QUESTION
Monty Frost’s tax-deferred retirement account is invested entirely in equity
securities. Because the international portion of his portfolio has performed poorly
in the past, he has reduced his international equity exposure to 2%. Frost’s
investment adviser has recommended an increased international equity exposure.
Frost responds with the following comments:
On the basis of past poor performance, I want to sell all my remaining international
equity securities once their market prices rise to equal their original cost.
Most diversified international portfolios have had disappointing results over the
past 5 years. During that time, however, the market in Country XYZ has
outperformed all other markets, even our own. If I do increase my international
equity exposure, I would prefer that the entire exposure consist of securities from
Country XYZ.
International investments are inherently riskier. Therefore, I prefer to purchase any
international equity securities in my “speculative” account, my best chance at
becoming rich. I do not want them in my retirement account, which has to protect
me from poverty in my old age.
Frost’s adviser is familiar with behavioral finance concepts but prefers a traditional
or standard finance approach (modern portfolio theory) to investments.
Justify the behavioral finance concept that Frost most directly exhibits in each of
his three comments. Argue how each of Frost’s comments can be countered by using
an argument from standard finance.
ANSWERS
Comment 1: On the basis of past poor performance, I want to sell all my remaining international
equity securities once their market prices rise to equal their original cost.
The first statement of Frost is an example of reference dependence. His inclination to sell the
international investments once the prices return to the original cost depends not only on the
terminal wealth value, but also on where he is now, i.e. his reference point. Frost’s decision
ignores any analysis of expected terminal value or the impact of this sale on her total portfolio.
This reference point, which is below the original cost, has become a critical factor in Frost’s
decision.
Monty Frost’s tax-deferred retirement account is invested entirely in equity
securities. Because the international portion of his portfolio has performed poorly
in the past, he has reduced his international equity exposure to 2%. Frost’s
investment adviser has recommended an increased international equity exposure.
Frost responds with the following comments:
On the basis of past poor performance, I want to sell all my remaining international
equity securities once their market prices rise to equal their original cost.
Most diversified international portfolios have had disappointing results over the
past 5 years. During that time, however, the market in Country XYZ has
outperformed all other markets, even our own. If I do increase my international
equity exposure, I would prefer that the entire exposure consist of securities from
Country XYZ.
International investments are inherently riskier. Therefore, I prefer to purchase any
international equity securities in my “speculative” account, my best chance at
becoming rich. I do not want them in my retirement account, which has to protect
me from poverty in my old age.
Frost’s adviser is familiar with behavioral finance concepts but prefers a traditional
or standard finance approach (modern portfolio theory) to investments.
Justify the behavioral finance concept that Frost most directly exhibits in each of
his three comments. Argue how each of Frost’s comments can be countered by using
an argument from standard finance.
ANSWERS
Comment 1: On the basis of past poor performance, I want to sell all my remaining international
equity securities once their market prices rise to equal their original cost.
The first statement of Frost is an example of reference dependence. His inclination to sell the
international investments once the prices return to the original cost depends not only on the
terminal wealth value, but also on where he is now, i.e. his reference point. Frost’s decision
ignores any analysis of expected terminal value or the impact of this sale on her total portfolio.
This reference point, which is below the original cost, has become a critical factor in Frost’s
decision.
