Personal Finance and Investments

A behavioural finance perspective

Keith Redhead

Routledgej j Taylor & Francis Croup

LONDON AND NEW YORK

Detailed Contents

CHAPTER 1 - Introduction 1Functions of Financial Systems 3

Investors and Borrowers 4

Personal Financial Planning 5

Budgeting 7

Managing Liquidity 7

Financing Large Purchases 7

Long-term Investing 8

Insurance 9

The Nature of Investment Risk 9

CORE Principles of Personal Financial Planning 10

CHAPTER 2 -The psychology of personal investment decisions 13Choice under Constraint 13

Objectives 13

Types of Risk 14

Constraints 16

Characteristics of Investments 18

Human Capital 19

Risk Management 20

C i EXHIBIT 2.1: Mis-selling or miscommunication? Apparent mis-selling of financial products may

V^ be the result of different perceptions of risk between advisers and clients

The Psychology of Personal Finance 23

Self-deception 24

Heuristic Simplification 26

The Catering Theory of Dividends 32

The Social Dimension 32

Influence of Emotion and Mood 33

Prospect Theory 34

The Disposition Effect 38

Avoidance of Psychological Biases 40

Saving and Self-Control 40

Habitual Non-Savers 42

Self-control, Personality Traits, and Social Mood 43

Influences on Retirement Saving Behaviour 44

Automatic Enrolment in Pension Schemes 45

Save More Tomorrow (SMarT) 45

Classifying Investors 46

The Need for Targeted Marketing 49

ix •

DETAILED CONTENTS

The Possibility of Misleading Marketing 49Maximin and Minimax 50

CHAPTER 3 - Interest rates and money market investments 55

Simple Interest and Compound Interest 55The Average Compound Rate of Interest 57Variable and Fixed Interest Rates 58Convention for Quoting Interest Rates 58Nominal and Real Rates of Interest 59

Measuring Inflation - RPI and CPI 63Rates of Interest versus Rates of Discount 64Interest Yield and Total Return 65Short Maturity (Money Market) Investments 65

J^> EXHIBIT 3.1: Legal ScGeneral Cash Trust

Foreign Currency Deposits 68Relative Performance of Money Market Investments 69

CHAPTER 4 - Investing in bonds 72Government Bonds, Corporate Bonds, and Eurobonds 72Default Risk and Bond Rating Agencies 74

J$ EXHIBIT 4.1: M&G Corporate Bond Fund

Alternative Forms of Coupon Payment 77Gilts (Gilt-edged Securities) 77

Issuing Gilts 77o

Conventional Gilts 78Double-dated Gilts 78Undated Gilts 79Index-linked Gilts 79Rump Stocks 80

Gilt Strips 80

jW EXHIBIT 4.2: Henderson Global Investors UK Gilt Fund (as at 31108/2001)

GiltYields 82Gilt Price Volatility 83Preference Shares 84The Relative Performance of Bonds 84

CHAPTER 5 - Property investment and mortgages 87Buying Your Own Home 87

Opportunities for Gearing 88Lack of Diversification 88Lack of Liquidity 89

• x

DETAILED CONTENTS

Buy-to-Let 89Property Unit Trusts, Real Estate Investment Trusts, and Property Companies 89

J$ EXHIBIT 5.1: Legal ^General UK Property Trust (28/05/2007)

Determinants of Property Prices 91The Role of Anchoring in Property Valuation 92Momentum in Property Price Trends 93A Comparison of Property and Stock Market Investments 94Mortgages and the Purchase of Property 95Characteristics of Repayment Mortgages 96

The Tilt 98Fixed-Rate Mortgages 99

The Miles Report on the UK Mortgage Market 101The Potential Use of Bond Options 103

Capped-Rate Mortgages 104Other Forms of Mortgage 105

Islamic Mortgages 106Equity Release Mortgages and Home Reversion Plans 106The Mortgage and Endowment Equations 107

jw EXHIBIT 5.2: Endowment Mortgage and Repayment Mortgage

Have E n d o w m e n t Mortgages Been a Bad Choice? I l l

Collateralised Loans as Opt ions 112

CHAPTER 6 - Stock exchanges 117The Functions of a Stock Exchange 117Primary and Secondary Markets 118Stock Exchange Listing 119Types of Stock Exchange 119Stock Market Trading Systems 120

Order-driven Systems 120Quote-driven Systems 123Bid-offer Spreads 124Markets in which the Trading Systems Operate 125

Types of Order 126Selling Shares in the Primary Market 126

j^ ) EXHIBIT 6.1: Rights Issues

Types of Share 128

CHAPTER 7 - Stock ind ices 131

Types of Index 131Index Weighting 132

Adjusting for Changes in the Constituent Stocks of an Index 137Evaluating Alternative Stock Indices 139

xi •

DETAILED CONTENTS

' EXHIBIT 7.1 :An example of an investment fund that aims to track the FTSE 100 index

CHAPTER 8 -The rationale and conduct of regulation 145Correction of Market Imperfections 145Economies of Scale and Delegated Monitoring 146Confidence in Minimum Standards 146Hazards of Regulation 147

Costs of Regulation 148Moral Hazard 148

Informal Self-Regulation 149Regulation of Investment Business in the UK 150

The Financial Services Authority (FSA) 150Financial Advisers and their Clients 151The Financial Ombudsman 152The Pensions Regulator, the Pension Protection Fund, and the Pensions Ombudsman 152

Quality Assurance in Investment Services 152Comparative Regulatory Systems 154

The Enforcement Theory of Regulation 155The European Union and the Regulation of Investments Business 156Enron, Worldcom, and Lemons 157

Shares as Lemons 157Bonds as Lemons 158

CHAPTER 9 - Mutual funds (unit trusts, OEICs, investment trusts) 163Benefits of Mutual Funds 163Differences between Unit Trusts, Investment Trusts, and OEICs 164

Investment Trust Share Buy-Backs 168

Jtq/ EXHIBIT 9.1: Example of an investment trust using share buy-backs (share repurchases)

Explanations for Investment Trust Discounts and Premiums 172Index (Tracker) Funds 174Tracking Error 175Exchange-Traded Funds (ETFs) 176Effects of Fund Charges 177

J © EXHIBIT 9.2: M&£ Fund of Investment Trust Shares

Charges, Commission, and Factory Gate Pricing 184Are Investors Deterred by High Charges? 185

Effects of Taxation on Investment Returns 185Individual Savings Accounts (ISAs) 188

CAT-marking 188Self-select ISAs 189Fund Supermarkets 189

Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) 189

H xii

DETAILED CONTENTS

Pound Cost Averaging 190

Dilution Levies, Dilution Adjustments, and Fair Value Pricing 193

Mutual Funds and the Provision of Liquidity 194

Evidence on the Performance of Mutual Funds 196

Star Performers and the Role of Chance 199

CHAPTER 10 - Life assurance and assurance-related investments 202

Term Assurance 202

Whole-of-Life Policies 203

Endowment Policies 204

Friendly Society Policies 205

Investment Bonds 205

With-Profits Funds 208

The Significance of Financial Strength 211

Criticisms ,212

CHAPTER 11 - Pensions 214

Jw EXHIBIT 11.1: The French State Tensions Reserve Fund

Types of Pension Schemes 216

Js^) EXHIBIT 11.2-.Teachers' Pension Scheme (England and Wales)

Occupational Pension Schemes in the UK 219

National Pension Savings Scheme 221

|!\ EXHIBIT 11.3: Pensions Commission (Turner Commission) - Key Conclusions of the First Report

W^ 'Pensions: Challenges and Choices' (2004)

Pension Transfers and Pension Unlocking 222o

Pension Funds 223

Accumulation of Pension Funds 224

Evidence on the Rate of Growth of Pension Funds 225

Annuities 225

Annuities as Pensions 227

Alternative Types of Annuity 228

Income Drawdown (Unsecured Pensions) and Phased Retirement Schemes 230

Applying the Principle of Diversification 231

Calculating a Level Annuity 231

Company Pension Scheme Balance Sheets 233

Life Cycle Analysis of Pension Funding 236

Fixing a Proportion of Pre-retirement Income 236

Fixing a Constant Consumption Stream 238

Variations on the Basic Equation 239

Estimated Effects of Delaying Pension Fund Contributions 239

XIII LJ

DETAILED CONTENTS

CHAPTER 12 -The importance and significance ofinstitutional investors 242Rise of the Institutional Investor 242Institutional Investors and Private Equity 244The Liquidity Theory of Asset Prices 245Short-Termism 247Influence of Institutional Investors on Companies and Analysts 250The Sandier Report 253

CHAPTER 13 - Portfolio diversification 261Expected Return and Risk 262The Principle of Diversification 264The Efficiency Frontier 267The Markowitz Equations 268ForeignJnvestments and Portfolio Risk 276

jgf*/ EXHIBIT 13.1: Example of an international fund

Asymmetric Correlation and Leptokurtosis 280Consistency and the Role of Direct Property Investment in Portfolios 282Direct Property Investment in Institutional and Private Portfolios 283Markowitz Diversification versus the 1 /N Strategy 283The Significance of Including a Risk-Free Asset Amongst the Investment Alternatives 286Asset Allocation Lines 289Behavioural Portfolios 290Value-at-Risk 291

Using Value-at-Risk to Ascertain Investor Risk Preferences 294Post-Modern Portfolio Theory 294Time Diversification 296The Roles of Financial Advice and Financial Education 298

CHAPTER 14 - Capital market theory: The capital asset pricing model 301The Meaning of Beta 301Estimating Future Values of Beta 304The Single Index Model 305The Security Market Line 306Trading Rules Based on the Security Market Line (Capital Asset Pricing Model) 307

Estimating Anticipated Returns 309Supply and Demand 311

Other Investment Management Applications 312Using the Single Index Model to Make the Capital Asset Pricing Model Operational 313Multifactor Forms of the Capital Asset Pricing Model 314Conditional and Unconditional Forms of the Capital Asset Pricing Model 316

CHAPTER 15 - Capital market theory: Alternatives and criticisms 318

Assumptions of the Capital Asset Pricing Model 318

H xiv

DETAILED CONTENTS

The Arbitrage Pricing Model 319The Role of Arbitrage 319An Example of Arbitrage 320The Nature of Risk Factors 322

Empirical Evidence 322Returns on Bonds 322Criticisms of Capital Market Theory 323The Zero-Beta Capital Asset Pricing Model 324Empirical Evidence 325Mutual Funds and the Death of Beta 326

CHAPTER 16 - Styles of portfolio construction 331

Active and Passive Management 331Passive Management 332Index Tracking 332Methods of Index Tracking 335

Full Replication 335Stratified Sampling 335Optimisation 336

J y EXHIBIT 16.1: M&_G Index Tracker Fund

Synthetic Index Funds (Futures Funds) 338Tracking Error 339Passive Core (Core-Satellite) Funds 341Stages of Portfolio Construction 341

Country Diversification versus Sector (Industry) Diversification 342Strategic and Tactical Asset Allocation 343Goals-Based Investing 343Value Stocks and Growth Stocks 346Implications of Style Investing 347Style Rotation 348Passive Strategies, Active Strategies, and Parrondo's Paradox 349Hedge Funds 350

Hedge Fund Performance 355Long-Term Capital Management 357

Socially Responsible Investing 359

j& EXHIBIT 16.2: Example of a Socially Responsible Investment Fund

J y EXHIBIT 16.3: Example of a Socially Responsible Investment Fund based on religious principles

Emerging Market Funds 363

Jjy EXHIBIT 16.4: Example of an emerging marketsjund

XV •

DETAILED CONTENTS

CHAPTER 17 - Evaluating the performance of fund managers 368Money- and Time-Weighted Measures of Return 369The Evaluation of Risk 370Reward perUnitofRisk 371

The Sharpe andTreynor Measures 371M Squared 372Information Ratios 372A Generalised Sharpe Ratio 373

Differential Return 373Jensen's Alpha 374Appraisal Ratios 375Use of the Capital Market Line 375

Problems with Portfolio Performance Evaluation 377Comparison Portfolios 378Value-at-Risk and the Omega Measure 378

Attribution 380Style Analysis 382

Assessing Market-Timing Skills 383Holdings-Based Performance Measurement 385Persistence of Performance 386

Using Transition Matrices to Measure Persistence of Performance 387

CHAPTER 18 -The economic environment 393

Business Cycles and Stock Markets 394Saving Ratios and the Economy 398

An Overview of Macroeconomic Analysis 398IS-LM Analysis 398Aggregate Demand and Supply 400 ,Inflation and the Phillips Curve 400Interest Rates 402

Stock Markets and the Money Supply Transmission Mechanism 404Political and Demographic Effects on Share Prices 406Exchange Rates 407

CHAPTER 19 - Dividend discount models 410Discounting Cash Flows 410Discounting Expected Future Dividends 412The Gordon Growth Model 413Estimating the Growth Rate of Dividends 414Stochastic Dividend Discount Models 415Multi-Period Models 415Discounting Capital Gains 418Effects of Investment Opportunities on the Share Price 418

Another Perspective on Share Pricing 419

E3 XVI

DETAILED CONTENTS

Problems with Dividend Discount Models 420Alternatives to Expected Dividends 42 3Fusion Investing 424

CHAPTER 20 - Company accounts and economic value added 426

The Balance Sheet 426The Profit and Loss Account 428The Cash Flow Statement 429Analysis of Accounts 430Creative Accounting and the Interpretation of Accounts 431Tobin's q 432The Abnormal Earnings Share Pricing Model 434

Ohlson's Model 435Economic Value Added 436

CHAPTER 2-1 - Ratio analysis 438

Price-Earnings Ratios 438Earnings Per Share 443DividendYield, Earnings Yield, and ROCE 443Other Market Ratios 444Financial Adequacy Ratios 445

Financial Leverage (Gearing) Ratios 445Coverage Ratios 445Short-Term Solvency Ratios 446

Z Scores 446Ratios as Indicators of General Market Movements 447The Yield Gap,;the Yield Ratio, and 'The Fed Model' 448Prbblems with Ratio Analysis 449Following Professional Investment Analysts 450

CHAPTER 22-Technical analysis 454The Nature of Technical Analysis 454Behavioural Finance and Technical Analysis 455Price Charts 457Chart Patterns 459

Price Channels (Trend Channels) 459Reversal Patterns 462Moving Averages 464

Dow Theory 467Elliot Wave Theory 467Other Technical Indicators 468Some Caveats 470Games People Play 471Implications of Crowd Psychology 472

xvii •

. DETAILED CONTENTS

Further Evidence from Empirical Research 473Complex, Ill-Structured Tasks 474

CHAPTER 23 - Market efficiency: Concepts and weak form evidence 479

Types of Efficiency 479The Meaning of Informational Efficiency 481Assumptions of the Efficient Market Hypothesis 483Price Anomalies (Arbitrage Failures) 484Empirical Evidence on the Weak Form of the Efficient Market Hypothesis 486

Overshooting (Overreaction) and Mean Reversion 488Momentum and Contrarian Strategies 489Serial Correlation in Volatility 491

The Magnitude and Selection Bias Issues 492

CHAPTER 24 - Noise trading and behavioural finance 494

Noise Trading and Rumours 494Behavioural Finance 497Underreaction 497Overreaction 499Inaccurate Perceptions of Risk 503

Prospect Theory 505Investors Have Feelings 508Criticisms of Behavioural Finance 510

CHAPTER 25 - Market anomalies 513

Earnings Surprises 513The Size Effect 514Value Investing (Ratio Effects) 516Mispricing as an Explanation of Anomalies 518Anomalies or Risk Premiums? 519Calendar Effects 520Other Anomalies 521The Capital Asset Pricing Model and Problems with Testing

the Efficient Market Hypothesis 524Data Mining 525Survivor (ship) Bias 525Testing Impossible Strategies 526

CHAPTER 26 - Further evidence on market efficiency 528Evidence Supporting Semi-Strong Form Efficiency 528Evidence Relating to the Strong Form of the Efficient Market Hypothesis (EMH) 530

The Trades of Insiders 530Using Non-Public Analysis: Mutual Fund Performance 5 31Implications for Rational Retail Investors 533Using Non-Public Analysis: Analysts' Forecasts 535Prediction Markets (Decision Markets) 536

• xviii

DETAILED CONTENTS

Degrees of Efficiency and the Adaptive Markets Hypothesis 537The Fractal Market Hypothesis 538

CHAPTER 27 - Stock market bubbles and crashes 540Characteristics of Bubbles and Crashes 540Social and Psychological Factors 542

The Role of Social Mood 546A Psychoanalytic Perspective 548The Implications of Behavioural Finance for Understanding Bubbles and Crashes 549

Representativeness and Narrow Framing 549Overconfidence 550Familiarity and Celebrity Stocks 551

Investor Overreaction 552The Crash 553Post-Keynesian Perspectives on Stock Market Bubbles and Crashes 554Buying on Margin and the Liquidity Theory of Asset Prices 555Types of Trade 557Monetary Imbalance and Extrapolative Expectations 559A Behavioural Model of the Dot.com Bubble and Crash 559

J y EXHIBIT 27.1 :A Behavioural Model of the Dot.com Bubble and Crash

Portfolio Insurance 561Research Using Experimental Markets 561Complexity Theory as an Explanation of Bubbles and Crashes 562Catastrophe Theory as an Explanation of Crashes and Surges 564Price Bubbles and Banking Crises 565

J y EXHIBIT 27.2: The run on the Northern Rock Bank in August 2001

CHAPTER 28 - Stock index futures 571Financial Futures 571

Example of Hedging with Futures 572Speculation and Arbitrage 572The Margin System 574Closing Out 574Futures Funds 575Contracts for Difference (CFDs) and 130/30 Funds 576

J y EXHIBIT 28.1:130/30 Funds

Equity Swaps 578

CHAPTER 29 - Stock index futures prices 581Arbitrage Pricing 581The Role of Hedgers and Speculators 587

xix •

DETAILED CONTENTS

The Role of Risk and Noise Traders 589Futures Prices and Expected Future Spot Prices 592

CHAPTER 30 - Hedging with stock index futures 594

The Nature of Hedging 594Sources of Hedge Imperfection 597Hedge Ratios 597What Index Level is 'Guaranteed' by Futures? 601

CHAPTER 31 - Stock options 607

Call Options 607The Profit/Loss Profile at Expiry 609The Profit/Loss Profile Prior to Expiry 610

Determinants of the Option Price (Premium) 611Put Options 611

The Profit/ Loss Profile at Expiry 612The Profit/Loss Profile Prior to Expiry 613

Writing Options 614Market Practices and Terms 616Boundary Conditions 618

CHAPTER 32 - Speculation with stock options 622

The Effects of Gearing 622Volatility Trading and the Collapse of Barings Bank 625Other Volatility Trading Strategies 627

CHAPTER 33 - Hedging with options 632Hedging the Value of a Shareholding 632

Long Versus Short Option Positions 633Hedging Anticipated Purchases 637Switching between Stocks without Trading in Stocks 639Vertical Spreads 643Option Cylinders 645Crash Options 645

CHAPTER 34 - Structured products 647Options Funds (Guaranteed Equity Funds) 648

The Nature of Options Funds 648The Fiduciary Call Approach 648The Protective Put Approach 649Break-Even Points 653

I EXHIBIT 34.1: Close UK Escalator 100 Fund and Close UK Escalator 95 Fund

Options Funds as Disaster Insurance 656Use of Exotic Options and Option Combinations 658

• XX

DETAILED CONTENTS

Jti) EXHIBIT 34.2: Family Safety Net Stockmarket Unit Trust

High Yield Funds (Covered Call Funds/Precipice Bonds/Scarps) 661Bonds with Variable Principals (Structured Notes) 665CoUateralised Debt Obligations (CDOs) and the Sub-Prime Mortgage Crisis 667

CHAPTER 35 -Warrants, convertibles, and split-caps 669Warrants 669

Covered Warrants 670The Capital Fulcrum Point 670

Convertibles 670Split-Capital Investment Trusts 673Shares and Bonds as Options 677

CHAPTER 36 - Option pricing and the Black-Scholes model 680

Option Prices as the Costs of Replication 680The Determinants of Option Prices 680The Black-Scholes Option Pricing Model 684Early Exercise 688

CHAPTER 37 -Variations on the basic Black-Scholes optionpricing model 690European-style Call Options on Dividend Paying Stocks 690American-style Call Options on Dividend Paying Stocks (Black's Approximation) 694European-style Call Options on Stock Indices 695The Greeks 699Pricing American-style Options 702Vahjing Options on Bonds 702Put-Call Parity and the Pricing of Put Options 703

Implied Stock Prices, Observed Stock Prices, and Stock Price Bubbles 706Reliability of the Black- Scholes Model 707

Implied Volatility 707Volatility Smiles and Volatility Smirks 708

CHAPTER 38 -The binomial option pricing model 711The One-Period Binomial Model 712Multi-Period Models 712Illustration of the Application of the One-Period Model 714Illustration of the Application of the Two-Period Model 715Illustration of the Pricing of an American-style Option 718The Binomial Model and the Assumptions of the Black-Scholes Model 722Real Options and Company Valuation 723

CHAPTER 39 - Currency forwards, futures, swaps, and options 729

International Money Market Investments 729Currency Forwards and Currency Futures 730

xxi D

DETAILED CONTENTS

Comparing Currency Forwards and Currency Futures 730Pricing Currency Forwards and Futures 732

Interest Rate Parity 732Covered Interest Arbitrage 732Synthetics and the Pricing of Forward Contracts 735The Significance of Bid-Offer Spreads 735

Hedging Currency Risk with Futures 738The 'Guaranteed' Exchange Rate 743

Currency Swaps 744Currency Options as Hedging Instruments 745Zero-Cost Options 746Delta Hedging with Options 746

CHAPTER 40 - Bond prices and redemption yields 751

Discount Models 751Valuing Coupon Streams as Annuities 755Consols and PIBs 756Accrued Interest and Rebate Interest 756Bond Price Convexity 757Bond Equivalent Yields, Effective AnnualYields, and Realised CompoundYields 758Horizon Return (Holding-Period Return) 760Index-Linked Gilt Redemption Yields 761

CHAPTER 41 - Duration and risk 763The Measurement of Bond Price Volatility (Duration) 763

A Formula for Calculating Macaulay's Duration 766Money Duration (Price Value of a Basis Point) 767The Behaviour of Macaulay's Duration 770Portfolio Immunisation 772Inverse Floaters and Floating Rate Notes 775Bond Index (Tracker) Funds 776Interest Rate Anticipation 777

CHAPTER 42 - Bond price convexity 779The Problem of Convexity 779The Value of Convexity 782Construction of Bond Portfolios 783Callable Bonds 783

CHAPTER 43 - Bond futures 785

Bonds 785Futures Contracts 785Hedging the Value of a Portfolio 786

Delivery, Price Factors, Invoice Amounts, and the Cheapest-to-Deliver Bond 789

XXII

DETAILED CONTENTS

Hedge Ratios 789Bond Portfolio Immunisation 792Adjusting Portfolio Duration with Futures 793

Determination of Bond Futures Prices 793Arbitrage Pricing 793The Role of Implicit Options 796Implied Repos 797

Basis Risk 798Synthetic Bond Portfolios 798Credit Derivatives 8 01

CHAPTER 44 - Yield curves and interest rate futures 804Yield Curves 804Construction of Bond Portfolios 808Forward Interest Rates and Expected Future Interest Rates 809The Forward Yield Curve 812Short-Term Interest Rate Futures 813Determination of Futures Prices 813Hedging the Yield Curve with Futures 814

Straddles 816Butterfly Spreads 817

A Generic Hedge Ratio 818Forward Rate Agreements (FRAs) 818

CHAPTER 45 - Interest rate swaps 820Hedging Interest Rate Risk 820Warehousing 822Floating Rate Notes (FRNs) 823Swap Pricing 823Credit Default Swaps 824

xxiii D