A Behavioral Finance Q (V2,P48,Q5)

I have a hard time to understand the difference between behavioral portfolio theory from prospect theory. I thought they were the same thing or closely related. Can you explain the answer of that EOC question(Q5) in more details? Thanks.

key difference seems to be the way gains / losses are treated in the two.

Here - both in case of a 15% gain and a 25% loss - the security is being SOLD.

For Prospect theory - with a 15% gain - you would take on more risk - and buy more, while for the loss case - you would sell it …

this is my understanding at the present moment…

This one puzzled me too . Naturally I chose prospect theory because of the skew between treating gains and losses.

I rationalized ( uselessly , because I have no real answer) that it is because :

  1. It is not a knee jerk reaction to a loss ( prospect theory stresses on loss aversion ) but a planned strategy that yet brings in a behavioral bias into focus.

But cpk may have hit on the right idea . Loss aversion is more pronounced in Prospect theory and you would delay selling to try and see if the stock recovers. You would also take gains early not to let the gains disappear. This person is having a more disciplined approach, which is nevertheless skewed in its probabilities

Hi janki u r from USA

Loss aversion investor won’t set selling strategy of gain 15% and loss 25%. So, prospect theory is not correct.

Don’t confuse loss aversion with risk aversion. A RISK averse person wouldn’t set this strategy of 15% gain/25% loss sell discipline, a LOSS averse person wouldn’t sell even if the loss was at the 25% limit because they FEEL that the stock is down only temporarily.

Behavioral portfolio theory has to do with structuring portfolios in layers, there is nothing here to suggest layering of the portfolio.

Prospect theory has to do with how gains and losses are evaluated, this seems to be more in line with the answer.

not sure where you are getting at Fin -> answer is BPT - not Prospect Theory.

The reason is - he is SELLING when there is a 15% gain – a Loss Averse person would end up buying the security when he sees the gain.

I thought the answer was prospect theory, I don’t have the book so I can’t look up their justification. However, I still don’t see how this has to do with layering your portfolio. Also, Loss averse investors tend to hold on to losers longer than justified and sell winners earlier than justified AND hold riskier portfolios as a result. A loss averse person is not necessarily a risk averse person.

I will check the guideline answer on this when I have the book with me, but I think what I’ve said here is correct. Let me know if it is not.

it is not .

The loss averse investor using prospect theory to evaluate prospects would:

hold on to losing positions of -25% as he is more risk seeking in the area of losses. He would ‘gamble’ his way out of a loss position rather than close it…since the client from Q5 will sell the losing position, this does not corroborate prospect theory…i think…

under prospect theory an individual is risk averse over gains/risk loving over losses, that means if he makes a gain, he is more likely to realise that gain,and if he makes a loss he would be more risky and continue to gamble , since he is loosing anyways…

I agree with Alladin, and see why the answer would not be prospect theory as long as they stick to their sell discipline.

the prospect theory guy would not sell if he has a loss … is what you both are saying … so that is inconsistent with that aspect. He would NOT have this sell discipline if he was a Prospect theorist.

(and yes, I realized I was wrong … corrected / edited my previous error post)

imagine it this way…in the area of losses the guy is a degenerate gambler putting coins in the slot machine despite having lost loads of money already , believing in that big payoff someday…in the area of gains the guy is like your grandma, if she finds 2$ on the floor she will be happy for a year…

The question would have been consistent with prospect theory if the client :

[a] Sold the 15 % gain position (because he is risk averse over gains) = grandma

[b] Continue investing in the 25% loss position (because he is risk loving over losses) = Gambler.

…i think,

The way I have understood Prospect Theory is that it defines the process of making decisions and not the outcome. I don’t believe that saying whether someone would or would not choose this sell discipline can be based on Prospect Theory alone without regard to the process the individual takes to arrive at this decision. This is why, as Prospect Theory states, people can come to different conclusions regarding the same decision.

how do you say the following, FinNinja?


The way I have understood Prospect Theory is that it defines the process of making decisions and not the outcome

End Quote:

the process of making decisions and the outcome are kind of intertwined there.

The 6 steps of editing - Codification, Combination,Segregation, Cancellation, Simplification, and Detection of dominance - esp. the last three steps - would be based on the outcomes of the first three steps and would decide the final outcome, wouldn’t it?

I am thinking that the sell discipline is the final outcome, are you saying that the discipline is one of the outcomes of the 6 steps of editing?

Any process involving steps would have an outcome to each step towards the final outcome. Isn’t Prospect Theory just a process of wittling down choices to come a perceived optimal choice by applying the outcomes of each step to the next appropriate editing phase?

I see why prospect theory is not the correct answer to this question, but I am having trouble grasping why it is BPT. From what I can see, BPT is striclty about constructing a portfolio in layers (risk free assets, semi-risky assets, and very risky assets to achieve goals); I don’t see anything about risk or loss aversion. Am I missing something?