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Chapter 23 Review and behavioural finance 665

This does not mean that the market share price is perfectly ‘correct’ or ‘accurate’ at any

point in time. It does, however, imply that market share price is an unbiased estimate of

the true value of the share investment. While actual market prices may fluctuate in a ran-

dom fashion around the ‘true’ value, investors cannot consistently outperform the market

(Smith, 2001).

Financial theory and practice

A good finance theory is one that offers useful explanations of existing behaviour and

provides a guide to future behaviour. We frequently find that rather restrictive assump-

tions are made in developing financial models. For example:

1 All markets – not just capital markets – are perfectly competitive.

2 Information is perfect and costless.

3 Transaction costs are zero.

4 No taxes exist.

These assumptions lead naturally to certain propositions that can be questioned.

First, only shareholders really matter. A perfect labour market implies that managers

and workers have sufficient mobility and can always find other equally attractive

alternative employment. Second, shareholders are only interested in maximising the

market value of their shareholdings. Given perfect, costless information, managers are

tightly controlled by the shareholders to implement and pursue value-maximising

strategies. Third, the pursuit of shareholder wealth is achieved by instructing man-

agers to invest only in those projects that are worth more than they cost. Financing

strategies, whether concerning dividends, capital structure or leasing, are largely irrel-

evant as they do little to increase shareholders’ wealth.

The assumptions underlying the theory of finance appear to be at odds with reality.

Information is imperfect; transaction costs and information costs may be sizeable.

Markets are frequently highly imperfect; management will usually have a good deal

of interest in the firm – an interest that may well conflict with that of shareholders.

Managers have far from complete knowledge of the set of feasible financing strategies

available, their cash flow patterns and impact on market values. Shareholders are even

less well informed. Taxation policy, bankruptcy costs and other factors can have a

major influence on financial strategies.

Whether we talk about markets, firms or managers, we are essentially looking at

behaviour – the behaviour of individual managers, investors or groups. This leads us

to consider what has been labelled behavioural finance.

23.3 BEHAVIOURAL FINANCE

Behavioural finance is the study of how psychological and sociological factors influ-

ence financial decision-making and financial markets. Financial economics traditional-

ly assumes that people behave rationally. We have focused in this book on market

efficiency and predictive models based on rational economic choices. This assumes that

people have the same preferences, perfect knowledge of all alternatives, and under-

stand the consequences of their decisions. The reality is frequently somewhat different.

Behavioural finance relaxes the tight assumptions of financial economics to incorporate

models based on observable, systematic and human departures from rationality. Its

adherents claim that it helps understand stock market anomalies, including stock mar-

ket overreaction, underreaction, bubbles and irrational pessimism. Some of the most

successful investors have long held the view that to understand the stock market you

must first understand the psychology of investors.

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666 Chapter 23 Review and behavioural finance

Behavioural finance draws on the work of psychologists such as Kahneman and Tversky

(1979, 1982) on how human decision-making varies from rational decision-making.

Examples of the main differences are:

■ Information processing. One example where humans typically have a bias in informa-

tion processing relates to loss aversion. This arises where investors or decision mak-

ers view gains and losses differently. This was observed in Chapter 8 where utility

functions were examined. The very word ‘loss’ is associated with psychological feel-

ings of responsibility, blame and shame. This is called regret – the feeling of bereave-

ment when a wrong alternative is chosen, as measured by the difference between the

payoff received and what could have been achieved. Typically, we find that an

expected loss has more than double the impact on us as a gain of the same magni-

tude. Shareholders holding diversified portfolios would not wish corporate man-

agers to exhibit such strong loss aversion in their decision-making.

■ Self-deception. Most drivers are convinced that they are better than the average driver!

Similarly, managers and investors can easily deceive themselves regarding their

capabilities. This can be seen in overconfidence or overoptimism, leading to sys-

tematic overestimation of what they can achieve, known as hubris. This is fre-

quently encountered in the field of merger and acquisition activity, as seen in

Chapter 20. Market traders may deceive themselves that they can consistently beat

the market, and ascribe above-average returns to their own skills but below-

average returns to bad luck.

Investors show various traits of behaviour

Is it possible to use the principles

of behavioural finance to make

money on the stock markets?

Some investors are certainly put-

ting it to the test. Behavioural

finance is the study of certain

psychological traits that inves-

tors display, which prevent them

from acting in a purely rational

manner.

Investors display a whole range

of traits. These include:

■ Loss aversion: an unwilling-

ness to accept losses that caus-

es them to hang on to losers

and sell winners.

■ Overconfidence: this causes

them to trade too often.

■ Confirmation bias: this causes

them to listen only to such evi-

dence as confirms their origi-

nal view.

Fuller & Thaler Asset Manage-

ment is a US fund management

group that is attempting to exploit

these investor weaknesses. One of

the group’s directors is Daniel

Kahneman, who received the

Nobel Prize for economics for his

behavioural work.

The company attempts to

exploit market anomalies associ-

ated with anchoring. This occurs

when investors develop a fixed

view about a company’s prospects

and are thus slow to react to new

and contradictory information.

This can work in two ways. The

group has a growth fund that

capitalises on the market’s

under-reaction to new positive

information. When companies

beat profit forecasts by a wide

margin, analysts can be slow to

upgrade their forecasts; they

hate to admit they were wrong.

The next set of results then con-

firms the faster trend and fore-

casts get upgraded. This shows

up in a ‘momentum effect’ on the

stock market, when shares that

have recently performed well

continue to do so.

The value fund looks for compa-

nies and shares that have been

beaten down by the market, but

are showing signs of improve-

ment. Investors perceive the com-

pany as a basket case and when

earnings prove better than expect-

ed, they dismiss the result as a

fluke. Eventually, as the improve-

ment process becomes permanent,

analysts and investors catch on,

upgrading their earnings fore-

casts and applying a higher rating

to those earnings.

These approaches have been

fairly successful so far. The

growth fund returned an annu-

alised 17.3 per cent, after fees,

between the start of 1992 and

the end of last year; the value

fund returned 18.8 per cent per

year between the start of 1996

and the end of last year.

Source: Philip Coggan, Financial Times, 27 March

2004, p. 10.

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Chapter 23 Review and behavioural finance 667

Similarly, corporate managers may consistently set unrealistically high targets.

Related to this is the mistake that the more the information gathered and time spent

analysing a decision, the more control we have over the outcome and, therefore, the

more confident that the outcome will be successful. This is termed the illusion of

control bias. It seems that overconfidence and the illusion of control lead stock mar-

ket investors to be overactive in their trading and incur high transaction costs,

resulting in poorer returns than had they traded less actively. Good decision-mak-

ing means knowing the limits to one’s knowledge, and the limitations imposed by

one’s endowment of resources and capabilities (Grant 2004).

■ Representativeness. Managers tend to make decisions based on stereotypes formed

from experience. They look for patterns and use charts to compare recent stock per-

formance with earlier patterns. Such an approach may lead managers to place

excessive trust in patterns repeating themselves rather than focusing on the funda-

mentals. The poor stock market performance of ‘glamorous’ shares may be because

investors overreact to successful companies thus inflating their share price and

reducing the investment yield.

■ Social effects. Perhaps the best known social effect is herd-like behaviour or ‘follow-

ing the crowd’, where a choice is made because everyone else seems to doing it.

■ Anchoring and adjustment. In reaching decisions, managers often place undue weight

on the first information received. The assessment made from the initial information

then acts as a data anchor, subsequent information being used to make minor

adjustments. Traditional budgeting is a good example of this approach, where the

current year’s budget, or actual performance, form the basis upon which incre-

mental adjustments are made to produce next year’s budget.

Behavioural finance raises some important issues.

1 Is it possible to exploit irrational behaviour when it arises? If any investor can iden-

tify that the market is acting irrationally, giving rise to a gap between market share

price and underlying value, he or she has the potential to exploit this profitable

opportunity.

2 How can investors avoid or minimise making irrational decisions, and so achieve

returns superior to other investors?

We consider these as they relate to market efficiency and corporate finance.

■ Market efficiency

Behavioural finance has examined how investors react to new information. Stock prices

appear to underreact to financial news such as earnings announcements, but overreact

to a series of good or bad news. Adherents of the Efficient Market Hypothesis argue

that:

■ Investors, in the main, value securities rationally.

■ Even if some investors do not act rationally, their irrational behaviour is random

and therefore cancels out.

■ But even if most investors act irrationally, the market will be rectified by rational

arbitrageurs who profit from the irrationality of others. Fama (1998) examined the

impact of stock market anomalies on market efficiency. He concluded that ‘market

efficiency survives the challenge from the literature on long-run return anomalies.

Consistent with the market efficiency hypothesis that the anomalies are chance

results, apparent overreaction to information is about as common as under-reaction,

and post-event continuation of pre-event returns is about as frequent as post-event

reversal.’

The psychology literature shows that people are irrational in a systematic manner.

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668 Chapter 23 Review and behavioural finance

Collective behaviour relates to the irrational behaviour of groups. Typically, this

gives rise to excessive market swings. Two examples of such are ‘herding’ and ‘price

bubbles’. These arise when a large group of investors make the same choice based on

the actions of others, which cannot be explained by fundamentals. The ‘dotcom’ price

bubble of the 1990s is a clear example of this type of behaviour. Most individuals find

comfort in being part of a crowd, rather than acting independently. Of course, more

often than not, the crowd can be right for a while, at least, until an overvalued market

lurches downwards into its long-overdue correction phase.

Most financial practitioners are subject to bias. Overconfidence, and emotion cloud

their judgement and misguide their actions. The question is whether they recognise

this behaviour and take steps to minimise this bias. Practical steps that can be taken to

reduce such bias include:

1 Recognise the circumstances leading to overconfidence.

2 Have a written plan for each position, especially exit strategies.

3 Review actions.

■ Corporate managers

While much of the behavioural finance literature considers the psychological aspects of

stock market trading, it also applies to investment and financing decisions within firms,

which is the main focus of this book. If finance managers are able to recognise the biases

in their judgements they will be better prepared to avoid or manage such bias in future.

Behavioural finance helps us understand:

■ Why most boards believe the market undervalues ‘their’ firm’s shares.

■ Why, more often than not, acquisitions fail to deliver the hoped for financial benefits.

Watch the herd, but don’t join it

‘Honey, it’s only a paper loss,’ is

the classic financial self delu-

sion. Yet many investors cling

desperately to bad investments

rather than realising the losses

and moving on.

This process of suppression is

well known to psychologists and

sociologists. Apart from the

losses themselves, people are

dominated by a fear of making

mistakes and of losing prestige.

These factors all play their part

in distorting people’s sense of

perception.

The two disciplines of econom-

ics and psychology, separate for

so many decades, are now united

under the banner of behavioural

finance. This combination is

potentially extremely useful to

investors. The objective of behav-

ioural finance is to give investors

insight into their own mistakes

and those of others. The subject

of behavioural finance has its

origins in the research in the

late 1970s of Americans Daniel

Kanemann and Amos Tversky.

Their work made waves at the

time and the surf is still up.

Joachim Goldberg, a German

behavioural finance guru, says

many people are psychologically

unable to follow rule Number

One: ‘Cut losses and let profits

run.’ This fundamental principle

is broken time and time again

because people are governed by

the wrong psychology. Goldberg

urges investors to forget what they

paid because it is no longer rele-

vant. It is a false reference point.

Likewise, the same miscon-

ceived psychology often encour-

ages people to invest still more

in a failed investment, thinking

they can recoup their losses by

buying at a bargain-basement

price in a bear market. However,

a bad investment does not get

better when you pour more

money into it.

Economists have always tend-

ed to underrate the importance of

psychology and focus on so-called

fundamentals. Yet, there are

many unpredictable economic

variables that affect stock mar-

kets. These range from political

events, ‘real’ infections such as

Sars and Chicken Flu to interest

rates, the gold price, the impact of

the weather on commodity prices

and a host of others. Psychology

is simply another variable.

Source: Brian Bloch, Financial Times, 3 July 2004,

p. 25.

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Chapter 23 Review and behavioural finance 669

■ Why financial projections in capital investment proposals are usually overoptimistic.

■ Why boards find it difficult to terminate (or even decide to escalate) unprofitable

projects or strategies.

Share valuation

Good financial public relations and communication with shareholders is vital for

any listed company, not least because the market should reflect all relevant infor-

mation in the company’s share price. Typically, we find that senior executives

believe that the market tends to underprice ‘their’ shares and fails to recognise the

true worth of the company. But in efficient markets the market price is an unbiased

estimate of the true value of the investment. Corporate managers may be prone to

biases of overconfidence, overoptimism and the illusion of control resulting in the

self-deception that they are better judges of share price than the market, and that

they can control outcomes.

In recent years, there has been a flurry of firms exiting the stock market, whereby

managers use finance provided by private equity capital specialists. Although the

motivation for this is diverse, it is common to hear directors complaining that the mar-

ket does not correctly value their firm, and/or analysts are insufficiently interested to

generate much research about their prospects (Evans, 2005).

Acquisitions

The bias of overoptimism and overcompetence may also lead boards to believe that

they can acquire a firm and produce greater returns than the previous management. As

discussed in Chapter 20, there may be sound strategic and economic motives for

mounting a takeover bid, but the evidence suggests that, on average, acquisitions are

bad news for the shareholders of the acquiring firm.

When takeover bids are contested, the bidding company may end up paying far

more for the target firm than was originally intended. In the language of behavioural

finance, this may be seen as the loss aversion bias – the strong desire to have some-

thing because it looks like it is being taken away from you – and the associated desire

to avoid regret from takeover failure.

Unprofitable projects and strategies

Many companies continue to operate projects or strategies long after they cease to

become profitable or value creating. Similarly, firms may continue to invest heavily in

a corporate turnaround even though there is little likelihood of it ever recovering such

investment. Overconfidence in management’s ability to improve performance is one

explanation. Another is termed entrapment; managers become entrapped in a strategy

or project to which they have committed not just corporate capital, but also personal

capital. Against all economic logic, they postpone decisions to terminate such projects

or strategies in the hope that they will eventually come good. Sometimes, the only way

to change direction is to remove the managers entrapped in this mindset.

There is considerable evidence (e.g. Staw, 1976, 1981) that managers are often reluc-

tant to ‘pull the plug’ on failing projects, or may even decide, in the teeth of adversity,

to even escalate their commitment, hoping for an eventual turnaround, when the

‘rational’ thing to do is to abandon (Staw and Ross, 1987). However, for managers,

blessed with information advantages, the rational course of action is to prolong their

employment. Indeed, because they often have a reputation to protect or at least not to

sully, prolongation is the lesser evil (Kanodia et al., 1989).

Firms need to have in place clear guidelines preventing the above arising through

such mechanisms as regular post-audit reviews (Neale and Holmes, 1990). These

mechanisms should specifically look for overoptimistic forecasts, irrational escalation

of commitment, entrapment and other systematic biases in behavioural finance.

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670 Chapter 23 Review and behavioural finance

23.4 THE CHANGING FINANCE FUNCTION – IF WE HAD 20/20 VISION!

The modern finance function can be subdivided into three main areas:

■ Transaction processing – e.g. accounts preparation, cost accounting, statutory

accounts, accounts payable and credit collections.

■ Control and risk management – e.g. treasury management, budgeting and forecasting,

performance reporting, cash management and internal audit.

■ Decision support – e.g. financial management, cost analysis, investment appraisal,

acquisitions and acquisition screening.

Currently in most firms, transaction processing takes up well over half the cost of the

finance function, but with the increasing focus on corporate governance, risk assess-

ment and value-adding activities, the decision support and control activities will con-

tinue to develop. Many companies regularly engage in benchmarking as a means of

assessing both the cost and quality of financial services offered as they seek to create

world-class finance functions.

But how will the finance function around 2020 differ to that operating in firms

today? In the last two decades or so, the practice of corporate finance has been evolv-

ing at a considerable pace and it is likely that this will continue, if not accelerate, over

the next decade. Globalisation continues to create competitive pressures on all parts of

business, including the finance function, which must play its role in allowing the firm

We are only human

Faced with complex financial decisions, investors often

employ heuristics, or rules-of-thumb, when making deci-

sions. Heuristics can be useful in everyday life, but these

inbuilt tendencies are too blunt a tool for the complex

environment of financial decision-making.

One such heuristic is mental accounting, whereby people

separate their finances into distinct accounts in order to

make decision-making easier. For example, would you treat

a gambling win in the same way as a salary increase? Most

people would not, as they see it as a windfall gain despite

the fact that in both instances they are equally well off. The

problem is that this may not lead to an efficient allocation

of resources (people often keep betting if they think they

are on a winning streak).

This has important ramifications. Investors only psy-

chologically realise a loss on an investment completely

when they sell and thereby ‘close’ the mental account.

When coupled with loss aversion – a tendency for people

to react far more strongly to losses than to gains – this

results in a reluctance to sell badly performing invest-

ments. Although the economic loss already exists, the

pain associated with it is only psychologically ‘booked’ at

the actual sale. As a result, investors are prone to selling

their winners and riding their losers.

A related error is self-deception. This occurs as investors

selectively reinterpret the success of their own previous

decisions, giving them an illusion of control in an uncertain

world. With hindsight bias, for example, we reconstruct our

own previous beliefs, thereby deceiving ourselves into

believing we are right more often than we actually are.

Overconfidence can also lead investors to underreact

to new information. An investor who has built up a good

investment story, and shared it with colleagues, instinc-

tively reacts negatively to contradictory news. Because

many analysts make the same mistake the share price

may respond gradually, and inefficiently, rather than

immediately.

These failings are just some of those uncovered by

behavioural finance. An understanding of this relatively

new field, at the very least, provides investors with a more

realistic view of how the market works. Where these

errors are exploitable it may even provide investors with

investment opportunities. But it does not seem that

investors can change their instinctive reactions to become

rational, unemotional financial machines. Inefficient mar-

kets are here to stay.

Source: Based on article by James Hand and Greg Davies, Financial Times,

25 October 2004, p. 6.

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Psychology will contribute to the next big breakthrough

Bill Sharpe, the brains behind the Capital Asset Pricing

Model and Nobel laureate, is at Stanford University’s

Graduate School of Business, where he grapples with such

gnomic questions as ‘is beta dead?’

One of the conclusions of the CAPM is that asset

returns are a function not of total risk, but rather the risk

of doing badly in bad times. Prof Sharpe suggests that a

simple measure is an asset’s ‘beta’ – the expected change

in returns given a 1 per cent change in the return from the

overall market.

The challenge to beta in the 1990s came from Eugene

Fama and Ken French, who did empirical work that

seemed to explain stock returns by the over-return on

equities, the size of the company and whether it was a

value or growth stock. Consequently, there was no room

for beta in this model. Prof Sharpe’s response is that

empirical research on financial markets is notoriously diffi-

cult. ‘If you don’t like an empirical result, wait till some-

one does it in another time period using a different

method or another country,’ he says. ‘I have done empiri-

cal work – lots of it. But I think empiricists need to be

modest.’

Prof Sharpe’s analysis of markets and finance has yet to

come to rest and he has several answers as to where

financial economics is heading. First, he argues that

finance has become too obsessed with mathematics. ‘We

have got so intent on having elegant solutions to closed-

form equations that we have tolerated some really stupid

assumptions about people’s preferences,’ he says.

Linked to this, he wants financial economists to strive

for a better understanding of how people really act. Does

that make Prof Sharpe a closet fan of behavioural finance,

which tries to explain financial markets by looking at

human psychology?

‘I’m a fan of good behavioural finance. It is not a ques-

tion of trying to show that people are irrational or throw-

ing out all the models that involve rationality. The interest-

ing thing is to find out what kinds of decisions people

make under conditions of uncertainty if they know what

they are doing.’

It is from this marriage of psychology and economics

that Prof Sharpe expects the next breakthrough in finance.

Fund managers, watch this space.

Source: Based on article by Simon London, Financial Times, 29 July 2002, p. 4.

Chapter 23 Review and behavioural finance 671

to be more responsive to customer needs. New technology and telecommunications

are creating new ways of doing business, offering a wide range of opportunities for all

aspects of finance. As trade barriers disappear and electronic commerce enables firms

to cross geographical boundaries, even smaller firms are able to compete in global

markets. These changes offer new investment opportunities in the form of cross-

country acquisitions and strategic alliances, and new opportunities to raise finance on

a larger scale with lower transaction costs.

Cost pressures will continue to be exerted on the finance function. New technology

and the continuing trend towards outsourcing large elements of the finance function

will likely drive down costs further.

Investors will become far more assertive and more effective in making their voices

heard in boardrooms. Insisting on managerial incentive schemes linked to value-based

management and similar approaches will ensure that agency problems are minimised.

Financial markets will become more efficient as technology improves and information

disclosure requirements increase, in the train of financial scandals such as those

involving Enron and Worldcom, and the ensuing Sarbanes-Oxley Act in the USA.

In this final chapter of the book we have reviewed the main theories behind the cor-

porate finance principles and practices outlined in previous chapters. The key materi-

al introduced was on the contribution that the emerging area of behavioural finance

Continued

SUMMARY

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672 Chapter 23 Review and behavioural finance

Further reading

Behavioural finance is a fast-developing topic. A good review of this may be found in Shefrin

(1999) and Smith (2001). Key articles on this subject are Barber and Odean (2000) and Fama

(1998).

makes to our understanding of the subject. We conclude with a brief look at how the

world of finance is expected to evolve in the coming years.

Key points

■ Financial management is more than applying rules and procedures. It explores the

behaviour of markets, firms and individuals.

■ Various theories explaining such behaviour include those of agency, risk aversion,

present value, portfolio, information asymmetry, options, and market efficiency.

■ Behavioural finance is the study of psychological traits that investors and managers

display that prevent them acting in a purely rational manner.

■ Examples of behavioural finance bias include regret, overconfidence, over-opti-

mism, the illusion of control, herd behaviour, and anchoring and adjustment.

■ Behavioural finance is particularly in evidence in stock market anomalies, share

valuation, acquisitions, and loss-making projects.

■ The role of the finance manager must evolve with the changes in financial markets,

technology and corporate governance.

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Solutions to self-assessment activities

Appendix A

CHAPTER 1

1.1 Tangible real assets: machinery and equipment, vehicles, stock

Intangible assets: patents

Financial assets: debtors, cash and building society deposits

Financial claims: trade creditors, loans, shareholders’ equity

The financial manager has two broad responsibilities:

1.2 (1) Providing financial information and advice for internal and external users. The financial accountant

prepares the statutory financial accounts and deals with the auditors; the management accountant pro-

vides information for decision-making, planning and control. Other departments, such as taxation,

may also report to the controller (or chief accountant).

(2) Managing cash and raising finance at the best possible rate. This is the responsibility of the treasurer

or financial manager. Typical functions within the treasury area are raising finance, the management

of cash, credit and inventory, foreign currency management and financial risk management.

1.3 The past ten years have seen a much greater emphasis on investor-related goals, such as earnings per share

and shareholder wealth. This is mainly attributed to the growth in shareholdings by institutional investors

(e.g. pension funds). The recognition that profitability is not necessarily the same as shareholder wealth has

led to greater emphasis on shareholder goals.

1.4 (1) The goal of maximising owners’ wealth is the normally accepted economic objective for resource allo-

cation decisions. Rather than concentrate on the organisation, it evaluates investments from the view-

point of the organisation’s owners – usually shareholders. Any investment that increases their stock of

wealth (the present value of future cash flows) is economically acceptable.

In practice, many of the assumptions underlying this goal do not always hold (e.g. shareholders are

only interested in maximising the market value of their shareholdings). In addition, owners are often

far removed from managerial decision-making, where capital investment takes place. Accordingly, it

is common to find that more easily measurable criteria are used, such as profitability and growth goals.

There are also non-economic considerations, such as employee welfare and managerial satisfaction,

which can be important for some decisions.

(2) Separation of ownership from management can give rise to managerialism – self-serving behaviour by

managers at the shareholders’ expense, e.g. pursuing managerial ‘perks’ (company cars, etc.), adopt-

ing low-risk survival strategies, settling for less than the best.

CHAPTER 2

2.1 Financial intermediaries are the various financial institutions, such as pension funds, insurance companies,

banks, building societies, unit trusts and specialist investment institutions. Their role is to accept deposits

from personal and corporate savers to lend to customers (e.g. companies) via the capital and money markets.

Financial intermediaries perform a vital economic service:

(a) Re-packaging finance: collecting small amounts of finance and re-packaging into larger bundles for

specific lending requirements (e.g. banks).

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674 Appendix A Solutions to self-assessment activities

(b) Risk reduction: investing sums, on behalf of individuals and companies, into large, well-diversified

investment portfolios (e.g. pension funds and unit trusts).

ing societies).

(d) Cost reduction and advice: minimising transaction costs and providing low-cost services to lenders

and borrowers.

2.2 Companies using the Main Market are generally those with a lengthy track record (i.e. a history of sta-

ble/growing sales and profits), seeking large amounts of capital, where the board is prepared to release a

sizeable proportion of its controlling interest.

AIM is designed to appeal to smaller and growing companies which seek access to risk capital or where

the board wishes to sell some of its holding, but cannot meet all the requirements for a full listing and

prefers less regulation.

The OTC market is for the remaining, smaller companies where shareholders occasionally wish to dis-

pose of shares. This is performed on a ‘matched bargain’ basis, using facilities offered by authorised securi-

ties dealers.

2.3 A major function of an active capital market is to provide a mechanism whereby investors can realise their

holdings by selling securities, and, obviously, for every seller, there has to be a buyer. Investors will be reluc-

tant to commit their funds to the capital market by subscribing to new share issues if they doubt their abil-

ity to find a willing buyer as and when they decide to sell their holdings. The more liquid the market, the

greater its ability to entice firms to make new share issues and investors to subscribe to them. Where mar-

ket liquidity is poor, companies will have to offer much higher returns, making share issues uneconomic.

2.4 If these rules ever applied, investors would have soon realised the potential, and would have bought in

November rather in advance of the expected price increase in December, thus creating a ‘November effect’,

and so on.

Try the same argument on the old stock market advice ‘Sell in May, and go away, and come back on

St Leger Day’ (the date of a horse race in the UK).

Many statistical tests have shown that all such dealing rules are usually inferior, and never superior, to

a simple ‘buy and hold’ strategy.

2.5 (a) On the face of it, this represents insider dealing, by people in the know.

(b) It could represent speculation and rumour. If the company is known to be weak, then it is a candidate

for takeover and people begin to speculate about how much the company may be worth in the hands

of an alternative owner.

ent UK rules (The City Code) allow a holding of up to 3% without declaration of beneficial ownership.

The upward movement could simply be due to this buying pressure. In reality, ‘abnormal’ buying

also promotes speculation.

2.6 (1) Some people are simply lucky.

(2) Some people stay lucky for several time periods, although shrewd ones remember to get out while ahead!

(3) In any time period, 50 per cent of investors ought to beat the market average.

(4) Some people deliberately assume high levels of risk for which a relatively high return is appropriate.

We should therefore talk about ‘risk-adjusted returns’ rather than simple returns.

(5) Some people have access to inside information. This, of course, contravenes strong-form efficiency but

it happens, although such information is unlikely to arrive in a steady stream over time.

2.7 (1) Admission of corporate and overseas membership with access to larger sources of capital.

(2) Introduction of the Stock Exchange Automated Quotation System (SEAQ) hastening the movement of

trading away from the floor of the Exchange to dealing by telephone and computer. This has led to

quicker dissemination of information, enabling it to be incorporated more rapidly into share prices.

Thus the market has become more information-efficient in the semi-strong form.

(3) Abolition of minimum commission and the expansion of membership have led to greater competition

for business among market makers. As a result, commission rates have fallen markedly.

2.8 The reader is refered to Section 2.9.

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