Risk Diversification & Behavioral Finance Assignment Help
Part A :
1. Describe how investing in more than one asset can reduce risk through diversification. Please discuss in detail
2. Define systematic risk. Please discuss in detail
Part B :
1. Detail financial anomalies from a behavioral finance perspective, giving an example of each.
2. Considering Hede (2012) discussion "Some behavioral finance thoughts on the present financial crises," summarize the various thoughts provided and focus into at least one item for a more detail argument either for or against Hede's claim.
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Answer: How investing in more than one asset can reduce risk through diversification.
Diversification is an efficient tool which is used to reduce the risk of investment under normal market conditions. Investing in one portfolio can increase the risk of loss because you are dependent on only one investment. The feature of a diversified portfolio is you hold many investments in your hand, and if one of your investment performs poor, it can be adjusted with the profit earned on other investment (Lee, 2011).
It is generally said that stocks & bonds often show the opposite trend and moves in the opposite direction. For example, it is seen that when stock prices fall, then, central banks cut their interest rates, which helps in reducing borrowing costs (Girard & Ferreira, 2011). Due to this bond prices rise. Mainly bonds are included in the portfolio to reduce risk not to expect higher returns. Diversification of investment can be done by selecting a portfolio either by asset class or by industry-wise.
Systematic risk can be defined as market risk, or volatility risk, which is beyond one's control and investor has invested in a specific asset class. From such type of risk, all investment and securities suffer. Mainly systematic risk deals with macroeconomic or, general economic factors. To understand systematic in a better way, we should understand what an unsystematic risk is. We can relate unsystematic risk with a specific asset class or group of securities within an asset class. For example; the stock sector related to industrials starts declining while another like the technology sector may be uprising (Polbennikov, Desclée & Hyman, 2010). So, a smart investor will have exposure to every sector, which helps in offsetting the risk. Systematic risk can be seen during the election when the change of power takes place. Change in public policy directly impacts and decide which industry rise and fall. In this scenario, investors can only make decisions when a public policy is announced.
Behavioral Finance is related to a sub-field of behavioural economics. It is based on proposing some theories which explain stock market anomalies, serves as downfall or rise in the stock price. The purpose behind understanding such anomalies is to understand why investors make certain financial choices (Kiyilar M. ve Acar O., 2009). Individual investment decision and market participation solely depend upon how investors get influenced by information structure and market conditions.
The efficient market hypothesis (EMH) allows that in the liquid market, all prices will reflect with available information in a given time. It gives a clearer explanation and understanding of why bubbles and panics occur. Anchoring signifies a level to a certain reference which describes why spending level is subject to an inherent risk from an investor's point of view. For example; An investor behaves adversely an according to the situation such as when his investment performs well, he thinks himself as an investment GURU but in opposite to that stops analysing and contributing towards investment when his investment performs poor (Ricciardi, V. and Simon, H. K. ,2000).
"Some behavioral finance thoughts on the present financial crises,"
Hede's claim is totally rational because, under uncertainty, the human being is totally irrational to see present outcomes and takes the wrong decision. When an investor analyses all available information before making the investment, he reduces the chances of loss and makes certain decisions. People do not get affected by extraneous factors when they have to make economic choices. For example, buying lottery tickets knowing the fact the winner will be one in 146 million is an anomaly to look into cognitive psychology which leads to irrational and illogical decision making of the people (Hede, P.D. ,2012).
Steps involved in the decision making process are said to be in an analytical sense; those steps are:
Recognising present situation or state,
Evaluating options and taking action considering the fact of reward and punishment,
Acting in terms of one's needs,
Re-evaluation of the action based on outcomes.
Hede's claim is correct that rationally made decision with decision making process accurately serves the objective of behavioural finance.
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