Question

Suppose there are two investors: Joe and Bob. 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.

Joe 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. Bob, 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.

Joe’s pension fund money is all in bonds, while Bob’s is all in equities. Which single feature of Prospect Theory provides the best explanation for the two men’s different portfolio allocations? Provide your reasoning.

Answer 1

The Prospect theory tells us that individual behavior tends to be inclined to react more adversely towards losses than to gains. This explains the frequent review of the portfolio by Joe as he is governed by this principle and wants to avoid losses. Also, this impacts his asset allocation and hence he has invested in bond funds in order to prevent losses as bond funds are less likely to have the downside and gives lesser but assured returns. Thus the Prospect theory which explains that losses affect the investors more also explains the fact that Joe has invested in bond funds and have stayed away from equity in spite of a long-term chance of having a greater return in equity to eliminate the chances of losses on a weekly basis.

A contrasting scenario is true for Bob who has invested in equity and track the portfolio only once in 5 years with the understanding that there is less than 10% chance of losses over that period of time. Since risk appetite of Bob is more and he is only reviewing the portfolio on a 5 yearly basis wherein the chances of losses decrease significantly, so he has decided to invest in equity.

Thus the period and frequency of review coupled with Prospect theory dictates the asset allocation in this case.

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