“Risk –averse” investors
It is well known that stock market traders in New York, Chicago, London, and Tokyo believe that people who have ‘risk aversion’ traits in their character do not develop into successful traders/investors on the global stock markets. This statement is both true and false for several reasons, which will come out in detail later on in this paper. Risk aversion is a term that is used in reference to an investment behavior whereby when an investor is faced with more than one investment options, which have similar expected returns, but varying risk levels will prefer the one that has the lowest risk.
In an event investors perceive high risks, usually “risk-averse” traders will move fast to liquidate their risky assets and then shift the funds to less risky stocks. Whereas most humans are ‘risk averse’, there exist two other categories: the risk seekers and the risk neutral. Risk seekers are people such as gamblers who assume very high risks for high-expected return while risk neutral, are those traders whose investment decisions are not affected by risk. Following is an analysis of the common behavioral traits of most traders while making investment decisions.
Most economic theorists state that investors think and act rationally when trading in stocks. Siller posits that, “in a perfect market, investors can access and use all of the available information to form rational expectations about the future in determining the affairs of companies and the economy as a whole” (1999, p.114). Therefore, the stock prices at all times reflect accurately all the available information and stock prices only fluctuate in events of unexpected outcomes.
This school of thought thus leads to a conclusion that financial markets and prices of stocks follow a ‘random walk’ and the general economy is always moving towards ‘equilibrium.’ Contrastingly, “in reality investors do not act rationally” (Siller 1999, p.144). Investor speculations tend to be pegged on fear and great desire to become rich, speculations that oscillate between stock prices only. This kind of distorted investment decision-making process leads to a strong conviction that the future expectations of a company would follow a fairly predictive and defined path.
Nik, Zainuddin, and Mohd (2003) in their study revealed eight common investor behaviors traits while making investment decisions (p.49). First, investors usually do not participate in all asset security categories. According to Kent, Hirshleifer, and Subrahmanyam, investors tend to concentrate on stocks that are on “their radar screens”. This means that investors may leave out major asset classes (like Bonds, real estate, commodities etc) (2001, p.941).
This bias therefore, leads to investors concentrating on the ‘popular’ stocks leaving other classes unexploited. By so doing, an investor limits his/her asset holding capacity to a narrow asset category which provides little hedging against unforeseen risks. As mentioned earlier, a rational investor’s actions are derived from market information and therefore more rational decisions, which would increase survival and success in the stock market. Secondly, individual investors are generally loss-averse. Kent, Hirshleifer, and Subrahmanyam also noted that the stock that investors choose to sell subsequently outdo the retained stocks (2001, p.68).
Therefore, the loss-averse investor is more reluctant to dispose off his/her stock at a loss than at a gain. Thirdly, investors most often base their actions on historical stock performance (prices) to predict future outcomes. This process, which entails technical analysis, means that the judgment is based on naïve comparisons of superficial attributes that would often result in inaccurate determinations.
Fourth, investors are more aggressive and overconfident in their judgments and actions thus often they fail to place enough weight on the market information. This aggressive trading trend tends to lower returns as the gains realized are reduced by the high transactional costs. Sixth, investors perceive stock value based on hearsays from the media, conversations, and tips from friends implying that, most people cannot differentiate the good and bad companies. Seventh, investors assume a ‘risk aversion’ as a key strategy to manage risk. Therefore, investors keep larger portions of their possession in risk-less assets in order to cushion themselves from the uncertainties in the market. Eighth, investors appear to exhibit unpredictable transaction trends; they transact on impulse based on information drawn from acquaintances and usually without prior plans.
From the above discussions, it becomes clear that the average investor is irrational and does not want to assume high risks. Risk-averse investors would only want to put their funds in risk-free assets such as bonds, real estates; this may reduce risk but will definitely no make one successful in today competitive world. As a result, the risk seeking and risk neutral categories might often realize more returns from the stock market than the risk-averse. On the other hand, the risk-averse would survive long compared to the other classes because the risk averse would want to hold assets over a long time of period hence reducing the risk factor significantly. As proposed by the modern portfolio theory the risk-averse investors would trade in the efficient frontier where the risk levels are lowest.
Qualities of a good trader
To succeed in stock trading, like any other valuable undertakings, one has to put his/her best efforts and work harder. Over the years, many people have invested in the stock markets but statistics show that most of them do not last more than a year. This does not however, mean that success in the stock markets is not achievable; a modest fraction of rational investors with good qualities have stayed for long in the stock trading and have realized big gains. While one can learn the technical skills that help in investment decisions, instinct, information, and logic are the main tools in handling investment decision making.
The psychology of investors
Psychological factors play an important role in determination of the direction of stock prices. Kenney points out that people are “generally prone to ‘cognitive illusions’ (such as becoming rich or being able to exit the market before the downturn)” (2003 p.8). Because of psychological illusions, investors are often unaware of the actual risks they assume. This fact coupled with the risk-aversion investor behavior perhaps is the reason why there is so much panic when the market enters the downturn phase, a time to buy, rather than selling (Owen & Rabnovitch 1983, p.745). Moreover, human beings are born optimists and this disposition explains why casinos swarm with luck-seekers day and night.
Similarly, optimism is what drives investors to purchase stocks when they hit historic high prices, a point they should be selling instead. Kent et al (2002) in the study of investors’ psychology observed that, movement of stock prices in the market is mainly due the perceptions of the investor (p.98). These perceptions include investor’s perceptions of the stochastic process of stock prices, perceptions of value, perceptions of risk management, and trading practices.
In addition to the psychological factors, there are other factors external to the investor that affect price movements which investors cannot afford to ignore in investment decision making. These factors include economical and political, micro and macro events and activities. Economic factors refer to the market forces of demand and supply, inflation, interest rates and trade flows. Political decisions and events greatly affect the stock prices coupled with the macroeconomic factors such as discovery of natural resources, and occurrence of mordant natural events like earthquakes and the likes.
As explicated in the foregone discussion, success in the stock market can be influenced by factors outside the investor’s control; however, the investor bears a great responsibility in achieving success or failure in stock trading. Moreover, above investment, decision-making is a function of instinct, information, and logic. To be a good investor one should be equipped with appropriate investment skills and knowledge of the factors that affect the whole stock market. In addition, investor should “assume a positive mental attitude, design a good research strategy, develop a good investment philosophy, effective risk management tools, and practice patience and consistency” (Chandra & Shadel 2007 p.348).
Qualities of a good trader
Good research strategy
Many people would want to invest but often they do not have good knowledge of the companies they can invest in and in information hunting, they resort to advice from friends. Instead, a good investor should follow these simple information search guidelines; what is the value of the company, is the company buying back shares, why is s/he investing in the company and how long does s/he want to hold the company share. In search for company information, the investor should endeavor to look beyond the current security price but seek to determine company’s market capitalization.
The need to determine the market capitalization is to facilitate determination of the actual price of stock, whether it is over or underpriced.. Other than the entire price of the company, investment options valuation can be made with the help of the price-earning ratio. The investor should not be deceived by the profits reported by the company when determining the attractiveness of a stock because Company profits are not very useful indicators of the attractiveness of a stock as per-share valuation.
In addition, before putting funds in a company stock, the investor should re- examine himself/herself to find out why s/he is interested in the particular opportunity. It is very dangerous to purchase a company stock simply because one is attracted to the corporation and perhaps because one likes its products or its people. This trend is a common investment mistake that has led to investors paying too much for a stock of the ‘best company in the world.’ Instead, the reason for investing in a company should be tagged on the fundamentals such as the current price, profits, quality of management, etc.
Lastly, patience is the greatest virtue in the success in stock trading. Therefore, if one’s intent of purchasing is not to keep the stocks for a relatively long time, then it is imperative to reconsider his/her moves.
Having established the strong link between investment decision making and psychological factors, it would therefore follow that a developing a positive mindset would nurture motivation, hard work, and discipline. These traits are important when carrying out objective research, which apparently requires enormous efforts and time; however, the result is more knowledge that will support investor decision making.
Successful investors draw from this personal trait and their willingness and ability to ask questions. The “I know -it-all” attitude would bar one from accessing vital information and therefore making oneself venerable to exploitation and perhaps engaging in a regrettable situation.
Instinct or common sense is important in the decision making process. It helps in situations where technical skills cannot be put to play and the information acquired needs to be examined and integrated in a simple and clear manner to allow accurate findings. Conventionally, there is nothing like ‘one-fits-all’ solution to the many challenging cases that people meet in business world. Therefore, playing by the rules of one’s instincts proves vital in different cases.
I think a significant amount of creativity is needed for successful investing, since it is of necessity to view stock trading from a multi-angle perspective, considering all the variables that affect an investment. In addition, creative thinking is required in determining the future earning prospects of a stock thereby aid in forecasting the results of current investing plans. Moreover, creativity is pivotal in an ever-changing world. New opportunities are arising by the day and only a creative mind can identify an opportunity, tap in the available resources, and kick-start a virgin project with the potential of outgrowing the known systems. If anything, the known trading systems came into being through creativity and there is no limit for evolution especially in the wake of globalization.
A successful investor, I presume is the one who can produce better results than his /her peers can. It therefore does not beat logic if you go buying the same securities as others, since the results will be the same. One therefore should engage his investment muscles further to discover the attractive but less popular stocks, which in turn will yield more than those of the others will. Following the masses in most cases amounts to little if not nothing. It pays to take risks and follow uncharted routes time from time and this behavior calls for independency especially in decision-making. However, this argument does not negate the relevance of consulting others.
A good investor should not just seek the “safe havens” and pitch a permanent camp but should be constantly on the look out for a more opportunities. Actually, the best stock market survival strategy for smart investors would be to focus on the less popular securities. Being flexible would also allow an investor to adapt more easily to the changing times and to equip the investor with relevant knowledge to enable him tab into the new opportunities in the market. As the old adage goes, a lost opportunity is just like a lost arrow; it is very difficult to come back.
The Modern Portfolio Theory
The modern portfolio theory (MPT) is based on the primary principle of the Random walk hypothesis, which posits that stock movements do not follow a predictable path. There are three forms of markets according to the MTP model, the weak, semi-strong and strong forms. The weak form market is one in which all information about the price and trading behavior lies in the market. Therefore, no information suitable for prediction about the future stock prices can be obtained from the analysis of the security data.
The semi-strong form market hypothesis, on the other hand, reacts quickly to new pubic information and therefore, studies of historical information to provide data for superior results. Lastly, the strong form hypothesis refers to the efficient market that all the company information is already embedded in the price of a security and only new information would result in price changes.
The hypothesis proposes the standard deviation as a key tool for risk measurement. It defines risk as a market condition where more than one outcome is possible when an investment has been made. Risk measurement by standard deviation is interpreted in as follows; when the standard deviation figure is small then it depicts a small risk and when the standard deviation is large then the risk is also large. Risk is directly proportion to standard deviation. Whereas the “risk-averse” investors find MPT principles appropriated to adverse market risks, it also provides great insights for the risk seeking/neutral investors who would find the following tips useful in creating efficient portfolios.
The MPT model proposes that the risky assets be combined with the risk free assets which then would lead to a trade off between returns and risk to yield in a risk adjusted returns, which are normally higher than the risk free returns. It also put forth the multi-period risk model, which illustrates the importance of the time horizon. This principle can be explained in the example below. Supposing that a portfolio has an expected return of 10% with a risk of +/- 20% over one year horizon, then in one year the actual returns of the portfolio has a 68% probability of being somewhere in the range 10% to +/- 20%. On the other hand, if the investor increases the time length to say 25 years, the expected returns will remain 10% however, the risk will fall to +/- 4 per year. (Note: Risk= 20/ (25=+/- 4%).
This analysis is called the law of large numbers. It follows thus, that in any one year the actual returns may considerably vary from the expected, but over time, the average variations smoothen and then will tend to lead the actual returns more closely to the expected returns. This principle will make the risk seeking and the risk neutral investors manage their portfolios better since as they invest in risky assets and increase the time horizon they significantly reduce the risk.
There is ingratiating evidence that stock traders commit major systematic errors. Furthermore, it emerges that psychological biases play a substantial role in determination of prices of stocks in the market. Some investors come out as being more of risk-averse, a fact that has a huge bearing on the amount of risks they can assume when trading in securities. Nevertheless, success of an investor is pegged on certain personal traits, which include patience, humility, independence, flexibility, creativity, attitude, research strategies, and risk management strategies. Further, the modern portfolio theory examined is in line to risk seeking and risk neutral investors.
It reveals numerous principles and models that if well utilized would tremendously boost the chances of an investor’s success in the stock trade. These principles include the law of large numbers, and the hedging principle. Lastly, the other factors that affect the stock prices such as economic and political factors; in spite of the fact that they place a significant weight in stock price movements; they do not determine the success or failure of an investor. Therefore, the potential to succeed or fail in the stock market lies with the investor himself.
Chandra, S., & Shadel, W., 2007. Crossing disciplinary boundaries: Applying financial Portfolio theory to model the organization of the self-concept. Journal of Research in Personality, 41(2), pp.346–373.
Kenney, D., 2003. Investor psychology plays key role in market plays. Business Press, 5-11.
Kent, D., Hirshleifer, D., & Subrahmanyam, A., 2001. Overconfidence, Arbitrage, and Equilibrium asset pricing. Journal of Finance, 56, pp.921-965.
Nik, M., Zainuddin, A., & Mohd, S., 2003. Stock Market Investment and the influential Factors in investment decision-making: the study on Kelantanese Investors. BRC, UiTM Kelantan.
Owen, J., & Rabinovitch, R., 1983. On the class of elliptical distributions and their Applications to the theory of portfolio choice, Journal of Finance, 38, pp.745-752.
Siller, R., 1999. Human behavior and the efficiency of the financial system. Amsterdam: Elsevier.