The financial systems can be looked upon as a combination of financial markets, institutions, and regulations that aim to perform a set of economic functions. Most of those functions have a direct bearing on investment decisions and behaviour. The functions might be regarded as the provision of means of:
- Settling payments.
- Investing surplus funds.
- Raising capital.
- Transferring funds from surplus units (savers) to deficit units (borrowers).
- Managing financial risk.
- Pooling resources.
- Dividing ownership.
- Producing information.
- Dealing with incentive problems.
Settling payments. This refers to the mechanisms for making payments. Mechanisms include cash, cheques, credit cards, and so forth. This relates to investment only in so far as there needs to be a mechanism of paying for investments.
Investing surplus funds. This is the investment process. Investors have varied needs and wishes concerning risk, return liquidity, and other characteristics of investments. A financial system should provide a wide range of investment choices so that individuals can satisfy their investment objectives.
Raising capital. Some people or organizations have expenditure that exceeds their income. They would need to raise capital by borrowing or selling shares. A financial system should provide suitable financial instruments for obtaining funds. Such instruments would include bank loans, various forms of bond, and various types of share.
Transferring funds from surplus units to deficit units. This brings functions 2 and 3 together. Not only should there be suitable financial instruments for investors and those raising capital, but there should be markets or intermediaries for bringing them together. For example, banks are intermediaries that transfer money from investors who deposit money to borrowers who receive loans. Stock markets transfer money from investors, who buy shares or bonds, to the firms that issue the shares and bonds.
Managing financial risk. Most people or organizations that invest or raise funds face risks from price movements. For example, an investor in shares will lose in the event of a fall in share prices. Financial systems should provide instruments for managing such risks. Risk management instruments include derivatives such as forwards, futures, swaps, and options. Other risks need to be managed, such as default risk. Financial systems generate credit rating agencies that inform investors of the levels of such risks.
Pooling resources. When businesses and governments borrow, they want to raise large sums of money. Individuals usually have small sums to invest. By pooling the small sums of a large number of individuals, large sums are made available to businesses and governments. The pooling of large numbers of small amounts is carried out by intermediaries such as banks, pension funds, and unit trusts.
Dividing ownership. When an investor buys shares in a company, the investor becomes part-owner of the company. The share issuance is a means of dividing the ownership of a company among a large number of investors. The transfer of ownership to investors entails the transfer of risks as well as prospective profits.
Producing information. The most common form of information produced by financial systems is information about prices. This would include prices of shares, bonds, and money (interest rates are prices of money). Information about prices allows investors to measure their wealth, and helps them to make decisions about how to allocate their wealth between different types of investment. Interest rates are likely to influence decisions about saving and borrowing.
Dealing with incentive problems. Incentive problems include principal-agent, moral hazard, and adverse selection problems. It is about such matters that regulation can be particularly important.
Principal-agent problems can arise when investors allow others to make decisions for them or follow the advice of others. For example, an investor may allow a financial adviser to choose investments. There is a risk that the adviser chooses the investments that pay the highest commission to the adviser, rather than the investments that are best for the investor. This would be a case of the adviser exploiting the situation of having more information than the investor. The investor is referred to as the principal, the adviser as the agent, and the inequality of information as asymmetric information.
The principal-agent situation can lead to moral hazard. Moral hazard can arise when the agent takes the decisions, but the principal bears the risks arising from those decisions. For example, a fund manager may make investments that are riskier than the investors would like. This could be possible as a result of the fund manager (the agent) having more information (asymmetric information) than the investor (the principal).
Adverse selection can be another consequence of asymmetric information. Consider the case of annuities. Annuities are incomes for life sold by insurance companies. In exchange for a lump sum, the insurance company guarantees a monthly income for the rest of the life of the person buying the annuity. Individuals know more about their health and prospective lifespans than insurance companies can know (asymmetric information). People with short life expectancy are less likely to buy annuities than those who expect to live for a long time (adverse selection). Those who expect long lives stand to benefit most from annuities. If insurance companies price annuities according to average lifespans, they will lose money because people are buying them will tend to have longer than average lives. Women tend to live longer than men. If annuities are priced to match average life expectancy (average of men and women together), women will buy annuities to a greater extent than men.
Investors and borrowers
The financial system serves the function of transferring money from those who want to invest to those wishing to borrow (the term borrower is being used loosely here since firms that raise capital by issuing shares are, strictly speaking, not borrowing but selling equity in their enterprises). Savers invest by depositing money in banks (or building societies), by buying bonds, or by buying shares. The borrowers may be individuals who obtain bank loans or mortgages, governments that sell bonds, or private companies that raise money by both of these means plus the sale of shares. The money passes from investors to borrowers through the intermediation of banks or stock exchanges. Most stock market investment by individuals is through the medium of institutional investments such as pension funds, insurance funds, unit trusts, and investment trusts. The financial system cash flows, where stock market investment is carried out through institutional investments.
PERSONAL FINANCIAL PLANNING
Personal financial planning is the process of planning one’s spending, financing, and investing in optimizing one’s financial situation. A personal financial plan specifies one’s financial aims and objectives. It also describes the saving, financing, and investing that are used to achieve those goals.
A financial plan should contain personal finance decisions related to the following components:
- Managing Liquidity.
- Financing Large Purchases.
- Long-term Investing.
The budgeting decision concerns the division of income between spending and saving. Saving will increase one’s assets and/or reduce one’s debts. If spending exceeds income (i.e. there is negative saving), assets will be reduced and/or liabilities increased. The excess of assets over liabilities is one’s net worth. Saving increases net worth (negative saving reduces it). Some saving might be a concise term, for example keeping some of this month’s salary to finance spending next month. Very short-term saving is part of the process of managing liquidity. Other saving is medium-term: saving for a holiday, a car, or a deposit on a house are examples. Such saving is to finance large purchases. Long-term saving can have an investment horizon of 40 years or more. The most crucial long-term saving for many people is saving for a pension to provide an income in retirement. Other purposes of long-term saving include the financing of children’s education, and building up an estate to pass to one’s heirs. Long-term saving for a pension will feel much more critical when the investor is 55 than when that investor is 25. However, early saving is far more productive than later saving. For example, £1,000 invested for ten years at 8% p.a. will grow to £2,159, whereas the same sum invested at the same rate of return for 40 years will grow to £21,725.
Liquidity is readily available cash or other means of making purchases. Liquidity is needed for items such as day-to-day shopping and meeting unexpected expenses such as repair bills. Liquidity management involves decisions regarding how much money to hold in liquid form and the precise forms in which the money is to be held. Generally, the more liquid an asset is, the lower the return to be expected from it. The most liquid assets are banknotes and money in cheque able bank accounts. These assets provide little or no interest. Slightly fewer liquid assets, such as deposit accounts in banks or building societies, provide more interest but are slightly less accessible. It usually is inappropriate to hold all of one’s wealth in liquid form since less liquid assets (such as bonds and shares) generally offer much higher expected rates of return. The alternative to using one’s liquidity might be to borrow, for example, by using a credit card. Credit management is concerned with decisions about how much credit to use, and what sources of credit to use. Whilst credit is a source of additional liquidity; it has the disadvantage that interest has to be paid, and often at a high rate and risk.
Financing Large Purchases
The finance for large purchases may be generated by saving, or by borrowing. Savings need not be in highly liquid form (until the purchase is made) but should not be in a risky form. Such savings would be expected to yield more interest than liquid cash, but a lower return than should be available from risky assets such as shares and long-term bonds. The accumulation of money for expenditure in one, two, or three years might be in the form of bank deposits or other short maturity money market investments. Over such a timescale, the risk of capital loss from investment in shares or long-term bonds might be seen as excessive relative to the potential extra return from such investments. As a general rule, the value of stock market investments increases more than in proportion to time whilst risk increases less than proportionately to the progression of time. Such connections make financial exchange ventures unacceptable for transient sparing, however genuinely reasonable for the drawn-out aggregation of riches. The sorts of enormous consumption for which sparing or obtaining are probably going to utilized incorporate occasions, vehicle buys, advanced education, and house buys. Immense uses, for example, house buy, are probably going to be mostly financed by getting (for instance by methods for contracts).
Short timescale consumptions, for example, occasions are bound to be financed by saving. The credit the executives included when obtaining requires thought of variables, for example, the number of years required for reimbursement and the reasonableness of the month to month reimbursements. For a specific size of obligation, decreasing the regularly scheduled instalments will involve expanding the number of years for which reimbursements will be made. Thought ought likewise to be given to the possible changeability of regular instalments. For instance, contract getting conveys the danger typically that financing costs, and subsequently, month to month reimbursements will rise.
Long term Investing
Even though there might be some different explanations behind long haul sparing, for example, financing youngsters’ training or arrangement of inheritance to give to one’s beneficiaries, the most significant is the arrangement of a retirement income. To value the size of what is included for an individual, think about the case of somebody hoping to subsidize 20 years of retirement pay from 40 years of work. Assume that the point is to keep up the way of life at the level accomplished during the working life. In the nonappearance of a forthcoming genuine pace of profit for speculations, 33% of the pay got while working should be spared to give the retirement salary. The need to spare 33% of one’s salary depends on a zero genuine net pace of profit for ventures (the genuine net pace of return is the return after assessing swelling and tax collection). Generally, the genuine net paces of profit for bank and building society accounts have been just a little over zero, on average. The accomplishment of high genuine net paces of return has required speculation in shares. So, the achievement of wise venture returns has required acknowledgement of the danger related to interest in shares. Anyway, that danger should be seen from a long-haul point of view.
The impacts of time broadening have been outlined by Fidelity, which is significant speculation the executive’s organization (Fidelity International 2005). Looking at the period 1985 to 2005, they discovered that the UK financial exchange (as estimated by the FTSE All-Share Index) created a benefit in 77% of one-year time frames, where a one-year duration is 12 sequential months (for example June 1986 to May 1987, March 1992 to February 1993). There was a benefit in 81% of five-year periods, where a five-year time frame is 60 back to back months (for example September 1988 to August 1993). Each ten-year period (120 back to back months) indicated a profit. A global arrangement of stocks (as estimated by the MSCI World Index) delivered figures of 71%, 81%, and 100% separately.
In a similar distribution, the short idea of securities exchange developments was featured. During the period 1990 to 2005, the UK financial exchange created an average return of about 9% p.a., and the worldwide portfolio indicated an average return of around 7% p.a. Anyway, eliminating the best 40 days diminished the UK regular yearly come back to somewhat under zero. Expulsion of the best 20 days diminished the average yearly profit for the worldwide portfolio to about less 2%.
Fancy et al. (2002) contended that since numerous word related annuity plans have an indefinite future venture period (no predictable end date), they should hold 100% of their advantages in the type of shares. There is by all accounts practically no danger that shares (on the other hand alluded to as values) would fail to meet expectations different ventures over such a long speculation horizon. They propose that the inability to hold 100% in shares mostly emerges from short capriciousness of securities exchange execution, which could require the organization (or another annuity supplier) to subsidize deficiencies in some years. There is additionally the vocation danger of speculation directors, who could locate that a couple of years of helpless speculation returns bring about the loss of their positions. The time skylines of suppliers and directors might be shorter than the speculation skyline of the annuity fund. Read more on Wikipedia.
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