#1. Does the narrowing of a confidence interval lead to more type 1 or type 2 errors. I always get this mixed up. Specify your answer as it relates to “Overconfidence” and also how it relates to “Assessing a Portfolio Manager’s Performance” - which is from a later session in the material. #2. What is the difference between “Regret Minimization” and “Loss Aversion” as it relates to holding on to a stock for too long because you don’t want to incurr a loss? #3. Am I correct in saying that “Fundamental Risk” can only be diversified away if an investor finds two perfect substitutes (highly unlikely)? #4. I see reference in the material that “Fundamental Risk” is considered “Systematic”. Am I correct in assuming that if a perfect substitutes pairs trade is not possible, that would mean the investor is subject to systematic risk ie: Fundamental Risk which cannot be diversified away? (One of the reasons for persistent mispricings) #5. Calculating Required Return. I see in Scwheser where sometimes they would have say a spending rate of 4% and inflation of 3% so they would calculate the required return as (1.04) x (1.03). Other times, I see it calculated as 4% + 3%. Which is the correct method? #6. Page 235 of Schweser in S4 states, “The main thing to take away from Figure 1 is that the level of wealth dominates age, so individuals who are classified as not wealthy will nearly always find a conservative investment policy optimal, while those who are wealthy will nearly always find an aggressive approach optimal” I found this to contradict material found in a later session where when a person had the majority of his wealth tied up in “Human Capital” ie: Earnings/Income represent most of his wealth and is considered risk-less or bond-like, they should take a growth orientation to their portfolio, particularly for someone young. So which is it?? #7. Which of the diversification techniques (Completion Fund, Exchange Funds, Sale, Heding) would result in the quickest way to diversify the position? Which would take the longest? That’s it for S3 and S4. Will have more to follow as I complete my review but was really hoping the group here could answer the above questions as I find it will be useful for all of us. PJStyles
#1 Type I error is a rejecting the null when you shouldn’t, this happens more often when the confidence interval gets smaller. But this doesn’t have anything to do with "overconfidence in SS3/4 does it? How are you linking the two? #5 either should be OK, multiplying is technically more correct. It’s been discussed before. #7. huh? why would you care which is the quickest? all readings talk about which is the most effective.
TooOld4This Wrote: ------------------------------------------------------- > #1 Type I error is a rejecting the null when you > shouldn’t, this happens more often when the > confidence interval gets smaller. But this doesn’t > have anything to do with "overconfidence in SS3/4 > does it? How are you linking the two? The material specifically states that Overconfidence leads to confidence intervals that are too narrow, which inevitably leads to surprises and the systematic understating of risk. So what you’re saying is that that a smaller confidence interval ie: 90% instead of say 95% will lead to more type 1 errors because we are rejecting the null more frequently? Still need a good example to wrap my head around this one. > #5 either should be OK, multiplying is technically > more correct. It’s been discussed before. Cool… thanks. > #7. huh? why would you care which is the quickest? > all readings talk about which is the most > effective. Schweser had a few sample questions discussing which would be the quickest or longest ways to diversify the position. Now that you mention effectiveness, which method is the most effective way of diversifying the investment and eliminating the taxable gain?
#7 quickest is sale, longest is completion portfolio #3 fundamental risk is associated with specific news coming out for one of the two companies, that can’t be diversified away. So even though you have your sector exposure hedged, you’re still facing fundamental risk #2 Loss aversion: Investor prefer large uncertain losses to small certain losses Regret minimization: Avoid anything that will make you feel regret ( Blame others for your mistakes, remember only periods of good performance, use a financial advisor, avoid cognitive dissonance, …) As you can see they both lead to the same effect, just pay attention to te details of the question.
My take - #1. Type2 error #2. Loss Aversion - you want to avoid a loss, so you may take a bigger gamble to get back. Regret Aversion - avoid making a decision which could lead to regret. #3. No. Fundamental risk cannot be diversified away. #4. Yes. Fundamental risk cannot be diversified away. #5. Either of them works. However, sometimes I have seen questions where the multiplication method eliminates one of the choices. #6. I would go with level of wealth as the primary means of determining risk tolerance. #7. Sale is fastest. Completion fund takes longest.
#6. I dont see any inconsistency. Human Capital represents most of your wealth when you are young. So when u invest say 1st yr savings (probably 2% of total wealth) in Equities, total portfolio (Capital + Equity) would still be conservative.
#1 Narrow confidence level will cause Type I error. Narrower confidence level happenes when your level of significance is is higher. Level of significance (a.k.a. alpha) is the probability of rejecting a true Ho or in other words probability of Type I error. When level of significance is higher say 0.1 vs. 0.05, confidence interval (1 - level of significance) is smaller, 90% vs. 95%, the t-value for 90% confidence level is smaller than for 95%, by having smaller t-value, it makes it easier for you to reject Ho, so chances that you reject Ho when its true are higher, and thus chances of commiting Type I error are higher, and thus you are more prone to keep/hire a manager, when he has no investment skill.
volkov… awesome explanation… I love it!!! Thanks! BidBadBadri… the way you explained it makes total sense… Thanks for the clarification guys… PJStyles