EOC Reading 7 - Q5
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Can anyone explain why isn’t it A - prospect theory since it seems to fit with the value function of prospect theory?
where the individual exhibits loss aversion on gains (selling after the stock has appreciated by 15%) as opposed to selling after the stock has depreciated by 25%?
If this investor were behaving under prospect theory, she would not consider selling a stock if its price had declined 25 percent. She would take the risk of recovering the initial investment, at least. Under prospect theory (and verified by empirical studies), investors are much more willing to take risk in the field of loses than under the field of gains.
For example, if the investor has the opportunity to realize a 15% gain on an investment, she is risk averse and will realize the gain as soon as possible. On the other hand, if the investor has a losing position, she is risk seeker now and will wait until the position is recovered (irrational because most of the time there are no indications of price recovery in the short term).
Under behavioral portfolio theory, investors invest on layers. Commonly, people has different goals in life and will invest according those goals, where the layer of the bottom is extremely risk averse to prevent financial disasters (losing house, food, education for children, etc). As wealth is accumulated and the first layer is covered, the investor will invest in more passional goals (get a house on the beach, a ferrari, etc).
The above investor seems to behave according behavioral portfolio theory as we are talking about her aspirational portfolio which is used to speculate.
This explains it, thank you
I totally understood your explanation about BPT but can you please shed more light in this context, why the mentioned scenario falls under aspirational risk bucket only?
If you see the investment strategy of this investor, it looks like the typical naive strategy of selling the winners and keep the losers until some threshold is passed. This speculation methodology seems not to be grounded under some rigorous analysis like fundamental analysis of stocks. This evidences the guy uses this portfolio as the aspirational bucket used to speculate on risky assets in order to seek high returns.
My view to this is that, since Prospect theory is based on loss aversion. The investor should sell immediately it tends towards loss. Hence, if the question is twisted that the investor will sell once losses start to accrue, I think it should then be a prospect theory perspective. Kindly help confirm my views. Thanks.