behavioral finance blue box question 2013, behavioral, understand, prescribed

morebeans

Hi this post is related to blue box question on page 39 of volume 2 of cfai 2013 book. (reading 7).
I think the asset allocation prescribed for the second investor is not optimal. I also do not understand the “thinking/reasonning” behind arriving at this allocation.
Instead of the solution given if the second investor puts all his money in the second layer. His minimum return would be .97(2000000)= 1940000. This is greater then the minimum amount required of “1800000”. Also he has a 80 percent chance of earnning a 5 percent return and hence have a final wealth of 1.05 (2000000) = 2100000 which is what is required.
Instead the answer given in the book does not even meet all requirements which is mentioned in the solution it self. Hence it is sub optimal in any case then why not go down the route as explained in my answer. can someone please explain

himanshumh

VR has the correct answer. BPT investor builds portfolios with lottery tickets and insurance policies , not a comprehensive constrained mean variance optimized portfolio.
He first builds the riskless layer by considering a mental account which never loses more than 200k at the most. This is the insurance layer . There are NO guarantees in layer 2 , which is a moderate risk layer . there is a guarantee of 1% in layer 1 , which is riskless. An insurance policy invokes a constraint of the wealth never falling below some aspirational level ( in this case 1.8 M). I think you have to read the layer 2 probability of loss carefully . -3% with 10% probability .So 10% loss with what probability ? Is it 0% probability? No. I bet there is some finite probability that it will lose 10% , i.e. wealth falls to below 1800000.
Mr. BPT Investor cannot tolerate this  utility point of view . He needs to be sure in riskless layer and totally risky in risky layer
So he builds the risky layer where he aspires to gain 100k. This is the lottery ticket layer.
Here CPK is correct . Aspirationally layer 2 can never provide 5% return , while layer 3 can . BPT Investor has worked with first two  of Shefrin/Statman’s 5 factors of BPT Portfolio construction:
1. Allocation to layers depends on goals.More important the goal more the allocation . Here layer 1 has greater allocation ( nearly 4 times layer 3 )
2. Allocation within layer depends on the aspiration for the layer . So the risky layer aspiration of loss is ( absolute maximum ) loss of 200 k , which is 50% of layer 3 allocation.
  Allocation within risky layer tries for 5% gain . Layer 2 can only provide 4.6% . Layer 3 can do ~ 25% . Sounds like a lottery ticket


His me

Fdez

yeah dawgs, lets start studying 9 months before the test!!

WarrenB1

lol yes you are right cirkon. my mistake. But the point is still valid.

ftwcfa

somehow…i think you are overthinking this…keep it simple mate,cpk has answered all there is

JRossSter

please reread my post.
1) the investor is a BPT investor, so looking at returtns/risk is not surprising:
I did not argue with what should be looked at. I only stated looking at the information given and taking  it for what it is.
2) the layers are defined in terms of risk/return/probabilities, so you need to convert money terms into returns
I did not argue with how layers are defined. I argued with how preferences were defined in this specific/particular case. and they are not defined in terms of expected return and cannot be converted into expected return, given the information given.
3) there is nothing magical about converting nominal prices into returns
I have no idea where this came from. What i said was it is not possible to convert the expressed preference of investor into an equivalent expected return requirement. In other words two statements below cannot be converetd into an equivalent expected return requirement. If yes, i would be most interested to know how.
1) Portfolio should not fall below 1800000
2) Aspiration of 2100000 with 80% probability
4) lastly there is a contradiction in using expected return metric in this specific case:
example:
lets assume layer 1: 95% probability of 4% return and 5% probability of 50% return.
The Exepcted return is: .95*4 + .05*50 = 3.8 + 2.5 = 9.5% return.
In this layer the expected return is greater than 5% but the “probabillity of of the return being greater or equal to 5% is only 5%”.
So if this was one of the layers in the question and you went by expeceted return calculation then you would have the wrong answer because the probability of a return being greater 5% HAS to be atleast 80% as explicitly stated in the investor preference and here it is only 5%.

Houjichasan

Rain01 wrote:
…..
Moreover given your arguement about investor looks at ER AND RISK. In this specific question he has NOT expressed his preference in terms of EXPECTED RETURN AND RISK. The only 2 things he has said i have already stated in previous post. So we cant enforce something which he did not say. How can you convert:
…..
[1] the investor is a BPT investor, so looking at returtns/risk is not surprising
[2] the layers are defined in terms of risk/return/probabilities, so you need to convert money terms into returns
[3] there is nothing magical about converting nominal prices into returns

hariRaj

It is not suggested answer in the book I am going by. He is a BPT Investor. Read the first para on Pg 38. BPT uses a Probability weighting function. In BPT Investors construct a portfolio in layers and expectation of returns and attitudes toward risk vary between the layers.
So Given statement 1 - probability weighted expected return (For entire layer) is what he will use. So 4.9% is the number and not the minimum probability and return that you have shown above. An Entire layer would either be selected or rejected based on the E(R) seen (which is Prob * return in the particular level within the layer).
And last line in Pg 38  Risk Aversion of investor is taken into account by constraint that limits risk of failing to achieve the aspirational level of wealth. At 80% probability - he will not achieve the 5% aspirational return.
He needs to be able to select Layer 2 first to go by whatever else you are saying above.

willsucceed

his aspiration levels is 2.1 Mill$ - so he requires a 5% return at 80% probability.
I agree with this statement
If he selects layer 2. there are 3 states of the world only and for our purpose they can be converted into 2 states of the world.
So lets says he selects layer 2.
1) The other two probabilities 5% (80 percent probabillity), 9% (10 percent probabillity) only provide him with 4.9% at 90% probability. That is not correct:There is a 90 percent chance that he will earn atleast 5%. (80 percent chance of 5% return and 10% chance of 9% return). FIRST CONDITION SATISFIED.
2) There is a 10 percent chance that he will earn -3%. So his minimum porfolio value is .97 * 2000000 = 1940000. 1940000  1800000 so SECOND CONDITION OF MINIMUM PORTFOLIO RETRUN OF 1800000 IS ALSO SATISFIED.
I dont know why you keeep giving me expected return calculations. who said anything about expected return or requiring a expected return. all that was said was that the portfolio should not fall below amount 1800000 and there should be atleast 80 percent chance of earning 21 mil.   
Forget about the suggested answer in the book.  just read the question and figure out what it is asking for and then see which answer is correct

Windjammer

his aspiration levels is 2.1 Mill$ - so he requires a 5% return at 80% probability.
Given the -3% at 10% probability - the layer 2 would not meet that requirement. The other two probabilities 5% (80 percent probabillity), 9% (10 percent probabillity) only provide him with 4.9% at 90% probability. Now do you get it?