CFAI EOC Reading 6 Question 5 (EOC)

[sachin_patel]

Client sells if stock appreciates 15 % or declines 25% from purchase price.
Answer says this is consistant with behavioral portfolio theory.
When I read, behavioral portfolio theory is related with layerd investing. layers like high risk, low risk etc..
There is nothing mentioned about layers here though..
Thanks!

 

[ink]

this is straight from the behavioral portofolio section:
“…the portfolios of investors reluctant to realize losses may continue to hold some securities not because of the securities’ potential, but rather because of the investor’s aversion to realize losses.”
read that section carefully. It explains very well how the utility function of investors changes based on the layer of investments. Investors can show risk aversion for some layers and risk seeking for other layers. See also Exhibit 4.

 

[sachin_patel]

Still confused.. If you look at the sentense you copied. It says “continue to hold some securities”
In the problem, the investor is actually selling the security.
Is it because 25% loss is too big of a number and should have sold before that?

 

[ink]

the short answer is because there is assymetry in the % return and % loss.
Look at Exhibit 4, because a lot of what is explained in that exhibit relates to behaviroal portofolio theory. Between points B and C, the utility function is convex, meaning that the investor is risk-loving. How does the shape of that function and risk loving behavior relate to the problem? An investor who is risk loving will sell too soon assets that gain in value and keep for too long assets that lose value, which is exactly what happens with this investor.

 

[sachin_patel]

ok i’ll go back and try again to look at the exhibit and see if I can make any sense out of it.