Suppose there are two investors: Michael and Steve. Both have pension funds, into which they deposit money each month from their paychecks. Both are in their early 30s, and anticipate retiring at around age 65. Neither anticipates withdrawing any money from his pension fund prior to retirement.Michael watches his pension fund closely, looking each week at whether has gone up or down in value. On a week to week basis, the US equity markets are down almost as often as they are up. Steve, on the other hand, only checks the value of his pension fund once every five years or so. On a five-year basis, the US equity markets are down less than 10% of the time.Michael’s pension fund money is all in bonds, while Steve’s is all in equities. Which single feature of Prospect Theory provides the best explanation for the two men’s different portfolio allocations?1 pointRisk seeking over lossesRisk aversion over gainsLoss aversion
Question
Suppose there are two investors: Michael and Steve. Both have pension funds, into which they deposit money each month from their paychecks. Both are in their early 30s, and anticipate retiring at around age 65. Neither anticipates withdrawing any money from his pension fund prior to retirement.Michael watches his pension fund closely, looking each week at whether has gone up or down in value. On a week to week basis, the US equity markets are down almost as often as they are up. Steve, on the other hand, only checks the value of his pension fund once every five years or so. On a five-year basis, the US equity markets are down less than 10% of the time.Michael’s pension fund money is all in bonds, while Steve’s is all in equities. Which single feature of Prospect Theory provides the best explanation for the two men’s different portfolio allocations?1 pointRisk seeking over lossesRisk aversion over gainsLoss aversion
Solution
The single feature of Prospect Theory that best explains the two men's different portfolio allocations is "Loss aversion". This is because Michael, who checks his pension fund weekly, is more likely to see losses due to the frequent ups and downs of the market. This could make him more averse to risk and therefore more likely to invest in bonds, which are generally considered safer. On the other hand, Steve, who checks his pension fund every five years, is less likely to see losses due to the general upward trend of the market over longer periods of time. This could make him less averse to risk and therefore more likely to invest in equities, which are generally considered riskier but offer higher potential returns.
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