CFAI Reading 5 (The Behavioral Finance Perspective) EOC Question #5 Re: BPT

[2timesthecharm]

Hello, could someone please help me understand why the statement below is most likely behaving consistently with BPT, as opposed to prospect theory? The statement as well as the explanation provided in the curriculum seem to be describing loss aversion. Many thanks!
“I follow a disciplined approach to investing. When a stock has appreciated by 15 percent, I sell it. Also, I sell a stock when its price has declined by 25 percent from my initial purchase price”

 

[agbonline]

Hello, I am also facing issue with this question. In addition to this i also feel diffilculty understanding question no 4 of practice questions from the curriculum. It says:
“Most of my clients need a well-informed advisor to analyze investment choices and to educate them on their opportunities. They prefer to be presented with three to six viable strategies to achieve their goals. They like to be able to match their goals with specific investment allocations or layers of their portfolio”
The solution says “The clients discussed in Statement 5 exhibit mental accounting bias because they consider their portfolio by matching its layers to goals. The clients may not have time themselves to examine the investment universe and arrive at optimal solutions, but they rely on their adviser to do this for them. Thus, they do not exhibit bounded rationality”
I dont understand the first line of the solution, how come matching layers to goals exhibit mental accounting bias?
Can anyone please help us out with these two questions?
Thanks in advance. I hope magician see this query

 

[cpk123]

statement 1: does not describe loss aversion. Someone averse to a loss - does not want a loss - no matter how big or small. The person has a target up price and a target down price. If the price exceeds 15% on the up side - he will sell. If it goes below 25% on the down side - he will sell again (this part the loss averse person will not do – if it goes below - he will expect it to rise in future back up to the level he bought it at, and continue to hold, possibly).
additionally given the staggered payoffs the person exhibits - up side @ 15%, downside @ 25% - it is BPT.

Quote:
1. In Markowitz’s portfolio theory, risk-averse investors construct diversified portfolios based on mean–variance analysis and consideration of the covariance between assets. They are concerned about the expected return and variance of the portfolio as a whole. In behavioral portfolio theory, however, investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers. The resulting portfolio may appear well-diversified, but diversification is incidental to and not necessarily an objective of the portfolio construction.”

Why is this behavior NOT loss aversion of prospect theory?

“In prospect theory, based on descriptive analysis of how choices are made, there are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen. The framing (editing phase) consists of using heuristics to do a preliminary analysis of the prospects, often yielding a simpler representation of these prospects. More spe- cifically, people decide which outcomes they see as economically identical and then establish a reference point to consider where these prospects rate. Outcomes below the reference point are viewed as losses, and those above the reference point are gains. In the second phase, the edited prospects are evaluated and the prospect of highest perceived value is chosen.”
[/qiuote]
so they do not stagger their reference point like the above investor has done. This is consistent with the statement i made before – not wanting a loss - no matter what. (with reference to single point…)
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Statement 2: “Most of my clients need a well-informed advisor to analyze investment choices and to educate them on their opportunities. They prefer to be presented with three to six viable strategies to achieve their goals. They like to be able to match their goals with specific investment allocations or layers of their portfolio”
matching goals with particular investment allocations OR layers in portfolio - is mental accounting. Not considering the entire portfolio as “fungible” - as a whole - and saying Layer X will meet need A, Layer Y will meet need B … etc. They are not looking at the goal of investment as a whole.

 

[agbonline]

Thanks brother.. It was very helpful. Cheers

 

[daharmattan1]

and mental accounting is sub-optimal precisely because it fails to consider the correlation between the assets in different parts of the portfolio

 

[sunseeker]

2timesthecharm Query one to me expresses Loss Aversion in line with Prospect theory because Losses and gains have no the

symmetric impact (15% gains against 25% losses), but they are distorted …

“ prospect theory explains apparent deviations in decision making from the rational decisions of traditional finance. These deviations result from overweighting low probability outcomes, underweighting moderate and high probability outcomes, and having a value function for changes in wealth (gains and losses) that is in general concave for gains, convex for losses, and steeper for losses than for gains….”