Behavioral Finance Perspective Blue Box Example #3

Andrew3032 · February 5, 2012, 7:54pm

Reading 7 page 41-42

Quite a convuluted process to wade through, if one were to actually perform all the necessary calcs.

I would like to think that the main objective on this reading would be to focus on areas that show up in the EOCs which appear to be more conceptual based understanding of the reading rather than burning up too much time making sure that one understands an example such as this one.

Would any retakers care to comment on this? I know I’ve heard to make sure and practice these blue boxes at this level in addition to the EOCs, but this particular example just begs the question… “My God man!!!”

niraj_a · February 6, 2012, 2:54pm

i wouldn’t use a lot of time mastering behavioral finance. just know the main terms and what they mean. you should be able to identify a behavioral finance trait based on a given situation etc. that’s all.

noscrubs008 · February 7, 2012, 4:09pm

I still don’t understand the Solution to this example. How did the author come up with such allocation? Could someone explain, please?

cpk123 · February 7, 2012, 5:25pm

do the search … it has been discussed posted multiple times before please.

noscrubs008 · February 7, 2012, 5:38pm

Thank you cpk123. I’ve found what I need in your old post. I’ll quote the answer here for those who haven’t found it.

cpk123:

Assume the second investor puts X amount into Layer 3 and the rest in Layer 1 (2000000 - X). You can find X using the following equation : (2M - X)(1 + 0.01) + X (1 - 0.5) = 1.8M Note that Layer 1 is expected to yield 1% and Layer 3 -50% with 15% prob. Since the first Layer is risk-free, the above allocation should result in 1.8M, which happens to be his safety level, with 15% probability. 2. Solve the equaton for X: X = 431,373 (21.57%) (2M - X) = 1,568,627 (78.43%) - The 2nd investor would get 2,067,451 with 50% prob: 1,568,627 (1 + 0.01) + 431,373 (1+0.12) = 2,067,451 (12% of return given in the vignette) - He’d get 2,339,216 with 35% prob: 1,568,627 (1 + 0.01) + 431,373 (1+0.75) = 2,339,216 (75% of return given in the vignette) You might wonder why the 2nd layer is not being used at all. I bet CFAI won’t draw up a question with more than one unknown I guess that given the low return on Portfolio 2 - with 4.6% - a better return is obtained with the portfolios layers 1 and 3.

Andrew3032 · February 7, 2012, 9:29pm

The op doesn’t really have anything to do with “how to calculate”.