Question

Monty Frost’s tax-deferred retirement account is invested entirely in equity securities.Because the international portion of his portfolio has performed poorly in the past, hehas reduced his international equity exposure to 2%. Frost’s investment adviser has recommended an increased international equity exposure. Frost responds with the followingcomments:

a. Based on past poor performance, I want to sell all my remaining international equitysecurities once their market prices rise to equal their original cost.

b. Most diversified international portfolios have had disappointing results over the pastfive years. During that time, however, the market in country XYZ has outperformed allother markets, even our own. If I do increase my international equity exposure, I wouldprefer that the entire exposure consist of securities from country XYZ.

c. International investments are inherently more risky. Therefore, I prefer to purchase anyinternational equity securities in my “speculative” account, my best chance at becomingrich. I do not want them in my retirement account, which has to protect me frompoverty in my old age.

Frost’s adviser is familiar with behavioral finance concepts but prefers a traditional orstandard finance approach (modern portfolio theory) to investments.

Indicate the behavioral finance concept that Frost most directly exhibits in each of histhree comments. Explain how each of Frost’s comments can be countered by using anargument from standard finance.

Short answer

a. Reference dependence.

b. Overconfidence (illusion of control)

c. Mental accounting

Step-by-step solution

Evaluation of Frost’s ‘a’ comments with behavioral finance concept

a. Frost’s statement is an example of reference dependence. His inclination to sell international investments, post return of its price to its original cost, doesn’t depend on its terminal wealth value but also on his reference point, which has become a critical factor in his decision.

In standard finance, alternatives are evaluated in terms of terminal wealth values and not in terms of some gains or losses relative to some reference point.

Evaluation of Frost’s ‘b’ comments with behavioral finance concept

b. Frost’s statement is an example of susceptibility to cognitive error at least on two counts –

(a) Displays behavioral flaw of overconfidence. He takes the past performance of country XYZ as a prediction for future performance.

(b) Investing only in securities of country XYZ shows the behavioral finance phenomenon of asset segregation.

In standard finance, the investor evaluates performance in portfolio terms by combining the country XYZ holdings with all other securities. They evaluate all potential investments, including country XYZ in terms of anticipated contribution to the risk-reward profile of the entire portfolio.

Evaluation of Frost’s ‘c’ comments with behavioral finance concept

c. Frost’s statement is an example of mental accounting that suggests investors segregate money into separate mental accounts and not combine outcomes. Frost is doing this by building a portfolio as a pyramid of assets where the retirement account represents a layer separate from a speculative fund. He is more risk averse to the retirement account than the speculative fund account.

In standard finance, decisions consider the risk and return profile of the entire portfolio rather than anticipated gains or losses on any particular account.