Fin200 Finance Effective Market Theory Assessment Answers

Solution 1

With the shifting trend of people towards investment to secure their future, many Australians have been showing interest in superannuation’s. This is the step taken by the Australian Government in which 9% of their income is transferred into superannuation schemes so that the benefit of savings can be enjoyed by the individuals after their retirement. These individuals are mainly attracted towards two types of superannuation plans which are:

• Defined Benefit Plan - As the name suggests, in Defined Benefit Plan the benefit paid to the employees is based on number of constraints which are put into a formula to get the fixed outcome. The constituents who are considered while calculating benefit from desired benefit plan includes employee’s final average salary, their age and number of his employment years. The formula for calculation of desired benefit plan is:

 Retirement Benefit = Benefit salary length of membership lump - Sum factor average service fraction.

For the employees working in tertiary sector who choose Desired Benefit Plan, their contribution from superannuation funds is pooled and invested in a selection of assets which is determined by the service provider they choose. As the benefit the employee will get is purely determined by the formula, their investment in the asset doesn’t affect their final payout and is completely irrelevant. This investment is the concern for the company and once registered, the company is liable to pay the employee the desired amount. This also implies that the registered person has a fixed benefit and he doesn’t get advances from profit on assets and giving annual bonuses entirely depends on the will of the company. Though this is not guaranteed, it forms a small proportion of the benefits the employee will get.

• • Secure Fund- In this investment the Australian Government provides a fixed interest on the securities and cash.
  • Stable Fund- In this investment also the interest on securities and bond are fixed but the investor gets to invest his savings in domestic and overseas shares and properties.
  • Trustees’ Selection Fund- In trustees selection fund the investor gets to select between option of investments like overseas or domestic shares, infrastructure or private equity investments, property assets etc.
  • Shares Fund- In this the employee can choose only between two options i.e. domestic and overseas share. This type of investment can be distinguished from other based on the risk and return. The secure fund is the least risky investment with the lowest rate of return which contrasts with the Secure Fund which carries the highest risk and has the highest rate of return. The employees who choose the Investment Choice Fund gets the retirement payout which entirely depends on the investment strategy they choose which is directly linked with the associated risk. (Bovbjerg, 2010)

Apart from this many companies in Australia are giving many pension and investment options to the individuals after their retirement. These options are provided in Investment Choice Plan and are described below (Bovbjerg, 2010):

• Indexed Pensions- This plan provides a fixed pension to the employee which is directly linked to the inflation rate of the market. The pensioner gets the benefit till his death and after that the benefit is transferred to the spouse or dependents of the individual.
• Single Life Indexed Pensions- This scheme provides an income higher than the standard indexed pension scheme but the benefits of this scheme are not transferrable after death.
• Allocated Pensions- Allocated pensions provides a regular access to the capital of the individual with the option to invest in any of the four available options. In this scheme the balance is transferrable after the death.
• Roll-Over-Options- the Roll over Options give the benefit of transferring the retirement fund into personal or industry superannuation schemes or in an approved deposit or a retirement savings account.
• Part-Cash Distribution- the Part-Cash Distribution give the employee the option of taking a part of their savings and using it for personal use and investment purposes. The participants are also allowed to choose both the options. The individual is required to be careful while choosing this scheme and should consider of this meets his income and lifestyle requirements. This scheme is highly affected by the factors such as effects of inflation rate and the time value of money.

Discuses above are some of the schemes provided by companies in Australia. Below are the discussions and factors which are needed to be considered by the individuals before investing into any kind of superannuation scheme (SRG Finance, 2017; Shah, 2013; U.S. Securities and Exchange Commission, 2017).

1. Fees-Lower the fees, better the investment. The account fee can have a negative impact on the savings of the individual and his payout at the time of his retirement. The fees can range from hundreds to thousands of dollars which entirely depends on the superannuation scheme the individual chooses. So it is very important to study the market carefully and choose between the service providers while making an investment decision.
2. Investment options-It is essential for a good superannuation scheme to provide with a number of investment opportunities which carries the minimum risk and fulfils all the requirements of the individual. It is expected from the person to compare the investment options or funds which have a similar mix of shares, case and interest. It only a decade is left in the retirement of a person he is recommended to invest in Australian or International shares for maximum benefit. Apart from this, it is best if he goes with a low cost industry or a fund which is flexible enough to give you an option to choose between the types of shares to buy.
3. Extra benefits- The employer is only permitted to pay 9% into the superannuation fund but in order to reap more benefits at the time of retirement the individual can contribute extra money himself and receive a bigger payout. It is recommended to choose a flexible super fund that is flexible and provides the individual with long term benefits.
4. Performance-While assessing the performance of the super funds, it is required to look at trends over the five tear period and not only the last year. The person should keep in mind that the investment is a long term so its performance over a longer period of time should be analyzed and accordingly the decision should be made. Apart from this the taxes and the fees of investment is also the constraints to be considered.
5. Insurance-Many industries offer a lifetime cover on income, life, health and many more. While choosing a superannuation fund, the individual should check the cover it offers and how much will it cost. It is seen that many companies which offer investments at low cost doesn’t provide this cover and even if they provide it is of very low value. So this is the factor that should be considered while choosing different superannuation funds.
6. Services-Another factor to be considered while choosing an investment plan is if they provide financial planning and investment advice which is in the favour of the investor. It is essential to do a proper research and analyze what are the different kinds of services different funds provide (Becker, 2017; SRG Finance, 2015).

After analyzing the different kind of factors we will now discuss about the time and value factors which are required to be considered by the employee before deciding upon superannuation decision (Host Plus, 2016):

• Interest rate risk - Negative and positive changes in the interest rates can affect the value of capital return on the superannuation investment.
• Market risk -Changes in the market related factors can create an environment which can have direct or indirect impact on the value of investment in the fund.
• Underlying investment risk - Underlying investment risks such as changes in the management of the company can also affect the value of the investment.
• Legislative risks -There can be circumstances in which the laws can change which can affect the benefits of the individual. For example, the change in tax rate levied on the investment can have a long term impact on the benefits.
• Liquidity risk -It should be remembered that for an investment to be liquidated quickly it should be sold at a discount which can have negative impact on the performance of the investment.
• Timing -The duration of time for which the investment is done can also affect the withdrawal benefit amount (Steiner, 2017).
• Currency risk-If a person invests in overseas property or shares, the fluctuations in the currency can affect the value of your investment. For ex. If a person has invested in Australia, the fluctuation in Australian dollar can affect the value of investment made. In order to mitigate international investments it is required to be hedged.
• Redemption/ switching risks-This is another factor related with the issue of time. The delay in the processing of the commencement of switching the investment can also affect the value as the investor may lose the opportunity to invest because of this delay.

It can be seen that there are number of elements which can affect the decision of choosing an investment option. So it is required to so a proper market study and analyze all the factors before choosing an investment strategy. If you’re about to switch the funds it should be made sure that the fees are low and the fund provides good returns.

Solution 2

Effective Market Theory (EMH) is an investment theory according to which it is not possible for an investor to beat the market because the efficiency of the stock market causes the price of existing shares to always reflect and incorporate the relevant information which can cause other investors to take interest in the opportunity, thus intensifying the competition. The theory states that the stocks in the share market are always traded at the fair value which makes it impossible for the investors to buy or sell shares at high and low values. In other words, it comprises them to purchase undervalued stock or sell them at inflated prices. So it makes it hard for the investor to outperform the market by the means of expert stock selection or by market timing. Thus the only way left with the investor to yield higher profits and return on investment is by taking risks and purchasing riskier investments (Investopedia, 2017). Owing to certain reasons it can be said that the efficient markets hypothesis does not imply that the portfolio selection is required to be done with a pin. Discussed below are some reasons which support the statement (Gitman & Hennessey, 2008; Brealey, et al., 2012):

• Perfect information is the criterion that assumes that the manager has to assume both complete information and the perfect ability to process all of it. The information is somehow always incomplete, sometimes asymmetric and too abundant which makes it hard to interpret the information correctly (Morning Star, 2017).
• According to the EMH, every investor enters the market of trading with the objective of getting the best returns which creates many risk and return objectives. Every investor has the reason which drives his will to push the ‘buy’ and ‘sell’ button. This reality of the market makes the nature of the price inefficient to the needs of the investor. The price fluctuation is thus an average of the needs of thousands of underlying investors (Lee, et al., 2009).
• The EMH also assumes that every investor is aiming towards getting highest returns along with higher risks. Still there are a high number of market participants who are not in alignment with this goal (Pettinger, 2009).
• It is the responsibility of the manager to make sure that the portfolio is well diversified. It is required to keep in mind that the large number of stocks is not the only reason which ensures the diversification as they all may be of the same industry and hence the portfolio will reflect the similar nature (Association of Corporate Counsel, 2017).
• The manager must ensure that the portfolio made by him is appropriate for his client and fulfils all his requirements. In the case where the client chooses pension fund, the manager should choose the safe investments i.e. choosing between stocks or bonds or combined portfolios offering lower beta.

A pension fund manager is equipped with certain goals which he has to achieve. These goals are target return and risk control goals. Throwing darts blindly at the stock page may help him to get diversified portfolios but then there is no way left which will help him to control the expected rate of return or avoiding the risk which is associated with the resulting portfolio (Read, 2012).

References

Association of Corporate Counsel, 2017. Effective Market Hypothesis. [Online]  Available at: https://acla.acc.com/documents/item/1325 [Accessed 25 May 2017].

Becker, M., 2017. The Five Most Important Factors for Your Investment Success. [Online]  Available at: https://www.thesimpledollar.com/five-most-important-factors-for-investment-success/ [Accessed 25 May 2017].

Bovbjerg, B. D., 2010. Defined Benefit Plans: Proposed Plan Buyouts by Financial Firms Pose Potential Risks and Benefits. s.l.:DIANE Publishing.

Brealey, R. A., Myers, ‎. C., Allen, ‎. & Mohanty, P., 2012. Principles of Corporate Finance. s.l.:Tata McGraw-Hill Education.

Gitman, L. J. & Hennessey, S. M., 2008. Principles of Corporate Finance. Canada: Pearson Education .

Host Plus, 2016. Section 4. Risks of super. [Online]  Available at: https://pds.hostplus.com.au/4-risks-of-super [Accessed 25 May 2017].

Investopedia, 2017. Efficient Market Hypothesis - EMH. [Online]  Available at: https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp [Accessed 25 May 2017].

Lee, A. C., Lee, J. C. & Lee, C. F., 2009. Financial Analysis, Planning & Forecasting: Theory and Application. s.l.:World Scientific.

Morning Star, 2017. Efficient Market Hypothesis. [Online]  Available at: https://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx [Accessed 25 May 2017].

Pettinger, T., 2009. Efficient Market Hypothesis. [Online]  Available at: https://www.economicshelp.org/blog/1661/economics/efficient-market-hypothesis/ [Accessed 25 May 2017].

Read, C., 2012. The Efficient Market Hypothesists: Bachelier, Samuelson, Fama, Ross, Tobin and Shiller. s.l.:Springer.

Shah, N., 2013. How to choose the right investment plan?. [Online]  Available at: https://www.moneycontrol.com/news/business/personal-finance-business/how-to-chooseright-investment plan-1658919.html [Accessed 25 May 2017].

SRG Finance, 2015. 7 Factors to Consider in Choosing a New Super Fund. [Online]  Available at: https://googleweblight.com/i?u=https://www.srgfinance.com.au/blog/7-factors-to-consider-in-choosing-a-new-super-fund/&grqid=a5hNQ0jl&hl=en-IN [Accessed 25 May 2017].

SRG Finance, 2017. 7 Factors to Consider in Choosing a New Super Fund. [Online]  Available at: https://www.srgfinance.com.au/blog/7-factors-to-consider-in-choosing-a-new-super-fund/ [Accessed 25 May 2017].

Steiner, S., 2017. Saving money or investing: Which is more important over time?. [Online]  Available at: https://www.bankrate.com/investing/saving-money-or-investing-which-is-more-important-over-time/ [Accessed 25 May 2017].

U.S. Securities and Exchange Commission, 2017. Financial Navigating in the Current Economy: Ten Things to Consider Before You Make Investing Decisions. [Online]  Available at: https://www.sec.gov/investor/pubs/tenthingstoconsider.htm [Accessed 25 May 2017].