Question 5Suppose that Mr. K buys 1,000 shares in a software company at $25 / share. The company is currently attracting considerable media attention for its new accounting software, a highly touted product that is expected to become the industry standard, with considerable improvements in both efficiency and ease of use. Mr. K is an accountant who also has considerable expertise in evaluating accounting software options. He read all of the software company’s advance information on the new package and carried out his own extensive research prior to buying the shares. Within two weeks of his purchase, the shares are up to $30, and Mr. K is tempted to sell them. He decides to hold on, however, as the industry excitement about the new software is increasing as the release date approaches. The shares continue to appreciate until there begin to be whispers about a serious bug in the software. In the weeks coming up to the release date, the company’s share price becomes increasingly volatile, as rumors and counter-rumors abound. The company’s share price falls below $30, and then below $25. Occasionally some positive stories on social media cause brief bounces in the price, but Mr. K is becoming increasingly pessimistic about the product. The shares are currently trading at $20. Although Mr. K now believes that the product will fail, he decides to hold onto the shares in the hope that a new rumor will bounce the price up to $25 so that he can sell.Which Prospect Theory feature best explains Mr. K’s behavior during the time that he has owned these shares? 1 point Risk aversion over gainsLoss aversion Risk seeking over losses
Question
Question 5Suppose that Mr. K buys 1,000 shares in a software company at 30, and Mr. K is tempted to sell them. He decides to hold on, however, as the industry excitement about the new software is increasing as the release date approaches. The shares continue to appreciate until there begin to be whispers about a serious bug in the software. In the weeks coming up to the release date, the company’s share price becomes increasingly volatile, as rumors and counter-rumors abound. The company’s share price falls below 25. Occasionally some positive stories on social media cause brief bounces in the price, but Mr. K is becoming increasingly pessimistic about the product. The shares are currently trading at 25 so that he can sell.Which Prospect Theory feature best explains Mr. K’s behavior during the time that he has owned these shares? 1 point Risk aversion over gainsLoss aversion Risk seeking over losses
Solution
The Prospect Theory feature that best explains Mr. K's behavior during the time he has owned these shares is Loss Aversion.
Here's why:
Loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring equivalent gains. It's thought to be twice as powerful, psychologically, as the power of gaining.
In this case, Mr. K bought the shares at 20, he decided to hold onto them. Despite believing that the product will fail, he hopes that a new rumor will bounce the price back up to $25, so he can sell and avoid a loss. This behavior is indicative of loss aversion, as he is more focused on avoiding a loss than securing a gain.
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