In the first part of this coursework, the explanations cover:
- Relationship between saving and investment
- Deficit in a countries budget meaning
- Gross Domestic Product meaning
- Effect of lowering interest rates
- Herd behaviour in investments
- Rational forecasts
- Dividend Valuation Model (DVM)
The second part of the coursework is an essay on Vanishing Technology (VT).
PART A | QUESTION 1A
It is important to understand the relationship between saving and investment. Saving can be seen as an avoidance of consumption. This results in individuals consuming less than their income. Investment is made in order to make more money and takes place when we buy new assets designed to enhance future productivity or capital appreciation. When there is a balance between saving and investment, saving can be used as funds for investment. In turn investment is a demand for those funds, each feeding the other.
In a closed economy where saving exceeds investment overall production is reduced and less money is being returned in to the economy as a whole. Even a short-term decline in economic growth can have a negative effect on employment and quality of life.
Running a deficit allows the government to continue investment at higher levels in an effort to convince people to continue to spend and allow the economy to recover. With no foreign trade to rely on to bring goods or services from outside, maintaining the equilibrium can be seen as worth the risk of the rise in national debt.
PART A | QUESTION 1B
A deficit in a countries budget is a shortfall between the income the government receives from taxes and the spending of that government. To bridge this shortfall, the government will usually bonds to raise the money to cover this deficit. This is essentially a form of borrowing that a government can make by selling bonds to the general public. Issuing bonds allows the government to borrow in its own currency ensuring that it not exposed financial risks in the exchange rate. Should the local currency drop in value, any foreign debt becomes substantially more expensive to replay.
PART A | QUESTION 1C
GDP (Gross Domestic Product is an indication of the goods and services that any particular economy produces over a given time span (usually each year). This is calculated by totaling Consumer Spending, Investments, Government Spending and Net Exports. Aggregate Demand is a representation of how much productivity there will be in an economy as a result of price levels within that economy.
A lowering of interest rates prompts an increase in consumer spending. This means that with individuals may have more spending power and choose to buy more luxury products or book holidays. This increased confidence promotes the sales of goods and services, shifting the Aggregate Demand curve to the right. Likewise, with lower interest rates available, businesses will take to opportunity to invest. This could be by expanding their business and purchasing new premises. This will have a similar expansionary effect on the Aggregate Demand.
PART A | QUESTION 2A
The extracts show a number of behavioural biases, as requested I will highlight two that I feel are most apparent.
Firstly, there are a couple of examples of ‘Overconfidence Bias’. As the name suggests, this represents an individual who has unwarranted faith in their intuition and abilities. They will believe that they are smarter and have better information than others around them. Overconfident traders will make more regular trades and take more risks.
The second extract from the selection shows ‘Anchoring Bias’. This is where a trader becomes fixated on a particular price of set of circumstances and does not take action even though they can see losses mounting up.
PART A | QUESTION 2B
Herd Behaviour is a part of human psychology that is not just limited to trading and investments. Humans are generally social animals, acting collectively as part of a group. This means that individuals can make decisions as part of a group that they would not necessarily make as an individual. These choices are influenced by who is around them and the choices that other people in the group make. This can be due to social conformity, where individuals are looking to be accepted. Or it can be based on a decision that a group of people can’t possibly be wrong.
Looking at the fundamental value of shares, which is determination of the intrinsic value based on analysis of the stock without looking what the market is saying on a particular day will provide a rational and realistic view of an investment. Herd mentality can be based on as little as fear of missing out or wanting to be part of a group. As this group invest and the price rises, yet more individuals think that they must know something so jump on to the same stock.
At this point, the price is in direct contradiction to the Efficient Markets Hypothesis, which states that the price of a financial asset reflects all the information available and responds only to unexpected news.
The herd buying of a stock, or sector of the market can cause a ‘bubble’, where the price continues to inflate. This leads to the inevitable ‘bursting’ of the stock as there has to be a point where the market will correct itself and the continuous rise of the price is unsustainable. While some traders may be luck and jump off at the right point, the majority see their investments dramatically drop.
PART A | QUESTION 2C
Robert Shiller posited that a rational forecast should not vary more than the historical average of the thing being forecast. He proceeded to collect data on stock prices and dividends all the way back from 1871. Then for each year, he calculated the present value of the dividends that would accrue to someone who bought a portfolio of stocks that existed at the time.
He found that the present value of dividends over the years is actually quite stable. However, stock prices; which should be interpreted as a forecast of the value of those dividends, are highly variable. Schiller proposes that when stock prices are high relative to the actual earnings of those stocks, the prices will eventually reduce and return to the expected historical norm.
PART A | QUESTION 2D
The knowledge that there is excess volatility in the market draws serious questions to the usefulness of models such as the Dividend Valuation Model (DVM). DMV assumes that the recent past is indicative of the future growth and that this figure will grow year on year, so works on expected values. But DVM ignores some important elements. It does not take account of any companies that do not issue dividends or cash balances that a company may hold so can seriously under-value a cash rich company.
Working form historical data, as Shiller did, demonstrates that DVM is not an accurate predictor of market movements, constantly underestimating the volatility of movement. This indicates that not only does it mean that investors don’t see the potential highs if they are willing to take the risk. They are also exposed to much greater falls, the losses from which could be catastrophic.
Word Count for Part A : 1113
PART B | QUESTION 3
Vanishing Technology (VT) is predicted by some analysts to be ”The Next Big Thing”. As such, this is an exciting time in the technology market with investors looking to buy in to companies developing ‘VT’ in the hope that they will benefit from a big payoff when the solution finally matures. It is always exciting to be at the bleeding edge of technology and to be early to invest.
However, history has shown that while the technology market can be very profitable for individuals who invest wisely, it is equally harsh to those who invest in new technologies that don’t have a future. The biggest warning of this was in the early 2000s when the markets experienced huge losses in tech stocks, after the Dot Com Boom became the Dot Com Crash.
The boom and bust situation at the turn of the millennium was one of the most extreme examples of a stock market bubble. The internet was new, and investors could see that it was going to radically change everything about the way that we lived. At the same time companies were popping up all the time with new products and services that took advantage of the internet. Not all of these businesses actually had a business model that suited the platform, but because the company had a ‘.com’ domain name, showing that they were an internet company, investors flocked to invest. A great example of this is Pets.com, a company that launched in 1998 and went public at a price of $11 per share in February of 2000. At this point the company was valued at over $82 million.
The problem with the company quickly became apparent as they were losing money on every sale, trying to offer low prices and free shipping on heavy bags of cat litter and pet food in an industry that typically worked on single figure margins anyway. Just nine months after it entered the stock market and at just two years old, the company went into liquidation as the share price hit just $0.19, a loss of over 98%.
This was not an isolated case, as lots of high-profile internet companies climbed high and suddenly went bust. This period was a bubble where investors poured money in to companies. In 1999 there were 457 IPOs (Initial Public Offerings), of which most were Tech companies. Of these, 117 doubled in value on the day of launch. Why investors ploughed so much money in to these companies can be put down to the fear of missing out. They could see all this investment and money being generated so they bought big on any start-up internet business believing that it would pay off in a big way for them.
In March of 200, the Nasdaq (the American stock exchange) hit an all-time high of 5132.52. Quite what happened next is unclear, but a sell-off of tech stocks began. Maybe investors were seeing that they had put money into companies that were not making profits, maybe that just decided to cash in? But the bubble that internet companies had been floating in finally burst and just two years, the Nasdaq lost 78% of its value as investors became wary of all stock, not just tech.
One of the reasons for the bubble was that investors were more interested in the momentum and novelty of the unknown scope of the internet. While it may be unlikely that we will see such a huge trading event on technology shares as a whole again, there are still room for ‘bubbles’ in technology sectors, especially when it comes to emerging technology as investors rush to be early and take advantage of the potentially huge gains when the company releases its solution and, preferably, owns its sector.
Generally, investing in tech is only really a path for those who will seek to fully understand the technology that they are investing in, together with learning about competing and complementary technologies to ensure that they have an understanding of the business models and how the companies plan to monetise in the future. As ‘Vanishing Technology’ is an emergent technology, anyone considering investment would be wise to consider these factors.
Currently there are three main players in the VT sector. Two are established companies and the third is a start-up founded only six months ago, with no track record in any previous business. Regardless of the standing of the companies themselves, ‘VT’ is a new and unproven technology that does not have any proven application in place and is still in early stages of development.
Only one of these is UK based, which could be important for investors in the UK in the current climate, as they will need to consider the currency in which they are looking to invest. The forecast for the US economy is poor, with economic experts predicting that interest rates will rise sharply. In addition, it is forecast that the dollar will fall against other major currencies including the UK pound.
This has implications for UK investors. If the predictions are correct high interest rates, inflation and the possible volatility that this may bring could choke possible business growth. There is the possibility that the US could fall into recession. Concerns over exchange rates in addition to market fluctuations can increase the risk of investing in companies that are listed on American markets.
So, with the potential pitfalls covered, if you still choose to invest, where should you put your money. With the three companies who are leading the charge in VT we need to consider which will provide the best return. To do this we need to look at the P/E ratios and see what this is telling us about each of the companies. Generally, we are looking for a lower P/E ratio to ensure that we get a quicker return. This assumes that the earnings from the shares are going to stay even.
In this situation though, we are looking to see earnings make a significant rise in the future, so the fact that the P/E of each company on the list is higher than the market average is not a red flag in the way it would be if this was a more established sector.
From the P/E ratio, Gonn Founded is clearly the most expensive investment combined with no history. It may be that this start-up could be nimbler than the others and provide some great earnings, but that is a very risky proposition as they are going to be looking for serious investment to get up and running and will not have the logistics, manufacturing or distribution channels available to the other companies.
DisserPeer is the most established company and is again valued higher than the average of the market. Because the company does have established practices, this may be more appealing, but the fact it is a US company means that there are issues with the strength of the dollar and the general economy.
The final and preferred option is a UK company. With almost two decades of business behind them, they will have everything that they need to launch and distribute a solution. The lower P/E ratio means that the shares are relatively inexpensive (although still higher than the market average). Being a UK company means there are no exchange rate issues, so investors will not suffer from the predicted down turn of the US economy.