I’m having difficulty understanding the solution to question 5, why is the answer C (behavioral portfolio theory) instead of A (prospect theory)?
My understanding is that behavioral portfolio theory focuses on investors having layers to meet their goals, while prospect theory suggests investors are loss averse - so why not A?
Any help would be much appreciated.
So I think that’s a crappy question… since they both have loss aversion in them…the response below states that prospect theory is when framing alternatives. Doesn’t really say that in the reading but eh. If you read 4.3.3 (BPT), you will see that layering is just one part of BPT, it also involves loss aversion. To be honest, the client sells stocks that decline 25% which I think is a relatively fair drop so even loss aversion seems relative, but he does cap gains so it fits kind of.
Here is the post talking about this question again:
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91320210
Others think this is a crappy question as well:
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91349238
Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth, and probabilities are replaced by decision weights. In prospect theory, the shape of a decision maker’s value function is assumed to differ between the domain of gains and the domain of losses. The value function is defined by deviations from a reference point and is normally concave for gains (implying risk aversion), convex for losses (risk-seeking), and steeper for losses than for gains (loss aversion). Decision weights are generally lower than the corresponding probabilities, except in the range of low probabilities. Normally this would mean Buy a stock when it declines, Sell a Stock when it appreciates. But Client 6 sells when it appreciates 15%, also sells when it declines 25%. So he is NOT consistent in his behavior when it is in the realm of gains and when in the realm of losses. So Prospect Theory is NOT an answer. It is also definitely NOT Expected Utility Theory (there the behavior would be with respect to a consistent amount of gains and losses (not different ones). So among the answer choices has to be BPT …