Investments

Investments

Due to the impossibility to cover all financial concepts in a couple of pages, the present selection underlines three theoretical constructs: the risk-return tradeoff, the dollar cost averaging and asset allocation.

Risk/Return Tradeoff. Some say that to be an investor one has to be relatively unemotional. The risk return tradeoff paradigm could be perceived as a test of one’s nerves. Risk in investing conveys the meaning of a return being different than expected and the traditional possibility than there may be a (total) loss of the funds invested.

In a financial time series analysis, Lundblad (2005) reviews two hundred years of the U.S. equity market history. A time-varying risk return tradeoff is at play, but in general risk return tradeoff is immune to temporal change.

Dollar Cost Averaging (DCA). Picking the tops and bottoms of the market can be a daunting task for an investor. Although DCA is a widely recommended strategy to purchase equity securities, Brennan et al. (2005) wonder if the occurrence might be influenced by irrational behaviour. The authors’ conclusion was that rational academic advice might be the worse alternative.

Asset Allocation. Asset preservation gains importance as a person gets closer to retirement. Theoretically, risk averse investors buy low risk securities such as bonds, while risk tolerance suggests high risk financial assets but also more exciting returns such as stocks. Hariharan et al. (2000) found that risk tolerant investors (as opposed to risk averse) maintained their more pronounced position in bonds than stock despite approaching retirement age.

The Capital Asset Management Model (CAMP) predicts that investment in risk-free assets is negatively correlated with risk tolerance and that agglomeration of risky securities would remain the same. Intuitively, one would tend towards a lesser investment in riskless obligations (Treasury Bills – United States government debt) with increasing risk tolerance, but the picture could be different. According to the writers, Wall Street is uncomfortable with the idea that risk tolerance fails to influence stock asset allocation.

In the European Union, Small to Midsized Enterprises (SMEs) are firms with yearly turnover of less than 50 million Euros and employing less than 250 people. In North America, the corresponding parameters are roughly 50 million dollars and 500 employees. Japan’s counterparts are less than 300 employees in manufacturing and other industries with capital of up to 300 million yen. The term Small to Midsized Businesses (SMBs) is also encountered.

Businessman Sitting Alone in Room. Illustration: Megan Jorgensen (Elena)

References:

    Brennan, M. J., Li, F. & Touros, V. N. (2005). Dollar cost averaging. Review of Finance, 9 (4): 509-535.

    Hariharan, G., Chapman, K. C., & Domian, L. D. (2000). Risk tolerance and asset allocation for investors nearing retirement. Financial Services Review, 9: 159-170.

    Lundblad, C. (2005). The risk return tradeoff in the long run: 1836-2003. Journal of Financial Economics, 85 (1): 123-150.