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1. Lou Donaldson and his neighbor, both U.S. residents, are meeting at a local restaurant. During lunch, they discuss investing and Donaldson, age 45, makes the following statements:
a. “My father was a buy-and-hold investor but I am an active trader. To keep trading costs low, I use an online brokerage firm. I have done well investing in technology companies because I know the industry.”
b. “I am holding a large position in Omega Corporation with a large unrealized loss. Omega’s stock price declined last year when reported sales and earnings failed to meet analyst expectations. I took advantage of the decline to increase my position. Omega sales growth has continued to slow over the last year, but I believe the stock is still a good investment.”
c. “I read a newspaper article reporting that commercial property values in the city have increased 14 percent annually since 2000. According to the article, the average commercial property in the city sold for $1.5 million last year. This makes me very happy because I just purchased a piece of commercial property last month. There is no doubt that it will be a good investment.”
Select the behavioral finance concept best exhibited in each of Donaldson’s three statements. Explain how the behavioral finance concept you selected affects Donaldson’s investment decision making. And no behavioral finance concept can be used more than once.
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2. Joyce Siosan is a 42-year-old lawyer at a prestigious law firm. She is meeting with Joel Murray, a financial advisor, to organize her finances. During the interview process, Siosan tells Murray that she has been purchasing short-term, out-of-the-money call and put options. Siosan acknowledges these options have a low probability of paying off and that the expected return from her options trading is negative. However, she states that she is attracted by the possibility of high returns when she can exercise in-the-money options. At the same time, Murray notes that Siosan has been purchasing low-payoff earthquake insurance on her home, which is located in a low-probability earthquake zone.
a. Describe Siosan’s utility function. Contrast her utility function with that assumed in traditional finance theory.
Siosan purchases a new luxury vehicle every two years and takes expensive annual vacations. She has a reputation for paying the entire bill at the upscale restaurants where she dines regularly with her friends. Siosan’s annual consumption, options trading, and housing expenditures are paid for entirely out of her salary income and half of her modest annual bonus. She deposits the other half of her annual bonus and any other non-salary sources of income into her relatively small retirement account, which excludes her options trading. Siosan is reluctant to incur debt and has only a small mortgage on her home, despite the fact that she will soon be made a partner in her firm and will have much higher earnings. Murray believes that Siosan exhibits behavioral biases that interfere with an optimal savings and consumption allocation. In particular, he thinks that she is not saving enough for retirement.
b. Discuss how Siosan’s behavior reflects the bias of
ii. Mental accounting
Explain how a rational economic individual in traditional finance would behave differently with respect to each bias.
Siosan’s retirement portfolio is allocated 50% to money-market securities and 50% to a few speculative stocks that she read about in an investment newsletter. Murray observes that Siosan’s retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean–variance framework.
c. Determine whether Murray’s observation about Siosan’s retirement portfolio allocation is correct. Justify your response with two reasons.
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