision. These factors will help an investor to make the right decision choices and increase their returns. An investor will always want to use frameworks that will help them maximize on returns and make the right investment decisions. The tracker and index funds will help the investor make effective investment decisions that will improve on their returns. Also, the framework will reduce the risk that investment managers will try to increase the investment costs. The investor will know the right decision and payment to make (Dulebohn, 2007). Disadvantages of the Efficient Market Hypotheses Gallery and Gallery (2009), Lepper and Iyengar (2006), and Duflo and Saez (2009) have disputed both the theoretical and empirical evidence of the theory. Behavioral economists link the flaws in financial markets to a combination of predictable human errors and cognitive biases such as overreaction, overconfidence, information bias, and representative bias (Sodelind et al., 2005). The reasoning errors have made most investors buy expensive growth stocks and avoid value stocks. Investors who reason will maximize on returns from the bargains in excessive selling of growth stocks and neglected value stock. The empirical evidence of the hypothesis is mixed and does not support various form of EMH theory. According to Finke and Huston (2003) low P/E stocks maximize on returns. Duflo and Saez (2009) refuted the assertion of various researches that the high returns can be linked to high beta in the market. The actively managed funds strive to outperform and surpass the market, thus when an investor chooses only the index fund, he or she will miss the opportunities that they can get extra returns that a manager have a potential of generating (Weisbenner & Liang, 2009). An investor will fail to achieve the benefits of investing in actively managed funds. An investor must invest in the actively managed funds in order to maximize on the benefits. For example, during an economic downturn, an effective manger will concentrate on the defensive sector and stocks that would outperform other cyclical stocks (Dulebohn, 2007). The opposite is true when the economy is functioning properly. Conclusion The research has shown how technical analysis hypothesis, fundamental analysis, random walk theory, and efficient market hypothesis has contributed to the level of investment in various markets. The hypotheses prove the thesis statement that a personal investment must involve evaluation of various market risks instead of just luck. Investors must evaluate their markets before making any investment decision. The research has proved that the technical analysis will provide an investor with the best investment strategy. An effective strategy will assist the investor to make decisions that fit his or her investment. The investor can use historical prices and monitor the trends of these prices to predict the future prices of the market. An investor will definitely invest during that period he or she knows that he or she will generate maximum returns. An investor will use fundamental analysis tools to know how his or her investment decisions. Fundamental analysis will help the investor to evaluate various security measures that determine the intrinsic value of a business. The analysis will determine the income statements, revenue, liabilities, and statements of the company, which will help an investor, know the position of the business that he or she wants to invest in and maximize on returns. Fundamental analysis will increase the understanding of the investor and he or she will be confident to invest in a business that he or she knows its position. Random walk theory depicts that prices in the market cannot be predicted, and they have a random movement. The theory is easy to understand and interpret. Various researches has shown that an investor will always want to maximize his or her profits and at the same reducing investment costs. This theory provides an investor with the ability to predict the market and know that the stock prices in the market are unpredictable, and investors have to know when they are to invest or not to invest. The efficient market theory shows that when the EMH hypothesis is correctly applied, an investor stands to achieve increased return. This is because when they use tracker and index funds they can reflect the market performance. This will reduce the extra charges levied by investment managers, fund managers, and researchers. The thesis of the research is proven and all personal investors must evaluate all the risks that they face in the markets before investing. The four hypotheses provide the best foundations that an investor can use to evaluate his or her investment decisions before making a final investment decision. Personal investment is a matter of risk evaluation. References Bajtelsmit, V. L., & Bernasek, A. (2007). Why do women invest differently than. Financial Counselling and Planning, 34-56. Duflo, E., & Saez, E. (2009). Participation and investment decisions in a retirement plan: the influence of colleagues’ choices,. Journal of Public Economics, 142-177. Dulebohn, J. V. 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