Personal Finance and Investments_ A Behavioural Finance Perspective

Personal finance-FM 8/18/08 2:38 PM Page i Personal Finance and Investments ‘The reader should not expect to find unambiguous answers to all the many questions concerning personal finance and investments,’ Keith Redhead argues in the preface to this new textbook, thus underlining the role personal judgement plays in personal finance and investments Personal judgement should be informed by many perspectives; hence his interdisciplinary approach to the study of personal finance and investments In this book, the author draws from finance, psychology, economics and other disciplines in business and the social sciences, recognising that personal finance and investments are subjects of study in their own right rather than merely branches of another discipline Considerable attention is given to some topics, which are either ignored or given very little attention in other texts These include: ■ ■ ■ ■ ■ the psychology of investment decision-making stock market bubbles and crashes property investment the use of derivatives in investment management regulation of investments business More traditional subject areas are also thoroughly covered, including: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ investment analysis portfolio management capital market theory market efficiency international investing bond markets institutional investments option pricing macroeconomics the interpretation of company accounts Packed with over one hundred exercises, examples and exhibits and a helpful glossary of key terms, this book will help the reader to grasp the relevant principles of money management The book avoids non-essential mathematics and provides a new approach to the study of personal finance and investments.The book will be essential for students and researchers engaged with personal finance, investments, behavioural finance, financial derivatives, and financial economics Keith Redhead is Principal Lecturer in the Department of Economics, Finance and Accounting at Coventry University Business School He is also the author of Introducing Investments:A Personal Finance Approach and Financial Derivatives:An Introduction to Futures, Forwards, Options and Swaps Personal finance-FM 8/18/08 2:38 PM Page ii Personal finance-FM 8/18/08 2:38 PM Page iii Personal Finance and Investments A behavioural finance perspective Keith Redhead Personal finance-FM 8/18/08 2:38 PM Page iv First published 2008 by Routledge Park Square, Milton Park,Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Avenue, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an informa business This edition published in the Taylor & Francis e-Library, 2008 “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2008 Keith Redhead All rights reserved No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Redhead, Keith, 1949Personal finance and investments : a behavioural finance perspective / Keith Redhead p cm Includes bibliographical references and index ISBN 978-0-415-42859-0 (hb) — ISBN 978-0-415-42862-0 (pb) — ISBN 978-0-203-89563-4 (eb) Investments Finance, Personal Investment analysis Portfolio management I.Title HG4521.R3655 2008 332.6—dc22 2007048856 ISBN 0-203-89563-0 Master e-book ISBN ISBN10: 0–415–42859–9 (hbk) ISBN10: 0–415–42862–9 (pbk) ISBN10: 0–203–89563–0 (ebk) ISBN13: 978–0–415–42859–0 (hbk) ISBN13: 978–0–415–42862–0 (pbk) ISBN13: 978–0–203–89563–4 (ebk) Personal finance-FM 8/18/08 2:38 PM Page v For Sue, with love and thanks Personal finance-FM 8/18/08 2:38 PM Page vi Personal finance-FM 8/18/08 2:38 PM Page vii Contents Preface xxiv Introduction The psychology of personal investment decisions 13 PART Basics of Money, Bond, and Property Markets 53 Interest rates and money market investments 55 Investing in bonds 72 Property investment and mortgages 87 PART Basics of Stock Markets 115 Stock exchanges 117 Stock indices 131 The rationale and conduct of regulation 145 PART Institutional Investments 161 10 11 12 Mutual funds (unit trusts, OEICs, investment trusts) 163 Life assurance and assurance-related investments 202 Pensions 214 The importance and significance of institutional investors 242 PART Capital Market Theory 259 13 Portfolio diversification 261 14 Capital market theory:The capital asset pricing model 301 15 Capital market theory: Alternatives and criticisms 318 PART Portfolio Management 329 16 Styles of portfolio construction 331 17 Evaluating the performance of fund managers 368 PART Investment Analysis 391 18 19 20 21 22 The economic environment 393 Dividend discount models 410 Company accounts and economic value added 426 Ratio analysis 438 Technical analysis 454 vii Personal finance-FM 8/18/08 2:38 PM Page viii CONTENTS PART Market Efficiency 477 23 24 25 26 27 Market efficiency: Concepts and weak form evidence 479 Noise trading and behavioural finance 494 Market anomalies 513 Further evidence on market efficiency 528 Stock market bubbles and crashes 540 PART Stock Index Futures 569 28 Stock index futures 571 29 Stock index futures prices 581 30 Hedging with stock index futures 594 PART Stock Options 605 31 32 33 34 35 36 37 38 Stock options 607 Speculation with stock options 622 Hedging with options 632 Structured products 647 Warrants, convertibles, and split-caps 669 Option pricing and the Black-Scholes model 680 Variations on the basic Black-Scholes option pricing model 690 The binomial option pricing model 711 PART 10 International Investing: Using Currency Derivatives 727 39 Currency forwards, futures, swaps, and options 729 PART 11 Bond and Interest Rate Analysis 749 40 Bond prices and redemption yields 751 41 Duration and risk 763 42 Bond price convexity 779 43 Bond futures 785 44 Yield curves and interest rate futures 804 45 Interest rate swaps 820 Glossary 826 References 856 Index 890 viii Personal finance-FM 8/18/08 2:38 PM Page ix Detailed Contents CHAPTER - Introduction Functions of Financial Systems Investors and Borrowers Personal Financial Planning Budgeting Managing Liquidity Financing Large Purchases Long-term Investing Insurance The Nature of Investment Risk CORE Principles of Personal Financial Planning 10 CHAPTER - The psychology of personal investment decisions 13 Choice under Constraint 13 Objectives 13 Types of Risk 14 Constraints 16 Characteristics of Investments 18 Human Capital 19 Risk Management 20 EXHIBIT 2.1: Mis-selling or miscommunication? Apparent mis-selling of financial products may 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 48Personal finance-Index 8/18/08 3:58 PM Page 895 INDEX direct property investment: institutional and private portfolios 283; portfolio diversification 282–3 disaster insurance: options funds 656–8 discount rates: and interest rates 64–5 discounted-rate mortgages 105 discounts: investment trusts 166, 168–9, 170, 172–4 disposition effect 38–40, 507 Distribution Technology 37, 42 diversification: and property investment 88; see also Markowitz diversification dividend discount models 410–25, 690, 762; alternative cash flow discounts 423–4; capital gains 418; discounted cash flow model 410–12; discounted future dividends model 412–13; and dividend growth rate estimates 414; and Free Cash Flow to Equity (FCFE) 423–4; fusion investing 424–5; Gordon growth model 413, 414, 415, 416, 418, 419, 421, 423; inflation bias 421–2; interest rates 421; investment opportunities and share price 418–20; investor sentiment 424–5; multi-period 415–16; problems 420–3; stochastic 415; variable estimate reliability 421 Dividend Irrelevance Theorem 414 dividend yield: market anomalies 516–17; market returns 396–7; ratio analysis 443 dividends: and stock indices 141 Djar, R.: and Kumar,A 456 Dodd, P 529 Dolvin, S.D.: and Templeton, W.K 299 dot.com: bubble and crash behavioural model 559–61 double-dated gilts 78–9 Doukas, J.A.: et al 523; and McKnight, P.J 490 Dow Jones Industrial Average 140, 141, 458, 464, 474, 573 Dow Jones Sustainability Index 361 Dow theory: technical analysis 467 Dowd, K 373 Dowen, R.J.: and Mann,T 199 downside risk: post-modern portfolio theory 295–6 Doyle, J.T et al 514 Dreman, D 547 Drew, M.E.: et al 225; and Stanford, J.D 225 dual-asset hedging 802 Duffield, S.: and Hill, I 242 Duflo, E.: and Saez, E 33 Dufwenberg, M et al 562 Dukes,W.P et al 420, 439 Dunbar, N 354 duration matching: bonds 772–4, 792 early exercise: binomial option pricing model 720, 722; BlackScholes option pricing model 688–9, 702 earnings yield: ratio analysis 444 earnings-per-share: profit and loss account 429; ratio analysis 443, 447 EBITDA: profit and loss account 429 Economic and Monetary Affairs Committee: European Parliament 156 economic cycles: and stock market cycles 394–8 economic environment 393–409; business cycles and stock markets 394–8; exchange rates 407–8; macroeconomic analysis overview 398–404; monetary transmission mechanism 404–6; political/demographic effects on share prices 406–7 Economic Value Added: company accounts 436–7 Edmans,A et al 509 effective annual yields: bond prices 758–60 efficiency frontier: portfolio diversification 267–8, 286, 289 efficient market hypothesis 332, 455, 481–2; adequate funds 483; assumptions 483–4; fundamental value trading 484; information availability 483–4; interpretations 483; investorperceived market inefficiency 484; property prices 93–4; rationality 483, 541 ego-involvement: investment 509–10 Elliot wave theory: technical analysis 467–8 Elmerick, S.A et al 298–9 Elton, E.J et al 507–8, 531, 534, 535 Emanuelli, J.F.: and Pearson, R.G 524 emerging market funds 363–6; developed market correlations 364; information risk 364; liquidity 364; political risk 363 emerging markets: stock indices 142 emotion and mood: attachment bias 510; psychology 33–4, 508–10, 546–8 Enderle, F.J 139 endowment bias 28 endowment effect 507 endowment mortgages: negative perception 111–12; payment equation 108–9 endowment policies: life assurance 204–5 enforcement theory: regulation 155 enhanced rate annuity 226 Enron 157–9 Enterprise Investment Schemes (EISs) 189–90, 244 enterprise value (EV): ratio analysis 444 equity carve outs: 3Com and Palm 485 Equity Premium Puzzle 503 equity release mortgages: and home reversion plans 106–7 equity risk premium 70 equity swaps: stock index futures 578–9 equity unit trusts 19 Erb, C et al 281 escalating annuities 228 escalation bias 507; psychology 36 895 48Personal finance-Index 8/18/08 3:58 PM Page 896 INDEX Estelami, H 462 Estrada, J et al 343 Ethical Investment Research Service (EIRIS) 360 Eurobonds 72, 73–4 European Private Equity and Venture Capital Association 245 European Union (EU): investment business regulation 156–7 Everett, R.: and Yook, K 345 Ewing, B.T 752 exchange rate risk 16 exchange rates 407–8; international portfolio balance 407, 408; monetary policy analysis 408 exchange-traded funds (ETFs) 176–7; advantages 177; small investor disadvantages 177 exercise price: options 607, 611, 612, 614 expectation with risk premium theory: interest rates 804, 807–8 experimental markets research: bubbles and crashes 561–2 factory gate pricing: fund charges 184–5 Fair, R 494 fair value pricing: mutual funds 193–4 Fama, E.F 481, 486, 510, 524; and Blume, M 487; et al 529; and French, K.R 314, 315, 377, 396, 495, 516, 517, 519–20, 524; and MacBeth, J.D 325 familiarity bias 499, 504–5, 515; bubbles and crashes 551–2; heuristic simplification 29, 291, 299 family responsibility: personal investment decisions 18 Family Safety Net Stockmarket Unit Trust 660–1 Farrar, D.E 289 Farrow, D 40 Fed Model: and ratio analysis 448–9 Fehle, F et al 496 Feldman, B.: and Roy, D 661 Fenton-O’Creevy, M et al 150, 455, 457, 504 Ferguson, R.: and Leistikow, D 173 896 Fibonacci numbers: technical analysis 467–8 Fidelity 9, 297 fiduciary call approach: options funds 648–9, 656, 658 Filbeck, G et al 22 fill-or-kill order 126 filter rules: technical analysis 468–9, 487 final-salary schemes: pensions 216, 217, 218, 219, 233–5 financial activation: retirement saving behaviour influences 44 financial adequacy ratios 445–6 financial advice and education: role 298–9 financial advisers: interest conflict 197; mis-selling and perception 23; risk perception 21–2, 23 financial asset risk 21 financial inhibition: retirement saving behaviour influences 44 financial journalism: and investment 197, 199–200 financial leverage ratios 445 Financial Ombudsman Service: regulation 152 financial risk management: financial system functions Financial Services Authority (FSA) 193, 211, 212, 298, 386, 532, 664; objectives 150; powers 151; regulation 25, 150–1, 152, 156, 159; risk categorisation 151 Financial Services and Markets Act (2000) 150 financial systems: functions 3–4 Financial Times 101–2, 761 Firth, M 529, 531 Fischoff, B 24; and Lichenstein, S 500 Fisher, K.L.: and Statman, M 424, 494, 548 Fisher Effect 63 Five-Factor Model: personality 43 fixed interest rates 58 fixed-rate mortgages 99–101; early redemption penalties 101; risk premium 100, 102 Flanegin, F.R.: and Rudd, D.P 472 Flannery, M.J.: and Protopapadakis, A.A 397 Fleming, M.J.: and Remolona, E.M 752 Fletcher, J.: and Kihanda, J 316 floating rate bonds 77 floating rate notes (FRNs): bond duration and risk 775–6; interest rate swaps 823 foreign bonds 74 foreign currency deposits 68–9 Foresi, S.: and Wu, L 709 Forgas, J.P 547 Forner, C.: and Marhuenda, J 491 Fortune 521 Fortune, P 514 Forward rate agreements (FRAs): and interest rate futures 818–19 forward yield curve 812 Foster, G 432 fractal market hypothesis 538 frame dependence: heuristic simplification 29–30 Francis, J et al 451, 452, 502 Fraser, S.P et al 215 Fraser,W.D et al 283 Frederick, S 40 Free Cash Flow to Equity (FCFE) 423–4 Freidrich, N.: and Glaum, M 420 French, K.: and Poterba, J 291 French, K.R.: and Fama, E.F 314, 315, 377, 396, 495, 516, 517, 519–20, 524 Friedrich, N.: and Glaum, M 420, 425, 437, 439, 724 Friend, I et al 531 friendly society policies: life assurance 205, 244 Froot, K.: and Dabora, E 348, 485; and Rogoff, K 408 FT Ordinary Share Index (FT 30) 143 FTSE 100 Index 140, 142, 143, 333, 339, 491–2, 579 FTSE All-Share Index 140, 142, 143, 333, 336, 339, 340, 355, 579 FTSE Hedge Fund Index 355 FTSE4Good stock indices 360 full replication: index funds 335 fund charges: annual management charge (AMC) 178; commission 184–5; deterrence 185; factory 48Personal finance-Index 8/18/08 3:58 PM Page 897 INDEX gate pricing 184–5; management 177; and mutual funds 177–85; reduction in yield (RIY) 178; stockbroker commissions 177; total expense ration (TAR) 178 fund of funds (FoF): advantages 354; charges 183, 354; evaluation 378 fund manager performance 196–9, 368–89; appraisal ratios 375; asset allocation evaluation 380–3; attribution 380–3; beta 377; capital market line 375; chance 377; comparison portfolios 378; currency selection evaluation 381–2; differential return 373–6; evaluation problems 377–80; holdings-based measurement 385–6; incentive fees and risk 507–8; information ratios 372–3; market-timing skills 383–5; Modigliani squared measure 372; money-weighted measure 369–70; omega measure 379–80; persistence 386–8; portfolio return 368; and reward per unit of risk 371–3; risk 369, 370–1; Sharpe measure 371, 373; stock selection evaluation 380–1; style analysis 382–3; time-weighted measure 369–70; transition matrices 387–8; Treynor measure 371; value-atrisk measure 378–9 fund managers: herding 198, 249–50; home bias 278; importance 196, 198; interest conflict 197; and momentum trading 198; short-termism 249–50 fund supermarkets: Individual Savings Accounts (ISAs) 189 fundamental trackers: index funds 334–5 funds transference: surplus units to deficit units Fung, J.K.W 588 fusion investing: dividend discount models 424–5 future time perspective 44 futures funds 575–6; advantages 339; disadvantages 339; index funds 338–9 Gadarowski, S 29 Galbraith, J.K 555 Gallimore, P 92 Gallo, G.J.: and Lockwood, L.J 196 gambler’s fallacy: behavioural finance 456 gamma 699, 700 Gaspar, J.P et al 197, 198 gearing: stock options 622–5 gearing opportunities: property investment 88 Gemmill, G 32; and Thomas, D.C 172 General Theory of Employment: Interest and Money (Keynes) 471 generalised antoregressive conditional heteroskedasticity (GARCH) 491 Generally Accepted Accounting Principles (GAAP) 427 Genesove, D.: and Mayer, C 36, 38 Gerard, H.: and Deutsch, M 544 Gibbons, M.: and Hess, P 520 Gibson, C 452 Gillan, S.: and Starks, L 251 Gilt-Edged Market-Makers (GEMMs) 125–6 gilts 77–84, 125; conventional 78; coupon yield 82; double-dated 78–9; and gilt strips 80; indexlinked 79–80; issuing 77–8; price volatility 83–4; redemption yield 82–3, 85; rump stocks 80; undated 79, 83 Giuliodori, M 406 Glaum, M.: and Friedrich, N 420, 425, 437, 439, 724 Glickstein, D.A.: and Wubbels, R.E 467 goals-based investing: complexity 346; portfolio management 343–6; and risk measurement 344–6 Goetzmann,W.: and Peles, N 26, 197 Goodmoney industrial Average 360–1 goodwill 426–7 Gordon Growth Model 309–10, 421, 423, 435, 508; dividend discount models 413, 414, 415, 416, 418, 419; price-earnings ratio 439–40, 442 government bonds 72, 73, 86, 227; futures 785–803; gilts 77–84 Goyal,A.: and Santa-Clara, P 326 Grable, J et al 546 Grable, J.E et al 22 graduated payment mortgages 105 greater fool theory 541–2 Greeks: Black-Scholes option pricing model 699–702 Greenspan,A 555 Greenspan put 554 Gregoriou, G.N 355 Gregory,A.: et al 530; and Tonks, I 533 Grinblatt, M.: and Keloharju, M 38, 507; and Titman, S 385 Grossman, S.: and Stiglitz, J 532 growth stocks 346–7 Gu,A.Y 520 Guerard, J.B 360 Gultekin, M.N and N.B 520 Guo, L.: and Mei, J 363 Guyatt, D 249 Hallahan,T.A et al 22 Hansz, J.A.: and Diaz, J 92 Harlow,W.V.: and Brown, K.C 199, 489 Harney, M.: and Tower, E 447 Harris, D 184 Harrison,T et al 44 Hartzell, J.C.: and Starks, L 251 Hasseldine, J.: and Diacon, S 30 Hauser,T.: and Vermeesch, D 343 Heath, C et al 36 Hedesstrom,T.M et al 31 hedge funds 350–5; annual returns 356; characteristics 350–1; Collateralised Debt Obligations (CDOs) 351; directional strategy 352; and diversification 352, 355; failure rate 352; flexibility 351–2; kurtosis 356; leverage 350, 352, 353, 354; lock-up periods 354; Long-Term Capital Management 354, 357–8; management reward structure 352; non-directional strategy 352, 353; performance 355–7; 897 48Personal finance-Index 8/18/08 3:58 PM Page 898 INDEX principal-agent problem 353; regulatory control 351, 354; risk 356–7; secrecy 351, 352; skewness 356, 357; survival analysis 355; survivorship bias 355, 356 hedge ratios: beta 597–8, 601, 603; interest rate futures 818; minimum variance hedges 600; naive 600; stock index futures 597–601 hedging: anticipated stock purchases 637–9; bond futures 786–92; butterflies and yield curve risk 817; crash options 645–6; currency futures 738–42; currency options 745–6; dualasset 802; futures 571–2, 573; guaranteed exchange rate and currency futures 743; imperfection sources 597; interest rate futures 814–17; and interest rate swaps 820–2; and long versus short option positions 633–7; minimum variance 600; nature 594–6; option cylinders 645, 659; shareholding value 632–7; stock index futures 587–9, 594–603; stock options 632–46; straddles and yield curve risk 816–17; synthetic options positions 639–43; vertical spreads 643–5 Henderson Global Investors Emerging Markets Fund 365–6 Henderson Global Investors International Fund 280 Henderson Global Investors UK Gilt Fund 81 Hendricks, D et al 532 Henriksson, R.D 384 herding 542–3, 545, 558; fund managers 198, 249–50; intentional 542–3; market sentiment 543; unintentional 542 Hershey, D.A.: Jacobs-Lawson, J.M 44; and Neukam, K.A 44 Herzberg, M.M.: and Wang, S 536 Hess, P.: and Gibbons, M 520 Heston, S.L et al 514 heuristic simplification: psychology 26–31, 52 898 high income equity unit trusts 19 high yield funds 661–4, 668; catastrophe bonds 664 Hill, I.: and Duffield, S 242 Hilton, D.J 154 hindsight bias 500–1; self-deception 24–5 Hirshleifer, D 542; and Shumway,T 33, 508, 553 Hogan,W.: and Batten, J 802 holdings-based style analysis 383 Holmes, P.: and Tomsett, M 590 home bias 278, 291 home reversion plans: and equity release mortgages 106–7 Hong, H et al 32, 396, 490 horizon return: bond prices 760–1 hostile takeover bids: and shorttermism 250 House of Commons Treasury Committee 147, 149, 160, 184 house money effect 546 HSBC FTSE 100 Index Fund 140–1 Huang, Z.: and Ko, K.J 497 Huberman, G 291 Hudson, R et al 466 Huhmann, B.A.: and Bhattacharyya, N 50 Hulbert, M 514 human capital 11, 19–20, 202; and stock market investment 20 Hung, M-W.: and Jan,Y-C 387 Hunter, D.M.: and Simon, D.P 282 Hwang, S.: and Salmon, M 543 hyperbolic discounting 228 Ibbotson, R.G.: and Brinson, G.P 397 illusion of control 500, 504, 550–1 impaired life annuity 226 imperfect substitution hypothesis 340 implicit options: bond futures 796 implied repos: bond futures 797 implied volatility 631; Black-Scholes option pricing model 707–8 incentive problems: financial system functions income drawdown schemes: pensions 230–1 income risk 10, 11, 16, 17–18, 19, 807 income tax 18 index funds 142, 143, 174–5, 200, 240, 241, 254–5, 275, 276, 332–5, 510, 512; advantages 333–4; bonds 776–7; charges 177, 334; diversification 333; drawbacks 334, 335; full replication 335; fundamental trackers 334–5; growth 225; index reconstitution 339–40; M&G Index Tracker Fund 337–8; management risk 333–4; optimisation 336; passive core approach 341; performance 196–7; and rational retail investors 533; redemptions and new investment 335; size weighting 334; stratified sampling 335–6; synthetic index funds 338–9; tracking error 175–6, 336, 339–41 index reconstitution: imperfect substitution hypothesis 340; and index funds 339–40; price pressure hypothesis 340 index tracking: methods 335–9 index weighting: stock indices 132–6 index-linked annuities 228 index-linked gilt redemption yields 761 index-linked gilts 79–80 Individual Savings Accounts (ISAs) 186, 188, 244, 290; CATmarking 188–9; fund supermarkets 189; self-select 189 Indro, D.C 247, 545 inflation: business cycles 397; measurement 63–4; and mortgage tilt 98–9; Phillips curve 400–2; time-series analysis 430–1 inflation accounting 431 inflation illusion 421–2 inflation risk 10, 16 information production: financial system functions information ratios: fund manager performance 372–3 information risk: emerging market funds 364 48Personal finance-Index 8/18/08 3:58 PM Page 899 INDEX informational efficiency 479–81; meaning 481–3; primary market 480; secondary market 480, 481 informational social influence: bubbles and crashes 544 insiders’ trades: and strong-form efficiency 530–1 institutional investors 242–58; dividend payment pressure 250; hostile takeover bids 250; influence on companies/analysts 250–2; liquidity 555–7; and liquidity theory of asset prices 245–7; and private equity 244–5; rise 242–4; Sandler report (2002) 253–6; short-termism 247–50 insurance: personal finance planning insurance company group schemes: pensions 219 Intel 451 interest rate futures: and forward rate agreements (FRAs) 818–19; hedge ratios 818; hedging the yield curve 814–17; price determinants 813–14; shortterm 813; and yield curves 804–25 interest rate risk: mortgages 103 interest rate swaps 820–5; credit default swaps 824–5; floating rate notes (FRNs) 823; hedging 820–2; pricing 823–4; warehousing 822–3 interest rates 71; anticipation and bonds 777–8; bond portfolio immunisation 772–5, 792; and bond price convexity 757, 779–84; bond prices 752, 765; business cycles 396, 397; central banks 404; and discount rates 64–5; fixed and variable 58; inflation 401; loanable funds 402–3; macroeconomic analysis 402–4; money supply and demand 403–4; nominal and real 59–63; quoting convention 58–9; simple and compound interest 55–8; stock options pricing 683–4, 703, 722; term structure theories 804–8 interest yield: and total return 65 International Financial Services London (IFSL) 243 International Fisher Effect 68–9 International Monetary Fund (IMF) 354 international money market investment: and synthetic bond portfolios 798–9 internet-related stocks 480; bubble and crash behavioural model 559–61; crash 551–2 intrinsic value 633, 637, 678, 681, 682, 720; call options 609, 610, 611, 618–19, 620, 621; put options 613–14, 618–19 inventory-turnover ratio 446 inverse floaters: bond duration and risk 775–6 investment risk: nature 9–10, 11 investment trusts 163; borrowing powers 166; discounts and premiums 166, 168–9, 170, 172–4, 177; investor rationality 172–3; mutual fund differences 164–8; net asset value (NAV) 165, 168; purpose 164; share buy-backs 168–72; split-capital trusts 167; value 165 investment-linked annuities 229–30 investor classification 46–9; moneydummies 47, 48; no purchase 47, 48; open books 47, 48; rationalactive 47, 48; relationaldependent 47, 48; repeat-passive 47, 48; risk seekers 48; safe players 48; targeted marketing 49 investor rationality: investment trusts 172–3 investors: and borrowers 4–5 irrational trading 358 Irwin, S.H.: and Park, C-L 473 IS-LM framework: macroeconomic analysis 398–400 Islamic mortgages 106 Iyengar, S.S.: and Lepper, M.R 253–4 Jacobs, E.M.: and Minhas, R.S 66 Jacobs-Lawson, J.M.: and Hershey, D.A 44 Jaffe, J et al 516 Jan,Y-C.: and Hung, M-W 387 Jang, J.: and Bessler, D.A 281 Jansen,W.J.: and Nahius, N.J 397 January effect: market anomalies 515, 520–1 Jegadesh, N.: and Titman, S 486, 489 Jennergren, P.: and Korsvold, P 487 Jensen, G.R et al 514 Jensen, M.C 531 Jensen’s alpha measure: fund manager performance 374–5 Jha,V 535 Johansen,A.: and Sornette, D 563 John Hancock Financial Services 504–5 Johnson, E.J.: and Chapman, G.B 468 Jones, C.P.: et al 514; and Latane, H.A 514 Jordan, J.: and Kaas, K.P 50, 497 JPMorgan Fleming Mercantile Investment Trust PLC: share buybacks 170–2 Jung, J.: and Shiller, R.J 540 Kaas, K.P.: and Jordan, J 50, 497 Kahn, R.N.: and Rudd,A 386 Kahneman, D.: et al 46; and Tversky,A 29, 92, 468, 499, 502, 510, 545 Kamstra, M et al 33, 553 Kanto,A.J et al 514 Karapetrovic, S.: and Willborn, W 153 Karceski, J 326, 545 Karpoff, J.M 251 Kasten, G.W.: and Swisher, P 295 Kat, H.M 333, 356; and Amin, G.S 355, 356 Kato, K.: and Shallheim, J 520 Katona, G 29 Kaul, G.: and Conrad, J 486 Keating, C.: and Shadwick,W.F 379 Keim, D.B.: and Stambaugh, R.F 520 Keller, C.: and Siegrist, M 47, 48 Keloharju, M.: and Grinblatt, M 38, 507 Kempf,A.: and Ruenzi, S 27, 253 Kendall, M 486 Keppler, M.: and Xue, X.H 521 899 48Personal finance-Index 8/18/08 3:58 PM Page 900 INDEX Key,T.: and Marcato, G 93 Keynes, J.M 471, 542 Kihanda, J.: and Fletcher, J 316 Kilka, M.: and Weber, M 505 Kimmel,A.J 495; and Audrain,A.F 495 Kindleberger, C.P 541, 553; and Aliber, R.Z 541 King, R.G.: and Kurmann,A 807 Kinney,W.R.: and Rozeff, M.S 520 Kirkby, S.: and Tourani-Red,A 505 Kirman,A.P 543 Kisor, M.: and Whitbeck,V.S 440–1 Kiymaz, H 530–1 Klein, D.P.: and Laatsch, F.E 63 Ko, K.J.: and Huang, Z 497 Kohers,T.: and Kohers, K 520 Kolb, R.A.: and Stekler, H.O 777, 778 Korsvold, P.: and Jennergren, P 487 Kosowski, R et al 199 Kothari, S.P.: et al 325, 517; and Shanken, J 491, 517 Kumar,A.: and Djar, R 456 Kurmann,A.: and King, R.G 807 kurtosis 356, 379–80 Kuttner, K.N.: and Bernanke, B.S 397 Kyriazis, D.: and Anastassis, C 437 La Porta, R et al 364 Laatsch, F.E.: and Klein, D.P 63 ladder options 658 ladder portfolio 775 Lakonishok, J et al 347, 516, 519, 545 Lamont, O.: and Thaler, R 485 Langer, E.J 25 large purchase financing: personal financial planning 7–8 last in first out (LIFO) 431, 529 Laster, D.S.: and Antunovich, P 326, 521, 522 Latane, H.A.: and Jones, C.P 514 Latzko, D.A 185 law of one price: price anomalies 485 law of small numbers 501 Learned, M.: and Lhabitant, F-S 357 Lee, C.: et al 172, 509, 522; and Swaminathan, B 348 900 Lee, I.H 545 Lee, J 49 Lee, S.: and Stevenson, S 282–3 Leeson, N 626 Legal & General cash trust 67–8 Legal & General UK Property Trust 90–1 Lehavy, R.: and Brav,A 28, 499 Leijonhufvud,A 405 Leistikow, D.: and Ferguson, R 173 Leland, H.E 565 Lepper, M.R.: and Iyengar, S.S 253–4 leptokurtosis 487–8; option pricing 708–9; and portfolio diversification 280–2 Lerman, Z.: and Levy, H 516 Lerner, J.S et al 28 level annuities 228; calculation 231–3 Levis, M 517 Levy, H.: and Lerman, Z 516; and Post,T 491 Levy, R 455, 491 Lewellen, J.: and Nagel, S 316 Lewis,A.: and Winnett,A 197, 361 Lhabitant, F-S.: and Learned, M 357 liability risk 21 Lichenstein, S.: and Fischoff, B 500 Liden, E.R 496 life assurance 20; endowment policies 204–5; friendly society policies 205; investment bonds 205–8; and related investments 202–13; term assurance 202–3; whole-of-life policies 203–4; with-profit funds 208–9; without-profit policies 203, 304 life cycle analysis: pension funding 236–9; post-retirement consumption maintenance 238–9; proportional postretirement pension 236–7 life expectancy: United Kingdom life-cycle investment hypothesis 407 lifestyling: pension fund management 220 limit orders 122–3, 125, 126, 462 Lin, C.H et al 28, 36 liquidity: capital asset pricing model (CAPM) 314–15; emerging market funds 364; institutional investors 555–7; property investment 89; theory of asset prices 245–7, 405, 406, 555–7 liquidity management: personal financial planning liquidity risk 16 liquidity trades 557–9 listing: stock exchanges 119 Liu,W 315; et al 514 Ljungqvist,A et al 252 Lo,A.W 537; et al 487 Lo,W.: and McKinlay, G 486 Locke, P.: and Mann, S 38 Lockwood, L.J.: and Gallo, G.J 196 Loewenstein, G et al 547 Lofthouse, S 634–5 London Inter-Bank Offer Rate (LIBOR) 775, 820, 822, 823 London Stock Exchange 125 Long-Term Capital Management 354, 357–8 long-term investment: asset value 8–9; personal financial planning 8–9; risk 8–9; stock market 8–9 long-term savings: Sandler report (2002) 253–6 longevity risk 45 Longin, F 645 Longstaff, F 485 look-ahead bias 526 Loughran,T 517 Lovatt, D et al 486 Lynch,W.A.: and Mendenhall, R.R 340 M&G Corporate Bond Fund 75–6 M&G Fund of Investment Trust Shares 183 M&G Index Tracker Fund 337–8 Macaulay’s duration 763–4, 765, 766, 768, 773–4, 792; behaviour 770–2; formula 766 MacBeth, J.D.: and Fama, E.F 325 McGreal, S et al 283 MacGregor, D.G et al 29 McKenzie, M.D et al 573 MacKillop, S 546 McKinlay, G.: and Lo,W 486 McKnight, P.J.: and Doukas, J.A 490 48Personal finance-Index 8/18/08 3:58 PM Page 901 INDEX McMillan, D.G.: and Speight, A.E.H 590 McRae,T 94 macroeconomic analysis 398–404; aggregate supply and demand 400; inflation and Phillips curve 400–2; interest rates 402–4; ISLM framework 398–400 Madhavan,A.: and Ming, K 340 Madrian, D.B.: and Shea, D 45 Magellan fund 199, 377 magnitude issue 492 Malkiel, B.G 225, 386, 521, 531, 533, 534; and Cragg, J.G 441; and Radisich,A 225 Malmendier, U.: and Shanthikumar, D 252 Management Buy-Outs (MBOs) 190 management risk 303–4 managerial capitalism 250 Mann, S.: and Locke, P 38 Mann,T.: and Dowen, R.J 199 Marais, D 447 Marcato, G.: and Key,T 93 Marcus,A.J 199, 377 margin system: stock index futures 574 Marhuenda, J.: and Forner, C 491 market anomalies 513–27; agency problems 522; beta 518; calendar effects 520–1; company reputation 521–2; data mining 523, 524, 527; dividend yield 516–17; earnings announcement surprises 513–14; impossible strategy testing 526; investment trusts 522; January effect 515, 520–1; liquidity on returns effect 523; mispricing 518–19; neglected firm effect 522–3; post-May prices 521; priceearnings ratio effect 516–17; price-to-book ratio 517–18, 519–20; risk premiums 519–20; size effect 514–15, 519–20; small firm effects 522; survivorship bias 525; value investing 516–18; weekend effect 520 market breadth 480 market depth 480 market efficiency 479–93; adaptive market hypothesis 537–8; allocative 479; analysts’ forecasts 535–6; degrees 537–8; fractal market hypothesis 538; informational 479–81; magnitude issue 492; mean reversion 488–9; operational 479; overreaction 488–9; price anomalies 484–6; and rational retail investors 533–5; selection bias 492; semi-strong form 482, 528–30; strong form 483, 530–7; types 479–81; weakform 481–2, 486–92 market orders 122, 126 market portfolio 286, 305, 306, 321, 322, 323 market risk 14, 318 market segmentation theory: interest rates 804, 808 market-makers: stock market trading 123–5 market-timing skills: fund manager performance 383–5 market-to-book ratio 428, 432–3, 437 marketing: investor classification 49 Markowitz diversification 262, 266, 290–1, 293, 299, 300, 341, 342, 505; and the 1/N strategy 283–5; asymmetric correlation 280–2; consistency 282–3; direct property investment 282–3; and downside risk 295–6; equations 268–76, 277, 293, 300; leptokurtosis 280–2; postmodern portfolio theory 294–6 Marsh, P.: and Dimson, E 70, 421, 535 Marshall, B.R et al 457–8 maturity matching: bonds 772, 792 Maury, R.V.: and Stone, B 43 maximin and minimax: risk measurement 50–1 Maximum investment plans (MIPs) 208 Mayer, C.: and Genesove, D 36, 38 Mazuy, K.: and Treynor, J.L 384 mean reversion: market efficiency 488–9 Mehra, R.: and Sah, R 546 Mei, J.: and Guo, L 363 Mendelson, H.: and Amihud,Y 523 Mendenhall, R.R.: and Lynch,W.A 340 mental accounting 344–5, 503, 507, 647, 668; heuristic simplification 30–1, 37, 290–1, 300 Meric, I et al 281 Merton, R.C 522 Metalgesellschaft 731 Michaely, R.: and Womack, K.L 452 Mikhail, M.B et al 535–6 Miles, D.: and Timmermann,A 517 Miles report: UK mortgage market 100–4 Mills,T.C 466 Ming, K.: and Madhavan,A 340 Minhas, R.S.: and Jacobs, E.M 66 minimax and maximin: risk measurement 50–1 Minimum Acceptable Return (MAR) 295 minimum variance hedges: hedge ratios 600 misleading marketing 49–50 mispricing: market anomalies 518–19 Mitchell, O.S.: and Utkus, S.P 45, 254 modified duration: bonds 763, 764, 766, 768 Modigliani, F 414 Modigliani squared measure: fund manager performance 372 momentum life-cycle hypothesis: style rotation 348–9 momentum strategies: and weakform efficiency 489–91 momentum trading 590; fund managers 198 monetary transmission mechanism: and stock markets 404–6 money duration: bonds 763, 767, 768, 779, 790 money illusion 71, 111, 421–2 Money Management 69 money market investments: currency derivatives 729–47; equity risk premium 70; foreign currency deposits 68–9; innovation 67; investment 901 48Personal finance-Index 8/18/08 3:58 PM Page 902 INDEX horizons 70; Legal & General cash trust 67–8; portfolio roles 66; relative performance 69–70; short maturity 65–8 money-purchase schemes: pensions 217, 218, 228 Montezuma, J 283 Montier, J 40, 151, 542, 562 mood: investment impact 33–4, 508–9 Moore,A 486 Moore, D et al 26 Moore, G.H.: and Boehm, E.A 396; and Cullity, J.P 395 moral hazard 4; assymmetric information 157, 158; and regulation 148–9, 160 mortgages: balloon 105; bond options potential 103–4; cappedrate 104–5, 113; collateralised loans as options 112–13; current account 106; discounted-rate 105; endowment 95, 96; equity release 106–7; fixed-rate 99–101; graduated payment 105; interest rate risk 103; Islamic 106; and long-term fixed-rate lending 100–1; Miles report on UK market 101–4; offset 106; payment equation 107–8; and property investment 87–114; repayment 95, 96–7; sharedappreciation 105–6; tilt 98–9; variable rate 88, 95, 96 Mosebach, M.: and Najand, M 407, 545 Moskowitz,T.: and Coval, J 291 moving averages: technical analysis 464–6 Muga, L.: and Santamaria, R 561 Mukherji, S 298 multiple listing 120 Murphy, R.J 379 musharaka: Islamic mortgages 106 Mussweiler,T.: and Schneller, K 463 mutual funds 163–201; benefits 163–4; beta death 326–7; commission 184–5; differences 164–8; dilution levies and adjustments 193–4; and Enterprise Investment Schemes 902 (EISs) 189–90; and exchangetraded funds (ETFs) 176–7; fair value pricing 193–4; and fund charge effects 177–85; high charge deterrence 185; and index funds 174–6; large fund families 198, 199; liquidity provision 194–6; performance measurement 196–9, 368–89; pound cost averaging 190–2; star performers and chance 199–200, 377; taxation and investment returns 185–8;Venture Capital Trusts (VCTs) 189–90 Myers-Briggs Type Indicator: personality 22 Nagel, S.: and Lewellen, J 316 Nahius, N.J.: and Jansen,W.J 397 Nair,V.B.: and Cremers, K.J.M 252 naive diversification 262, 283 Najand, M.: and Mosebach, M 407, 545 Nanda, S.: and Ahmed, P 347 narrow framing 507, 549–50; heuristic simplification 28, 353 NASDAQ stock exchange 120, 125 Naser, K.: and Pendelbury, M 432 National Pension Savings Scheme: United Kingdom 221–2 Neale, M.: and Northcraft, G 27, 92 neglected firm effect 522–3 Neukam, K.A.: and Hershey, D.A 44 Nevins, D 344 New York Stock Exchange (NYSE) 125 Niarchos, N.A.: and Alexakis, C.A 487 Niederhoffer, F.M.: and Osborne, M.F.M 486, 531 nifty-fifty stocks: and heuristic simplification 26–7 no-arbitrage band: bond futures 796; stock index futures 584–5, 586, 587, 588, 589 Nofsinger, J.R 39, 547, 548, 553; and Baker, H.K 510 noise trading 249, 538, 558; advertising 496; and behavioural finance 494–512; bounded rationality 496–7; inaccurate risk perception 503–5; media 496; overreaction 499–502, 545; prospect theory 503, 505–8; and rumours 494–7; stock index futures 589–92; uncertainty and correction 496; underreaction 497–9 non-cumulative preference shares 129 non-savers 42–4; materialism 43 non-systematic risk 14–15 normative social influence: bubbles and crashes 544 Northcraft, G.: and Neale, M 27, 92 Northern Rock crisis: United Kingdom 567 Norwich Union Sustainable Future UK Growth Fund 362 O’Brien, C et al 228 occupational pensions 214, 215, 216, 219–21; insurance company group schemes 219; multiemployer schemes 219–20; selfadministered 219, 220; transfers and unlocking 222–3 Odean,T 24, 38, 347, 500, 507; and Barber, B 24, 500, 550, 551 offset mortgages 106 Oliver, M.J.: and Pepper, G 245, 405, 472, 555, 557 Olsen, R.A 474, 563 Olson, K.R 43 omega measure: fund manager performance 379–80 open order 126 Open-Ended Investment Companies (OEICs) 163, 193–4; dilution levies and adjustments 193–4; fair value pricing 193–4; mutual fund differences 164–8; purpose 164; sale 165; value 165 opening purchase: options 616 opening sale: options 616 operating profit 428 operational efficiency 479 optimisation: index funds 336 optimism bias 500, 553; selfdeception 25 option cylinders 645, 659 48Personal finance-Index 8/18/08 3:58 PM Page 903 INDEX option theory: bonds and shares 677–9 options funds 648–61;Asian options 658; break-even points 653–5; cliquet options 658; Close UK Escalator 100 Fund 655–6; Constant Protection Portfolio Insurance (CPPI) 652; disaster insurance 656–8; exotic options and combinations 658; fiduciary call approach 648–9, 656, 658; ladder options 658; protective put approach 649–52, 657 order-driven systems: stock market trading 120–3 ordinary shares 128 Osborne, M.F.M 486; and Niederhoffer, F.M 486, 531 Osler, C.L 464 outcome bias: self-deception 25 overconfidence bias 661; bubbles and crashes 550–1; selfdeception 24, 25, 349 Overmeyer, I.: and Ryan, P 491 overreaction: bubbles and crashes 552–3; market efficiency 488–9; noise trading 499–502 ownership division: financial system functions Paas, L.J et al 291 Palm and 3Com: equity carve outs 485 Panchenko,V 563 Papke, L.E 254 Park, C-L.: and Irwin, S.H 473 Parker,W.D.: and Prechter, R.R 473 Parrino, R et al 252 Parrondo’s paradox: investment strategy 349–50 participating preference shares 129 passive core funds: index funds 341 Pastor, L.: and Stambaugh, R 315 Pearson, R.G.: and Emanuelli, J.F 524 Peers,A 530 Peles, N.: and Goetzmann,W 26, 197 Pendelbury, M.: and Naser, K 432 Pension Compensation Scheme 221 pension funds 223–4; accumulation 224–5; growth rate 225 Pension Protection Fund 152, 221 pensions 1, 214–41; additional voluntary contributions (AVCs) 214, 217, 223, 231, 244; Alternatively Secured Pension (ASP) 230–1; annuities 225–30; automatic scheme enrolment 45; career average revalued earning (CARE) scheme 217; company scheme balance sheets 233–5; defined-benefit 216, 217, 220–1, 233–5; defined-contribution 216, 217, 220; delayed contributions effects 239–40; demographic time bomb 1–2, 12, 243; diversification principle 231, 241; final-salary schemes 216, 217, 218, 219, 233–5; French state pensions reserve fund 215–16; fund management 220; income drawdown schemes 230–1; insurance company group schemes 219; life cycle analysis and funding 236–9; lifestyling 220; lump sum components 217–19; money-purchase schemes 217, 218, 228; National Pension Savings Scheme 221–2; occupational 214, 215, 217, 219–21; personal 217; phased retirement schemes 230–1; regulation 152; retirement saving behaviour influences 44–6; scheme types 216–19; state 214, 215; tax credit 214;Teachers’ Pension Scheme 218–19; transfers and unlocking 222–3; Turner Pensions Commission (2004) 222 Pensions Act (1995) 220, 235; minimum funding requirement (MFR) 235 Pensions Act (2004) 221, 223 Pensions Ombudsman 152 Pensions Regulator 152 Pepper, G.: and Oliver, M.J 245, 405, 472, 555, 557 Permanent Interest-Bearing shares (PIBs): bond prices 756 Personal Equity Plans (PEPs) 186 personal financial planning 5–9; budgeting 7; CORE principles 10–12; insurance 9; large purchase financing 7–8; liquidity management 7; long-term investment 8–9 personal investment decisions: age 17; choice under constraint 13; constraints 15, 16–18, 51; existing assets 17; family responsibility 18; income 17–18; income tax 18; investment characteristics 18–19; liabilities 17; objectives 13–14; psychology 13–53; risk management 20–2; risk types 14–16; taxation 18 personal pension plan 215 Pesaran, M.H.: and Timmermann, A 523 Peters, E.E 487, 538 Peterson, P.P.: and Chance, D.M 724 Pettit, R.R 530 phased retirement schemes: pensions 230–1 Phillips curve: inflation 400–2 Political effects: share prices 406–7 political risk 16 Pontiff, J 172 Pope, P.F et al 531 portfolio construction: active management 331–2; bonds 783, 808–9; bottom-up strategy 342; country versus sector diversification 342–3; emerging market funds 363–6; goals-based investing 343–6; growth and value stocks 346–7; hedge funds 350–7; index tracking 332–5; Parrondo’s paradox 349–50; passive management 332; socially responsible investing 359–63; stages 341–2; strategic asset allocation 343, 344; style investing implications 346–7; style rotation 348–9; styles 331–67; tactical asset allocation 343, 344; top-down strategy 342; value and growth stocks 346–7 903 48Personal finance-Index 8/18/08 3:58 PM Page 904 INDEX portfolio diversification 94, 200, 241, 261–300; 1/N strategy 283–5; asset allocation lines 289–90; asymmetric correlation 280–2; and behavioural portfolios 290–1; consistency 282–3; country versus sector 342–3; currency risk 277–8, 279; direct property investment 282–3; downside risk 295–6; efficiency frontier 267–8, 286, 289; expected return and risk 262–4, 268–76; foreign investments and risk 276–9, 281–2; Henderson Global Investors International Fund 280; home bias and familiarity 278; leptokurtosis 280–2; Markowitz approach 262, 266, 267, 277, 280–5, 290–1, 293, 300; Markowitz equations 27, 268–76, 293, 300, 341; and naive diversification 262; post-modern portfolio theory 294–6; principle 264–7; risk-free assets 286–9; systematic and non-systematic risk 266–7; and time diversification 296–8; valueat-risk (VaR) 291–4 portfolio immunisation: bonds 772–5, 792; dedicated portfolio construction 772, 792; duration matching 772–4, 792; maturity matching 772, 792 portfolio insurance 649, 652; bubbles and crashes 561, 568 portfolio trades 557–9 positive feedback trading 590; fund managers 543, 544 Post,T.: and Levy, H 491 post-modern portfolio theory 294–6 Poterba, J.: and French, K 291 Pound, J.: and Shiller, R.J 32 pound cost averaging 190–2 Prechter, R.R 43, 547; and Parker, W.D 473 precipice bonds 661–4 prediction markets: and semi-strong form efficiency 536–7 preference shares 84, 85, 128–9 preferred habitat hypothesis: 904 interest rates 808 premiums: investment trusts 166, 168–9, 170, 172–4 press coverage: investment 29 Presson, P.: and Benassi,V 551 price anomalies: callable bonds 485; equity carve outs 485; law of one price 485; market efficiency 484–6; reasons 484–5 price pressure hypothesis 340 price-earnings ratio 438–42, 447; backwards-looking 439; dividend payout rate 440; forward-looking 439; Gordon growth model 439–40, 442; historical average 439; regression analysis 440–1; required return rate 440; sector average 439 price-end biases: technical analysis 462 price-to-book ratio 346, 428, 432–3, 437; institutional ownership 517–18; market anomalies 517–18, 519–20 price-to-liquidation ratio 444–5 price-to-sales ratio 445 price-weighted indices 132–6 primary market selling: stock exchanges 126–8 primary-market dealing 118–19 principal-agent problems 4, 157–8, 255–6, 353 private equity: and institutional investors 244–5 professional investment analysis 450–2; conflicts of interest 452; inaccuracy 451; inconsistency 451; motivations 452; sale recommendations 451–2; share valuing 452; timeliness 451 profit and loss account: company accounts 428–9; earnings per share 429; EBITDA 429 projection bias 546 property companies 89–90 property investment: buy-to-let 89; buying your own home 87–8; diversification absence 88; gearing opportunities 88; indirect 89–91; liquidity 89; and mortgages 87–114; portfolio diversification 282–3; and property price determinants 91–2; and property unit trusts 89–91; risks 87–8; stock market investments comparison 94–5 property prices: anchoring 92–3; appraisal smoothing 92–3; and demand 91, 92; determinants 91–2; efficient market hypothesis 93–4; and supply 92; trend momentum 93–4; valuer and buyer emphasis 92 property unit trusts: and property investment 89–90 prospect theory 294, 503, 505–8, 647, 709; disposition effect 507; endowment effect 507; post-loss risk 507–8; psychology 34–8; and reference points 36–7 protective put approach: Constant Protection Portfolio Insurance (CPPI) 652; options funds 649–52, 657 Protopapadakis,A.A.: and Flannery, M.J 397 psychology: behavioural portfolios 290–1; and bias avoidance 40; catering theory of dividends 32; cognitive dissonance 197; disposition effect 38–40; emotion and mood 33–4, 508; escalation bias 36; heuristic simplification 26–31; personal finance 23–40, 494–512; personal investment decisions 13–53; prospect theory 34–8; self-deception 24–6; social dimension 32–3; socionomic hypothesis 33, 311; weather 33, 508 pull to par: bonds 702–3, 760 purchasing power parity (PPP): exchange rates 408 pure expectations theory: interest rates 804, 805, 806–8 put options 611–14, 621, 632–3; at-expiry profile 612–13; bubbles and crashes 554, 561; in-themoney 614, 633; intrinsic value 618–19, 633; and long versus short positions 633–7; pricing 703–7; prior-to-expiry profile 613–14; time value 613–14, 633 48Personal finance-Index 8/18/08 3:58 PM Page 905 INDEX put-call parity: Black-Scholes option pricing model 703–7 put-call ratio: technical analysis 469 quality assurance: investment services 152–4 quanto option 746 quote-driven systems: stock market trading 123–4 Rabinovich,A.: and Webley, P 41 Radisich,A.: and Malkiel, B.G 225 Rahman, S 573 Raines, J.P et al 555 Ramyar, R.: and Batchelor, R 455, 468 Randall, M.R et al 243 Rapson, D et al 359 ratio analysis 430, 438–53; accounting practices 449, 450; accounts-receivable-turnover ratio 446; acid-test ratio 446; coverage ratios 445–6; current ratio 446; distraction 450; dividend yield 443; earnings yield 444; earnings-per-share 443, 447; enterprise value (EV) 444; fed model 448–9; financial adequacy ratios 445–6; financial leverage ratios 445; general market movements 447–8; group account aggregation 449; inventory-turnover ratio 446; price-earning ratios 438–42, 447; price-to-liquidation ratio 444–5; price-to-sales ratio 445; problems 449–50; reporting dates 449; return on capital employed (ROCE) 444; shortterm solvency ratios 446; weighting ratio importance 450; yield gap 448–9; yield ratio 448–9; Z scores 446–7 Ray, R 536 Ready, M.J 466 real estate investment trusts (REITs) 89–90 real options: binomial option pricing model 723–4, 725 realised compound yields: bond prices 758–60 rebate interest: bond prices 756–7 redeemable preference shares 129 redemption yields: and bond prices 751–62 regression analysis: price-earnings ratio 440–1 regulation: comparative systems 154–5; and consumer confidence 147; cost 148; economies of scale and delegated monitoring 146; enforcement theory 155; European Union (EU) 156–7; financial advisers and clients 151; Financial Ombudsman Service 152; Financial Services Authority (FSA) 150–1; hazards 147–9; institutional capture 147; market imperfection correction 145–6; and minimum standards confidence 146–7; moral hazard 148–9; pensions 152; and quality assurance 152–4; rationale and conduct 145–60; and selfregulation 147–8, 149–50; United Kingdom 150–4 Reichtenstein,W 179 Reinganum, M.R 514, 516 relative strength: technical analysis 468, 469 Remolona, E.M.: and Fleming, M.J 752 rental property 19 renting property: advantages 87; disadvantages 87 repayment mortgages: characteristics 96–7; payment equation 107–8, 109 representativeness bias 456, 457, 460, 470, 501, 502, 521–2, 549–50, 559, 565; heuristic simplification 26, 27 resource pooling: financial system functions 3–4 Retail Price Index (RPI): inflation 63–4, 79, 761 retirement saving behaviour influences: automatic scheme enrolment 45; financial activation 44; financial inhibition 44; focus group research 44; future time perspective 44; knowledge 44; psychology 44–6; risk tolerance 44; save more tomorrow (SMarT) 45–6 retrievability bias 502, 553; heuristic simplification 28–9, 353 return on capital employed (ROCE): ratio analysis 444 returns-based style analysis 383 reversal patterns: head-andshoulders configuration 462–3, 464; technical analysis 462–4 rho 699 Rhodes, M 386–7, 532 Richards,A.J 524 Richardson, M.: and Boudoukh, J 397 rights issues 127–8 risk 14–16; existing assets 17; family responsibility 18; fund manager performance 369, 370–1; hedge funds 356; inaccurate perceptions 503–5; income 17–18; investor age 17; and portfolio diversification 262–4, 266–7; portfolio diversification and foreign investments 276–9, 281–2; stock index futures 589–92; vividness 505 risk management 20–2; adviser and client perception 21–2, 23; misselling and perception 23; valueat-risk (VaR) 291–4 risk measurement: maximin and minimax 50–1 risk tolerance: saving 44 risk-free assets: portfolio diversification 286–9 Ritter, J.R 394 Roberts, H 486 Roberts, R 352 Rodney, B.: and Booth, P 111 Rogoff, K.: and Froot, K 408 Rohwedder, S.: and Attansio, O.P 215 Roll, R 281, 494, 516, 517, 524; and Cornell, B 532 Roll critique: capital asset pricing model (CAPM) 323 Rosenberg, B et al 517 Ross, S.A 173 Roy, D.: and Feldman, B 661 Royal Dutch 348, 485 905 48Personal finance-Index 8/18/08 3:58 PM Page 906 INDEX Rozeff, M.S.: and Kinney,W.R 520 Rudd,A.: and Kahn, R.N 386 Rudd, D.P.: and Flanegin, F.R 472 Ruenzi, S.: and Kempf,A 27, 253 rumours: and noise trading 494–7 rump stocks: gilts 80 Russell 2000 Index: reconstitution 341 Ryan, P.: and Overmeyer, I 491 S&P 500 Index 487, 514; and reconstitution 340, 341 Saez, E.: and Duflo, E 33 Sah, R.: and Mehra, R 546 Salmon, M.: and Hwang, S 543 sample size bias 504 sample size neglect bias 456 Samuelson, P.A 540 Samuelson,W.: and Zeckhauser, R 28 Sandler report (2002) 175, 253–6 Santa-Clara, P.: and Goyal,A 326 Santamaria, R.: and Muga, L 561 Sapp,T.: and Tiwari,A 198, 315 Sarno, L et al 808 save more tomorrow (SMarT): retirement saving behaviour influences 45–6 saving ratios: economic growth 398 saving and self-control 40–3; environmental controls 41; expenditure control techniques 41; habitual non-savers 42–3; materialism 43; rules of thumb 41–2; time horizon 41 Schachter, S et al 32 Schiereck, D et al 490 Schneller, K.: and Mussweiler,T 463 Schultz, P.: and Battalio, R 707 Schwartz, R.A 563 Schwarz, N et al 509 Scottish Widows 42, 43 secondary-market dealing 118–19 security market line (SML): anticipated return estimates 309–11; capital asset pricing model 306–7, 319, 321; supply and demand 311–12; and trading rules 307–9 selection bias 492 self-attribution bias 499–500 906 self-control: personality traits and social mood 43; and saving 40–3 self-deception 24–6; hindsight bias 24–5; memory 26; optimism bias 25; outcome bias 25; overconfidence 24 Self-Invested Personal Pension (SIPP) 224 self-regulation: investment business 147–8, 149–50 semi-strong form efficiency 482, 523; analysts’ forecasts 535–6; event studies 528–30; and market anomalies 513–27; mutual fund performance 531–3; non-public analysis 531–3, 535–6; prediction markets 536–7; and rational retail investors 533–5 Sethi-Iyengar, S et al 254 settling payments: financial system functions Shadwick,W.F.: and Keating, C 379 Shafir, E.: and Tversky,A 253 Shallheim, J.: and Kato, K 520 Shanken, J.: and Kothari, S.P 491, 517 Shanthikumar, D.: and Malmendier, U 252 share types: stock exchanges 128–9 shared-appreciation mortgages 105–6 shareholders’ funds: company accounts 427, 428 Shariah law 359–60, 363 Sharpe,W.F 382, 531 Sharpe measure: fund manager performance 371, 373 Shea, D.: and Madrian, D.B 45 Shefrin, H 546; and Statman, M 37, 38, 290, 291, 345, 507, 521; and Thaler, R 40 Shell 348, 485 Shiller, R.J 424, 487, 488, 509, 548, 552; and Campbell, J.Y 448; and Jung, J 540; and Pound, J 32 Shleifer,A 155; and Barberis, N 347; and Summers, L.H 496, 545; and Vishny, R 353, 496 short interest ratios: technical analysis 468, 469 short maturity investments 65–8; bills 66; certificate of deposit (CD) 65; commercial paper 66 short selling 350–1, 353, 356, 526 short-term solvency ratios 446 short-termism 247–50; dividend payment pressure 250; fund managers 249–50; hostile takeover bids 250; stock market investors 247–8 Shumway,T.: and Hirshleifer, D 33, 508, 553 Siebenmorgan, N.: and Weber, M 284 Siegel, J 395, 396 Siegrist, M.: and Keller, C 47, 48 Simon, D.P.: and Hunter, D.M 282; and Wiggins, R.A 469 Simon, H 537 simple interest: and compound interest 55–7 single index model: capital asset pricing model (CAPM) 305–6, 313–14 Sirri, E.: and Tufano, P 347 size effect 508; arbitrage pricing model 515; behavioural finance 515; capital pricing asset model (CAPM) 515; market anomalies 514–15, 519–20; price-earnings ratio effect 515, 516 skewness 356, 357, 380 Slovic, P.: and Alhakami,A.S 311; et al 547 smart money effect: new cash flow performance 197–8 Smith, G.: and Anderson, J 522 Smith, M.P 251 Smith,V.L 544 snake bite effect 546 social mood: bubbles and crashes 546–8; investment 32–3, 397, 508–9 socially responsible investing (SRI): Dow Jones Sustainability Index 361; ethical screening 359–60; Goodmoney industrial Average 360–1; long-term commitment 361; performance 360–1; portfolio construction 359–63; property funds 359; religion 359–60, 363 48Personal finance-Index 8/18/08 3:58 PM Page 907 INDEX socionomic hypothesis 33, 311 Song,W-L 251 Sornette, D.: and Johansen,A 563 Soros, G 532–3 speculation: stock index futures 572–3, 579, 587–9; stock options 622–31 Speight,A.E.H.: and McMillan, D.G 590 split-capital investment trusts 167, 673–7; maturity date 673, 675; risk 676; zero dividend preference shares 673, 675, 676, 679 stakeholder pension 214, 215, 217, 244 Stambaugh, R.: and Pastor, L 315 Stambaugh, R.F.: and Keim, D.B 520 stamp duty 87 Stanford, J.D.: and Drew, M.E 225 Starks, L.: and Gillan, S 251; and Hartzell, J.C 251 Statman, M 359; and Clarke, R.G 141, 545, 546; et al 24, 38; and Fisher, K.L 424, 494, 548; and Shefrin, H 37, 38, 290, 291, 345, 507, 521 Stekler, H.O.: and Kolb, R.A 777, 778 stepped preference shares 129 Stevenson, S 283; and Lee, S 282–3 Stiglitz, J.: and Grossman, S 532 stock exchanges 117–30; bid-offer spreads 124–5; functions 117–18; hybrid trading systems 125; listing 119; multiple listing 120; national 119; order types 126; order-driven systems 120–3, 125; over-the counter (OTC) 120; primary market selling 126–8; primary and secondary markets 118–19; quote-driven systems 123–4; regional 119; share types 128–9; trading systems 120–6; types 119–20 stock index futures 353, 571–80; 130/30 funds 577–8; arbitrage pricing 581–7; basis risk 597, 602; closing out 574–5; contracts for difference (CFD) 576–8; equity swaps 578–9; and expected future spot prices 592–3; fair value premium 581, 589; futures funds 575–6; hedge imperfection sources 597; hedge ratios 597–601; hedging 571–2, 573, 587–9, 594–603; margin system 574; market exposure 598, 603; no-arbitrage band 584–5, 586, 587, 588, 589; noise trading 589–92; prices 581–93; risk 589–92; speculation 587–9; speculation and arbitrage 572–3, 579; spot/future index level guarantees 601–3 stock indices 131–44; arithmetically-averaged 139, 143; broad-capitalisation 139; completeness 139–40; constituent stock changes and adjustment 137–9; and dividends 141; emerging markets 142; evaluation 139–43; functions 139; geometrically-averaged 139, 143; index funds 333, 334; index weighting 132–6, 141–2; and institutional investor performance benchmarking 142, 143; investability 139–40; investor acceptance 140; multicountry weighting 142; types 131–2 stock market cycles: and business cycles 394–8 stock market investments 2, 7–8; long-term savings 9; property investment comparison 94–5; risk 94 stock options 607–21;Americanstyle 607, 618–19, 620–1, 702, 718–22; binomial option pricing model 711–25; Black-Scholes option pricing model 680–9, 690–710; boundary conditions 611, 618–21; call options 607–11, 620; crash options 645–6; European-style 607, 619–21; ex-dividend date and pricing 684, 688, 689; exchangetraded 607, 614; gearing 622–5; hedging 632–46; hedging anticipated purchases 637–9; interest rates and pricing 683–4, 703, 722; intrinsic value 681, 682; long versus short positions 633–7; market practices and terms 616–18; option cylinders 645, 659; option series 616; over-the-counter (OTC) 607; price determinants 680–4; pricing models 680–725; put options 611–14, 621; replication costs and pricing 680; speculation 622–31; and synthetic options positions 639–43; time value 681–3, 684; vega 627; vertical spreads 643–5; volatility and pricing 682–3, 684, 693, 703, 722; volatility trading 625–30; writing options 614–16, 633–5 Stone, B.: and Maury, R.V 43 stop order 126 straddles: volatility trading 625–7, 628; yield curve risk 816–17 strangles 663; volatility trading 628, 629, 630 stratified sampling: index funds 335–6 Strebel, P.J.: and Arbel,A 522; and Carvell, S.A 515 strike price: options 607, 611, 612, 614 Strong, N.: and Xu, X.G 278 strong form efficiency 483; evidence 530–7; insiders’ trades 530–1 structured capital-at-risk products (scarps) 661–4 structured products 647–68; collateralised debt obligations (CDO) and sub-prime crisis 667–8; high yield funds 661–4, 668; options funds 648–61; variable principal bonds 665–7 Sturm, R.R.: and Atkinson, S.M 199 style analysis: fund manager performance 382–3; holdingsbased 383; returns-based 383 style investing 346, 347–8; active 346; fundamentalists 347–8; passive 346; and style rotation 348–9; switchers 347–8 907 48Personal finance-Index 8/18/08 3:58 PM Page 908 INDEX style jitter 346 style rotation 348–9; momentum life-cycle hypothesis 348–9 sub-prime mortgage crisis: and collateralised debt obligations (CDO) 667–8 Sullivan, R et al 466, 520 Summers, L.H 488; and Shleifer,A 496, 545 Sunder, S 529 surplus funds investment: financial system functions survivorship bias 378, 525; hedge fund analysis 355, 356 Swaminathan, B.: and Lee, C 348 Swank, P.B et al 9, 297 swaptions 820 Swedish Premium Pension Scheme: heuristic simplification 31 Sweeney, R.J 487; and Bremer, M.A 519 SWIP Islamic Global Equity Fund 363 Swisher, P.: and Kasten, G.W 295 synthetic bond portfolios 798–801 synthetic index funds 338–9; advantages 339; disadvantages 339 synthetic options positions 639–43 Szykman, L.: and Agnew, J.R 253 Taffler, R.J.: and Breton, G 432; and Tuckett, D.A 548–9 Tang, L et al 49 taxation: and mutual fund investment returns 185–8; personal investment decisions 18 Taylor, S.J 466 Teachers’ Pension Scheme 218–19 technical analysis 454–75, 481, 510, 565; and behavioural finance 455–7; chart patterns 459–66, 470–1; crowd psychology 472–3; Dow theory 467; Elliot wave theory 467–8; Fibonacci numbers 467–8; filter rules 468–9, 487; and game-playing 471–2; moving averages 464–6; mutual fund cash holdings 469; nature 454–5; predictive power 487; price charts 457–9; priceend biases 462; price/trend 908 channels 459–62; profitability 473; put-call ratio 469; resistance level 461–2; relative strength 468, 469; reversal patterns 462–4; risk and profitability 473; self-fulfilling prophecies 472; short interest ratios 468, 469; support level 461–2, 463; trading ranges 457, 460–2; transaction costs 473–4; usefulness 471; and weak-form efficiency 492–3 Templeton,W.K.: and Dolvin, S.D 299 term assurance: life assurance 203–4 Tetlock, P.C 496 Thaler, R 41; and DeBondt,W.F.M 489, 501, 502, 508, 519, 552, 553; and Lamont, O 485; and Shefrin, H 40 Thaler, R.H.: and Benartzi, S 29, 45–6, 254, 291, 457 theta 699 Thomas, D.C.: and Gemmill, G 172 time diversification: portfolio risk 296–8 time value 633, 637, 678, 681–3, 684, 720; call options 610, 611, 623; put options 613–14 time-series analysis: company accounts 430; inflation 430–1 Timmermann,A.: and Blake, D 385; and Miles, D 517; and Pesaran, M.H 523 Titman, S.: and Daniel, K 520; and Grinblatt, M 385; and Jegadesh, N 486, 489 Tiwari,A.: and Sapp,T 198, 315 Tobin’s q: company accounts 432–4 Tomsett, M.: and Holmes, P 590 Tonks, I.: and Gregory,A 533 Tourani-Red,A.: and Kirkby, S 505 Tower, E.: and Harney, M 447 Traded index securities (TRAINS) 177 transmission mechanism: monetary policy 404–6 Treasury bills 64, 66 trend statements: company accounts 430 Treynor, J.L.: and Mazuy, K 384 Treynor measure: fund manager performance 371 Tuckett, D.A.: and Taffler, R.J 548–9 Tufano, P.: and Sirri, E 347 Tumarkin, R.: and Whitelaw, R.F 504 Turner, J 45 Turner Pensions Commission (2004): United Kingdom 222 Tversky,A.: and Kahneman, D 29, 92, 468, 499, 502, 510, 545; and Shafir, E 253 undated gilts 79; volatility 83 underreaction: noise trading 499–502 unit trusts 163; fair value pricing 194; mutual fund differences 164–8; sale 165; trustee role 164; value 165 unit-linked annuities 229 United Kingdom (UK): investment business regulation 150–4, 156, 159; and long-term fixed-rate lending 100–4; Miles report on mortgage market 101–4 United States of America (USA): long-term fixed-rate lending 100–1, 102, 104 Universities Superannuation Scheme 219 unweighted indices 132–6 US Savings and Loans Associations 100–1 Utkus, S.P.: and Mitchell, O.S 45, 254 value investing: market anomalies 516–18 Value Line Investment Survey 521 value stocks 346–7 value-at-risk (VaR): fund manager performance 378–9; investor risk preferences 294; risk management 291–4 value-weighted indices 132–6, 140, 141; free float basis 141 Van de Velde, E et al 360 Van Eaton, R.D.: and Conover, J.A 20 Vandewaller, N et al 563 48Personal finance-Index 8/18/08 3:58 PM Page 909 INDEX variability analysis: company accounts 430 variable interest rates 58 variable principal bonds 665–7 Varki, S et al 462 vega 699 Venture Capital Trusts (VCTs) 189–90, 244; tax advantages 190 Vergin, R.C 396 Verhofen, M.: and Ammann, M 508 Vermeesch, D.: and Hauser,T 343 vertical spreads 643–5 Vespro, C 340 Vishny, R.: and Shleifer,A 353, 496 volatility trading: butterflies 628, 629, 630; long straddle 625–6, 628; short straddle 625–7; stock options 625–30; strangles 628, 629, 630 Volkman, D.A 385 Volpin, P.F.: and Cocco, J.F 256 Vuolteenaho,T.: and Campbell, J.Y 518 Wall Street Journal 535, 777 Walter,A.: and Weber, F.M 198, 542, 543 Wang, P.: and Day,T.E 474 Wang, S.: and Herzberg, M.M 536 warehousing: interest rate swaps 822–3 warrants 669–70; capital fulcrum point 670; covered 670; servicing costs 669 Watson, J.J 43 weak-form efficiency 481–2; contrarian strategies 489–91; empirical evidence 486–92; mean reversion 488–9; momentum strategies 489–91; overreaction 488–9; and technical analysis 492–3; volatility serial correlation 491–2 Weber, E.U et al 505 Weber, F.M.: and Walter,A 542, 543 Weber, M.: and Biais, B 501; and Kilka, M 505; and Siebenmorgan, N 284; and Welfens, S 39 Webley, P.: et al 361; and Rabinovich,A 41 weekend effect: market anomalies 520 Weidig,T et al 377, 378 Weigand, R.A 198 Weigel, E.J 384–5 Welch, I 545 Welfens, S.: and Weber, M 39 Wermers, R 225 Whaley, R.: and Bollen, N.P.B 709 Whitbeck,V.S.: and Kisor, M 440–1 Whitelaw, R.F.: and Tumarkin, R 504 whole-of-life policies: life assurance 203–4 Wiener process 702 Willborn,W.: and Karapetrovic, S 153 winner–loser problem 489 Winnett,A.: and Lewis,A 197, 361 with-profit funds 208–11; criticisms 212–13; financial strength 211–12; free asset ratio 211; information deficit 212; market value adjustment 212; misnomer 212; risk capital margin 210, 212; risk reduction 210; smoothing 208, 209, 211; terminal bonus 208, 210; transfer value 212–13 with-profits annuities 229 Wolverton, M.L.: and Diaz, J 93 Womack, K 28, 499 Womack, K.L.: and Michaely, R 452 Wood, G.E.: and Booth, P 227 Woolridge, J.R 535 world-event risk 16 Worldcom 157–9 writing options 614–16, 633–5 Wu, L.: and Foresi, S 709 Wubbels, R.E.: and Glickstein, D.A 467 Wurgler, J.: and Baker, M 424 Xu, X.G.: and Strong, N 278 Xue, X.H.: and Keppler, M 521 Yao, R et al 22, 546 yield curves: and bond portfolio construction 808–9; bond returns 322–3; butterfly spreads and hedging 817; expectations with risk premium theory 804, 807–8; forward interest rates and expected future interest rates 809–12; forward yield curve 812; hedging and futures 814–17; and interest rate futures 804–25; market segmentation theory 804, 808; preferred habitat hypothesis 808; and pure expectations theory 804, 805, 806–8; straddles and hedging 816–17 yield gap: ratio analysis 448–9 yield ratio: and ratio analysis 448–9 Yook, K.: and Everett, R 345 Z scores: ratio analysis 446–7 Zeckhauser, R.: and Samuelson,W 28 zero coupon gilts 80 zero-beta capital asset pricing model 324–5 zero-cost options 746 Zielonka, P 457 Zweig, M.E 49, 396 Personal Finance 39 909 ... of personal finance and investments.The book will be essential for students and researchers engaged with personal finance, investments, behavioural finance, financial derivatives, and financial... Approach and Financial Derivatives:An Introduction to Futures, Forwards, Options and Swaps Personal finance- FM 8/18/08 2:38 PM Page ii Personal finance- FM 8/18/08 2:38 PM Page iii Personal Finance. .. is available from the British Library Library of Congress Cataloging in Publication Data Redhead, Keith, 194 9Personal finance and investments : a behavioural finance perspective / Keith Redhead