Investor Behavior: The Psychology of Financial Planning and Investing

Answers to Discussion Questions

CHAPTER 2 TRADITIONAL AND BEHAVIORAL FINANCE

1. Describe the primary differences in the measurement of risk between the utility function used in expected utility theory by traditional finance and the value function posited by prospect theory in behavioral finance.

The value function in prospect theory reflects three important properties that distinguish it from the traditional utility function. First, value is measured in terms of changes in wealth from a reference point whereas a utility function measures value based on the level of wealth. Second, the value function is convex for losses reflecting risk taking and concave for gains reflecting risk aversion whereas an individual's utility function evaluates risk aversion, risk neutrality, or risk loving. Third, the value function is steeper for losses than for gains due to loss aversion.

2. What is the difference between risk aversion and loss aversion?

Risk aversion refers to the preferences of a person who would prefer the expected value of a gamble to the gamble itself. Loss aversion refers to the finding that people view a gain as adding less to utility than a loss of equal size takes away from it.

3. What does modern portfolio theory (i.e., traditional finance) say about how an investor should form an optimal stock portfolio?

The investor should identify the optimal portfolio, which is the market basket. Next, the investor decides how much risk he is willing to take. If more risk averse, the ...