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Assignment solutions to Investor Psychology assignment 1 2021
- Institution
- University Of South Africa (Unisa)
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- Behavioral Finance
Theoretical answers to all questions in the assignment
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Specific Outcome 1Question 1
1.1
(a) Prospect and probability distribution: A prospect is a series of wealth outcomes,
each of which is associated with a probability, whereas probability distribution defines
the likelihood of possible outcomes.
(b) Utility functions and expected utility u
numbers to possible outcomes in such a way that preferred choices receive higher
numbers and represents the satisfaction received from a particular outcome. On the
other hand, expected utility is an account of how to choose rationally when you are
unsure of the outcome that will result from the acts. It is the weighted average of the
utilities of each of its possible outcomes, where the utility of an outcome measures the
extent to which that outcome is preferred. (Ingersoll, 2019)
(c) Risk aversion, risk seeking and risk neutrality: Risk aversion is simply described
return with an unknown risk on investment (Ackert, 2010). Risk seeking is an investors
desire for capital perseverance and willingness to gain returns at a lower rate this
type of investor accepts the greater investment uncertainty in exchange for possible
high incomes. Risk neutrality is an emotional preference explained by a situation
whereby an investor is indifferent to risk regardless of the change to risk height.
1.2
(a) Systematic and non-systematic risk: Systematic risk is also known as non-
diversifiable risk, is the uncertainty inherent to the entire market segment. Also referred
to as the volatility, it consists of the day-to-day fluctuations in a price and is
essential for returns because the market movement is the reason why individuals make
money from stocks. Systematic risk cannot be eliminated no matter how many stocks
are added to the portfolio.
Non-systematic risk is also known as diversifiable risk and refers to the type of
uncertainty that comes with the company or industry that you invest in. Non-systematic
risk can be reduced by diversification and is not rewarded since investors can eliminate
it by diversification.
(b) Beta and standard deviation: Beta deviation measure the volatility risk of a stock as
a whole and measures the performance of a portfolio or security in relation to the
movements of the market. When a beta value is more than 1, this means that the
security is performing in line with the performance of the market. Whereas when the
beta value is less than 1 then the performance of the security is less volatile in the
market. In contrast, standard deviation is associated with more risk and is used to
, calculate the risk of a stock individually. The risk of returns is calculated in standard
deviation and this means that an increase in standard deviation is an increase in risk
involved in a particular investment. When the standard deviation is high, it indicates a
higher risk.
(c) Direct and indirect agency cost: Agency costs are internal costs incurred due to the
competing interests of shareholders (principals) and management teams (agents).
Expenses that are associated with resolving this disagreement and managing the
relationship are referred to as agency costs and can be further subdivided into direct
and indirect agency costs. Direct agency cost often result from corporate expenditures
that benefit the management but involve a cost to the stakeholders. It includes
corporate spending that would help management maintain a cordial relationship
between the agent and principal. An indirect agency cost is any cost incurred by a
principal to modify the behaviour of an agent so that the actions of the agent are more
aligned with the best interest of the principal.
(d) Weak, semi-strong and strong form market efficiency: Weak form is when prices
reflect all the information contained in historical returns only and no form of technical
analysis is utilized effectively to aid investors in making trading decisions. The semi
strong form, however, is when prices reflect all publicly available information. This
includes information obtained from the firm financial statements, estimation about the
future earnings or any other publicly available information. The strong form asserts that
all the information, regardless of whether this information is public or private is fully
reflected in securities prices. This form of the efficient market hypothesis includes all
the information about the market data, public information, and the private information
(Maverik, 2020).
1.3
(a) Momentum and reversal: Momentum is the rate of acceleration of a price or
volume. It refers to the force or speed of movement and is usually defined as a rate.
Momentum exists when returns are positively correlated with past returns. A reversal
exists when returns are negatively correlated with past returns. It is reliable for short
term intervals of one month and typical for longer intervals of 3-5 years.
(b) Value and growth stocks: Value stocks are stocks that are trading below what they
are worth and thus provide a superior return. Growth stocks are stocks that are
considered to have the potential to outperform the overall market overtime because of
their future potential.
(c) Fundamental risk and nose trader risk: Fundamental risk is also known as
systematic risk and non-diversifiable risk. It is a risk that affects the entire economy or
many persons or groups within the economy and cannot be eliminated or reduced by
diversification. Fundamental risk can be caused by a natural disaster, inflation,
unemployment and even war. Noise trader risk is a form of investment risk associated
with the decisions made by so called noise traders. The higher the volatility, in the
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