Essay Question: How different investor types impacts Market Efficiency
Individual investors
When individuals talk regarding marketing efficiency, they simply refer to the degree to which the aggregate decisions of all participants in financial markets are accurately reflecting the value of companies and their shares at any given time (Allen and Gale, 2000, pp. 236-255). Therefore, it requires the determination of the intrinsic value of the company while providing a constant update to valuations because new information is becoming familiar. Consequently, the more a financial market becomes accurate, it will be able to price securities and the more efficient it is said to be. Thus the principle of the efficient financial market hypothesis. It states that a financial market can correct the price of securities in time-based on the current information available. Therefore, stocks are not undervalued because stocks are always trading at the price that is equivalent to their intrinsic value.
It is reasonable beyond doubt that financial markets are considerably efficient most of the time (Byrne and Davies, 2003, pp. 50-89). However, it has been proved that such markets can overreact to emerging positive and negative information. Therefore, as an individual investor, you should ensure that accurate payment of the price of the shares is made to the research company before buying stocks from such firms. Similarly, an individual investor should analyze on whether or not the financial market is appearing to be reasonable in its stock pricing.
The stock prices should reflect all the available information on the market. According to the individual investors, they cannot beat the market indexes by picking the stocks and looking for a secret formula is a waste of time since stock prices do follow a random walk. According to Barber and Odean, individual investors with an average household and an account at a large discount company will underperform with about fifteen basis points every month based on gross returns before expenses (Barber and Odean, 2011, pp 1-5). Similarly, an individual investor may be better in the financial market by not trading in the securities. Consequently, the securities that are sold by the individual investors will perform as compared to the stocks that they purchased.
The performance of individual investors in the financial market is relatively good in the short run with subsequent returns that are more than the neutralized gains in the short run. Therefore, they will lose on the average. On the other hand, the huge flow of cash into these funds will push the stock prices temporarily, and the individual investors will benefit from the momentum impacts in the short run. This paper shows that individual investors are successful in finding ways of losing money because they are just unlucky in the financial markets. However, the truth of the matter is that financial markets are inefficient, and some investment strategies will lead to underperformance or beat the stock market in the long run.
Institutional investors
The growth of institutional investors has been strong in the past decades not only due to their overall expansion in financial sectors that is relative to Growth Domestic Product (GDP) but because of a boost in their share of overall claims in finance (Davies and Steil, 2001, pp. 2-7). According to Davies and Steil, the growth of institutional investors can be drawn to different supply and demand factors that have facilitated investment through institutions to attract the households (Davies and Steil, 2001, p. 3).
Regarding the supply factors, institutions have rendered their services relatively in a more efficient manner than banks and other direct holdings, thus satisfying the duties of the financial system more effectively (Davies, 2002, pp. 2-5). The demand part stem the households by enhancing their needs for the type of financial functions that the institutional investors are capable of fulfilling. On the supply section, there is a lot of ease in diversification, improved control in corporate section, liquidity, deregulation, taking advantage of technological developments, enhanced competition, fiscal inducement, and difficulties of pensions in social securities. The demand side highlights the demographic features such as the funding of pensions, and growth of wealth (Financial Times, 1999, p. 4).
The integration of financial institutions increases the attractiveness of institutional investments by making a better return in risk trade-off to be attainable (Davies, 2008, pp 46-103). Similarly, it increases the range of instruments. For instance, the availability of private equality in the financial market as well as the corporate bonds and loans with securities that diminish with the supply of government bonds. Additionally, the increased liquidity and cheaper transaction costs from the market integration are increasing the comparative advantage of the financial institutions over the intermediation of banks. In the security markets, financial innovations may arise that are designed to the need of the institution, and this can include the current and unavailable instruments like bonds with returns that are connected to the average earnings. Consequently, this could be appropriate to life insurers and pension funds as assets are matched to liabilities (Mercer, 2001, p. 49).
The mutual funds are usually the vehicles that pass the assets for investment purposes in the financial markets. Therefore, they seek to provide and improved profile and greater risk return on liquidity to individual investors through the exploitation of synergies from the pooling assets of several individuals (Investment Company Institute, 1995, p. 12). Thus, economizing transaction and management costs while providing low minimum holdings. Hence, it is different from the long-term institutions since it provides short-term liquidity on pools of resources even though at the rates that rely on the present market prices either through the direct redemption of holdings in the financial market or through the ability of trading shares in the funds of exchanges. Consequently, mutual funds greatly influence the financial markets because they are the residual claimants that bear all the risks.
Hedge fund
This is a private and unadvertised mutual fund that is limited to rich investors that are willing to experience high and short-term risk in exchange for high potential return (Boland and Fidler, 2002, pp. 121-130). Hedge funds influence the financial markets in the sense that it engages the unlimited short-term trading. It also takes short positions as it borrows a greater extent as compared to other institutions. Since investors in hedge funds have the ability to leverage and willingness of risk taking, they create sharp movements in financial markets. Consequently, it provokes other institutions to similar activities. Similarly, they can have additional scope in acting in a contrarian way than other types of institutional investors in the financial market.
High-frequency investors/ traders
Efficiency is an important semantic load in finance, but its main meaning in this paper is the incorporation of swift information into prices. Therefore, there is strong evidence that the high-frequency investors or traders improve the efficiency of financial markets. According to Castura et al. the statistical prices mean less reversion and this resemble a close random walk in the market (Castura et al., 2010, pp. 44-67). Similarly, O’Hara and Ye, high frequency resembles a greater market efficiency than other traders (O’Hara and Ye, 2011, pp. 459-474). Since HFT adopt the use of computer systems such as GPS, it has become incredible and more efficient especially at informational tasks. Hence, it has become a financial analogue of the financial market advances.
Factors that prevent different investment types from influencing efficiency of markets
Cost of transaction
The HFT is valuable both extraordinarily and incredibly. However, high-frequency traders or investors (HFT) reduces the average cost of trading for the investors. On the other hand, it poses a systematic risk to the financial markets. Thus, hurting investors through front running and this will reduce the confidence of the investors. The HFT are engaged in costly technologies that will not end for the investors especially if the market regulators such as the government do not act immediately.
Tax rate
The rate of tax will always raise the cost of financial transactions. Therefore, frequently traded securities such as treasuries will be affected more than the securities that are traded on less frequently. Similarly, the tax rate will also reduce the transaction volume, and this will make some trading activities such as transaction derivatives to manage risks, and the computer-aided high-frequency trading to be unprofitable. The financial transaction tax will weaken the available frail recovery, and this will cause harm to the investors that are saving for retirement and the high-frequency investors
Market liquidity
Liquidity in the financial markets determines the success of offerings in public companies. It also reduces the cost and underwriting, and makers of the financial market. Similarly, it also reduces the cost of investing through lower volatility and cost of the transaction. Therefore, from the macro point of view, the liquid capital markets are important for allocation of efficient capital, and this results in lower cost of capital to the issuers (Lipsky, 2007, pp. 59-62). On the other hand, a liquid market on a micro level ensures that there is access to a range of diverse investors with different trading strategies.
Government
A government in the evolving financial markets usually play an important role in the development of the economy, particularly in the strategic sectors (Bikhchandani and Sharma, 2000, p. 21). However, there is a clear trend towards the divestment to the holding of government in a more developed and emerging financial markets. Consequently, this allows a private sector to play a more important duty in the financial markets (Davies, 2002, pp. 49-51).
Conclusion
The most affected investors are the high-frequency investors because they have up to date information and the ability to execute faster investments. Similarly, the HFT, who are conducting trade upon the stale prices. Due to the dominance of pay as you go and the lack of sustainability of the present systems, institutional investors are the most appropriate investors. For instance, pension funding provides the scope for expansion thus making institutional investors great in the relevant and mature markets due to their major funding elements. Similarly, a mutual fund is more likely to increase as individuals seek to offer their retirements due to pension reforms.
References
Allen, F. and Gale, D. (2000). Bubbles and Crises. Economic Journal, pp.236-255.
Barber, B. and Odean, T. (2011). The Behavior of Individual investors. Journal of Finance, 52(1-54).
Bikhchandani, S. and Sharma, S. (2000). Herd Behavior in Financial markets. A review of working paper 48, Washington DC.
Boland, V. and Fidler, S. (2002). Financial Times. Where Financial Risk falls.
Byrne, J. and Davies, P. (2003). Financial Structure forthcoming. Cambridge University Press.
Castura, J., Litzenberger, R., Gorelick, R. and Dwivedi, Y. (2010). ). Market efficiency and microstructure evolution in U.S. equity markets. A high-frequency perspective. Working paper (RGM Advisors).
Davies, P. (2002). Ageing and Financial Stability. Berlin: Springer.
Davies, P. (2002). Institutional Investors, Corporate governance and Performance of Corporate Sector. Discussion Papers and forthcoming Economic systems, pp.2-5.
Davies, P. (2008). Institutional Investors, financial markets efficiency and financial stability.
Davies, P. and Steil, B. (2001). A comprehensive Perspective on the Institutional Investment Industry. London: The MIT Press, pp.2-7.
Financial Times. (1999). Financial Times Survey Pension fund Investment.
Investment Company Institute. (1995). Mutual fund shareholder response to market disruption Perspective, 1(1).
Lipsky, J. (2007). Developing deeper capital markets in emerging market economies.
Mercer, W. (2001). European Pension fund managers guide 2001.
O’Hara, M. and Ye, M. (2011). Is market fragmentation harming market quality?. Journal of Financial Economics, 100(1), pp.459 – 474.
