holding both insurance & lottery ticket (chap 6)

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PhilMtx

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Hello everyone,
I am confused.
Schweser explains that Behavioral Portfolio Theroy (BPT) layering can results in irrational holding of both insurance, a low-risk layer and high-risk lottery tickets by the same individual.
CFAi book finishes its section about Prospect Theory (PT) with the same point. “This (PT) is consistent with people simultanously buying lottery tickets and insurance while investing conservatively”.
-Phil
 
The two are seperate but similar:
For PT theory, buying lottery tickets and insurance is a exteremly low probability of a massive payout (life insurance doens’t even benefit the person buying it, they’re dead). However, in their investments they pick very safe investments because they fearful of losses. In one situation they’re accepting risk when the payout is vastly unknown or unlikely, in the other situation they’re not accepting much risk for an anticpated low return.
The issue is the individual is taking excessive ‘risk’ with returns that are unknown and can’t be forecasted. When they are given a predictable return, they choose to be safe and pick low-risk low yield investments. The two behaviors do not make sense when combined in an overall portfolio. The individual should not be comfortable with risk taking in an unknown return environment and should be taking more risk in investments that can be somewhat forecasted.
At least that’s how I interrupted it :)
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For BPT, layering of a portfolio is supposed to be set up in a way where the base layer is a set of highly liquid safe investments which the investor can withdraw to pay for normal everyday events or even unexpected life emergencies.
The top layer is smaller, longer term and titled towards high risk investments.
When you combine the two layers, you end up with a strange looking portfolio where a chunk of your investments are very very safe and have almost no yield whereas the other portion of the portfolio has a very high risk profile with very large potential gains. Does it make sense to have the two extreme’s in one portfolio? Probably not.
 
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