Portfolio Theory (Chapter 8) Flashcards
What are the main differences between MVT and BPT?
MVT:
-described on mean-variance frontiers
-satisfies wants for utilitarian benefits (high expected returns + low risk)
-investors consider portfolio as a whole
-investors measure risk by variance of returns (standard deviation)
-investors have single risk aversion in portfolio as a whole
-investors are always risk averse, risk is measured by variance of returns
BPT:
-described on bahvioral-wants frontier
-satisfies wants for utilitarian AND expressive + emotional benefits
-investors consider portfolio as layered pyramids
-investors measure risk by probability of shortfall from goal or amount of shortfall
-investors have risk aversion for each mental account
-investors are always risk averse, risk is measured by probability of shortfall from goal
What is meant by the mean-variance frontier?
In MVT, investors places his portfolio on the mean-variance frontier (=curve) and optimizes his frontier by choosing the portfolio with the highest expected return for each level of SD.
-> trade-off between high-expected returns and wants for low SD
What is meant by the “food portfolio analogy”? How does that relate to investors?
Dietitians consider not only utilitarian benefits of high nutrition and low cost, but also the expressive and emotional benefits of palatability, variety, prestige and culture.
-> diners want full range of food benefits
Investors want usually the same: investment portfolios on the behavioral-wants frontier are optimal for investors who want the full range of investment benefits.
What are examples of portfolios that lie on the behavioral-wants frontier?
Portfolios that provide expressive + emotional benefits of social responsibility, patriotism and familiarity, pride and avoidance of regret, and convention.
What is an example of a portfolio that satisfies wants for social responsibility? How does this portfolio relate to the mean-variance frontier?
e.g. exclusion of stocks of nuclear companies
MVT:
-separate portfolio production from portfolio spending (invest in stocks from nuclear companies yielding greatest wealth and then spend extra wealth in contribution to antinuclear campaign)
BPT:
-separation fo production of wealth from its spending makes no sense to social responsible investors
-consequently, expected annual returns of constrained socially responsible portfolios fall below unconstrained MVT portfolios by more than 3%
-BPT frontier lies below MVT frontier
What is the problem about wants for patriotism & familiarity in portfolio theory?
-Patriotic & familiar investments yield expressive + emotional benefits
-they promote home bias = preference for investments in home countries
-imply cognitive + emotional errors misleading investors into bearing extra risk with no extra expected return (forgoing risk-reducing benefits of global diversification)
What is the problem about wants for adherence to convention in portfolio theory?
=desire of individuals to conform with social norms and conventions, even if doing so may not be in their best interest (“herding behavior”)
These wants arise from the desire of belonging to a social group, avoids disapproval or punishment, and gain social status or approval
For example, some investors may have ethical or social considerations that they want to incorporate into their investment decisions. Others may have liquidity constraints, tax considerations, or preferences for certain types of assets or industries. Ignoring these factors can result in suboptimal portfolio allocations and returns.
Adherence to convention may lead to herding behavior, where investors follow the same strategies and asset allocations without considering their individual circumstances
What are difficulties that hamper transformation from ignorance to knowledgeable investor when correcting cognitive and emotional errors?
- socioeconomic status:
-> Low status of people associated with more pessimistic beliefs about stock returns than higher status - Misperception about benefits of portfolio diversification
-> people with low financial literacy believe that diversification increases volatitlity (adds risk) of portfolio
-> people with high financial literacy believe diversification increases expected returns of portfolios, when it actually leaves expected returns unchanged - Errors related to correlations - investor needs to decrease correlation in portfolio
-> not considering correlations are errors increasing the risk of portfolios -> impose utilitarian costs without compensating with utilitarian, expressive and emotional benefits
Why is considering correlations in portfolios important?
Not considering correlations are errors increasing the risk of portfolios -> impose utilitarian costs without compensating with utilitarian, expressive and emotional benefits
The benefits of diversification are low when correlations are high
The benefits of diversification are high when standard deviations are high
What is meant by: “Benefits of diversification are all about falling to the gap”?
Diversified investors give up hope of having their entire portfolio at the top of the gap but they gain the freedom from fear of having their entire portfolio at the bottom of the gap
-> Diversification does not eliminate the possibility of losses, it only mitigates it
How can wants and correcting of errors be assessed by investor’s questionnaires?
Investor questionnaires are designed to help investors identify their wants and needs and develop a personalized investment strategy.
Most questionnaires asses the conflicting wants for high expected returns and low risk.
BUT, can also asses the wants beyond high expected returns and low risk.
How can questionnaires be used to assess the conflicting wants FOR high expected returns and low risk?
- Questions about risk aversion as 1. variance aversion or 2. loss aversion.
- Questions that involve stakes that have little impact on life-time resources.
- Questions that probe loss capacity (I plan to hold the investment for…).
How can questionnaires be used to assess the wants BEYOND high expected returns and low risk?
- Questions about wants for maximization (men have greater wants for maximization = winning)
- Questions about confidence
- Questions about regret aversion (maximization seeking is associated with regret aversion)
- Questions about social values (e.g. support for abortion rights)
What are limitations of investor’s questionnaires?
- May not account for the complexity of real-world situations.
- May not capture the full range of investor preferences.
-> investors should also seek advice of financial professionals
What are the different risk measures in MVT and BPT?
MVT -> risk aversion as risk as standard deviation
BPT -> risk aversion as shortfall aversion as shortfall risk of aspired level of wealth / return
