TERM PAPER

Submitted to: Gujarat Technological University, Ahmadabad As a part of PhD course

Guided by: Prof. (Dr.) Snehalkumar H Mistry Professor, C.K.Pithawalla Institute of Management,

Submitted by: Samir Thakkar, PhD Registration no. 8141 Parul Institute of Management, Vadodara

Samir Thakkar, Reg. No. 8141

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ALTERNATIVE INVESTMENT
An alternative investment is an investment product other than the traditional investments of stocks, bonds, cash, or property. The term is a relatively loose one and includes tangible assets such as art, wine, antiques, coins, or stamps (Greenwood, 2008) and some financial assets such as commodities, private equity, hedge funds, venture capital, film production (Schwartz, 2010) and financial derivatives. There is a wide variety of literature on alternative investments; however, this term has been used broadly and can also be used to refer to financial alternatives such as derivatives or other alternatives such as energy. It is difficult to find research on the investment characteristics of tangible alternatives such as art or wine due primarily to a lack of good quality data. Investors The Merrill Lynch/Cap Gemini Ernst & Young World Wealth Report 2003, based on 2002 data, showed high net worth individuals, as defined in the report, to have 10% of their financial assets in alternative investments. For the purposes of the report, alternative investments included "structured products, luxury valuables and collectibles, hedge funds, managed futures, and precious metals" (James P. Gorman, 2003). By 2007, this had reduced to 9% (Robert J. McCann, 2008). No recommendations were made in either report about the amount of money investors should place in alternative investments Characteristics Alternative investments are sometimes used as a tool to reduce overall investment risk through diversification. Some of the characteristics of alternative investments may include:

Low correlation with traditional financial investments such as stocks and shares Alternative investments may be relatively illiquid It may be difficult to determine the current market value of the asset There may be limited historical risk and return data A high degree of investment analysis may be required before buying Costs of purchase and sale may be relatively high Page 2

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FUNDAMENTAL ANALYSIS
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis(Waring, 2000). The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis. Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

to conduct a company stock valuation and predict its probable price evolution, to make a projection on its business performance, to evaluate its management and make internal business decisions, to calculate its credit risk.

Two analytical models

When the objective of the analysis is to determine what stock to buy and at what price, there are two basic methodologies 1. Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by purchasing the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. 2. Technical analysis maintains that all information is reflected already in the stock price. Trends 'are your friend' and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns. Investors can use any or all of these different but somewhat complementary methods for stock picking. For example many fundamental investors use technicals for deciding entry and Samir Thakkar, Reg. No. 8141 Page 3

exit points. Many technical investors use fundamentals to limit their universe of possible stock to 'good' companies. The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works. Fundamental analysis includes: 1. Economic analysis 2. Industry analysis 3. Company analysis On the basis of these three analyses the intrinsic value of the shares are determined. This is considered as the true value of the share. If the intrinsic value is higher than the market price it is recommended to buy the share. If it is equal to market price, hold the share and if it is less than the market price, sell the shares.

BEHAVIORAL ECONOMICS
Behavioral economics and the related field, behavioral finance, study the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns and the resource allocation. The fields are primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. In so doing they cover a range of concepts, methods, and fields. Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest. There are three themes which are prevalent in behavioral finance (Shefrin, 2002)

Heuristics: People often make decisions based on approximate rules of thumb and not strict logic.

Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely on to understand and respond to events.

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Market inefficiencies: These include mis-pricings and non-rational decision making.

Issues in Behavioral Economics Behavioral finance

The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors affect prices and returns, creating market inefficiencies. It also investigates how other participants arbitrage such market inefficiencies. Behavioral finance highlights inefficiencies such as under- or over-reactions to information as causes of market trends (and in extreme cases of bubbles and crashes). Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider behavioral economics' academic cousin, behavioral finance, to be the theoretical basis for technical analysis (KirkPatrick & Dahlquist, 2007). Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell shares or other equity, if doing so would result in a nominal loss (David Genesove, 2001). It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of low demand. Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle, something conventional finance models have been unable to do so far. Experimental finance applies the experimental method, e.g. creating an artificial market by some kind of simulation software to study people's decision-making process and behavior in financial markets.

Financial models
Some financial models used in money management and asset valuation incorporate behavioral finance parameters, for example:

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Thaler's model of price reactions to information, with two phases, underreactionadjustment-overreaction, creating a price trend One characteristic of overreaction is that average returns following announcements of good news is lower than following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to news, thus requiring adjustment in the opposite direction. As a result, outperforming assets in one period are likely to underperform in the following period.

The stock image coefficient

Criticisms Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies are either quickly priced out of the market or explained by appealing to market microstructure arguments. However, individual cognitive biases are distinct from social biases; the former can be averaged out by the market, while the other can create positive feedback loops that drive the market further and further from a "fair price" equilibrium. Similarly, for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case for many anomalies (Fama, 2009). A specific example of this criticism appears in some explanations of the equity premium puzzle. It is argued that the cause is entry barriers (both practical and psychological) and that returns between stocks and bonds should equalize as electronic resources open up the stock market to more traders. In reply, others contend that most personal investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials.

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References:
Alternative Investment-Wikipedia,the free encyclopedia. (2012, March 28). Retrieved June 12, 2012, from Wikipedia,the free encyclopedia:

http://en.wikipedia.org/wiki/Alternative_investment Armstrong, J. S., Coviello, N., & Safranek, B. (1993). Escalation Bias: Does It Extend to Marketing? Journal of the Academy of Marketing Science , pp. 247-253. Behavioural Economics-Wikipedia,the free encyclopedia. (2012, April 24). Retrieved June 12, 2012, from Wikipedia,the free encyclopedia:

http://en.wikipedia.org/wiki/Behavioral_economics Benartzi, S., & Thaler, R. H. (1995, February). Myopic Loss Aversion and the Equity Premium Puzzle. The Quarterly Journal of Economics , pp. 73-92. David Genesove, C. J. (2001). Loss Aversion and Seller Behavior, Issue 8143. National Bureau of Economic Research . Fama, E. (2009, August 11). Fama on Market Efficiency in a Volatile Market. (D. Salisbury, Interviewer) Fundamental Analysis-Wikipedia,the free encyclopedia. (2012, May 13). Retrieved June 25, 2012, from Wikipedia,the free encyclopedia:

http://en.wikipedia.org/wiki/Fundamental_analysis#cite_ref-0 Greenwood, J. (2008, October 06). First class returns for alternative investments-Telegraph. Retrieved July 2, 2012, from telegraph.co.uk:

http://www.telegraph.co.uk/finance/personalfinance/investing/3144943/First-class-returnsfor-alternative-investments.html James P. Gorman, R. E. (2003). World Wealth Report. Merrill Lynch/Cap Gemini Ernst & Young. KirkPatrick, C. D., & Dahlquist, J. R. (2007). Technical Analysis: The Complete Resource for Financial Market Technicians. NJ: Financial Times Press. Samir Thakkar, Reg. No. 8141 Page 7

Robert J. McCann, B. L. (2008). World Wealth Report. Merrill Lynch/Cap Gemini Ernst & Young. Schwartz, S. K. (2010, October 18). Alternating Investing: Film Production. Retrieved June 30, 2012, from CNBC:

http://www.cnbc.com/id/39342145/Investing_In_The_Big_Screen_Can_Be_A_Profitable_St ory Shefrin, H. (2002). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Oxford University Press. Waring, D. (2000). An Introduction to Fundamental Analysis and the US Economy. Retrieved June 27, 2012, from Informed Trades : http://www.informedtrades.com/13036-introductionfundamental-analysis-us-economy.html#post13168

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