Question

Question: During an interview with her investment adviser, a retired investor made the following two statements:

a. “I have been very pleased with the returns I’ve earned on Petrie stock over the past two years, and I am certain that it will be a superior performer in the future.”

b. “I am pleased with the returns from the Petrie stock because I have specific uses for that money. For that reason, I certainly want my retirement fund to continue owning the Petrie stock.”

Identify which principle of behavioral finance is most consistent with each of the investor’s two statements.

Short answer

Answer

a. Overconfidence

b. Mental accounting

Step-by-step solution

Evaluation of retired investor’s comments in part a with behavioral finance concept

a. Overconfidence – Investor is exhibiting overconfidence in Petrie’s stock because of its past performance especially the last two year’s record. But the investor’s level of confidence should reflect the stock’s overall record not just past two year’s record

Evaluation of investor’s comments in part b with behavioral finance concept

b. Mental accounting – The investor seems to have segregated the money into two accounts – a. returns from Petrie’s accounts and b. remaining funds. In this context, she is maintaining a separate set of mental account. Her “specific uses” should be viewed in the context of overall spending needs and should consider the risk and return profile of the entire trust.