Claire Pierce comments on her life circumstances and investment outlook:
I must support my parents who live overseas on Pogo Island. The Pogo Island economy has grown rapidly over the past 2 years with minimal inflation, and consensus forecasts call for a continuation of these favorable trends for the foreseeable future. Economic growth has resulted from the export of a natural resource used in an exciting new technology application.
I want to invest 10% of my portfolio in Pogo Island government bonds. I plan to purchase long-term bonds because my parents are likely to live more than 10 years. Experts uniformly do not foresee a resurgence of inflation on Pogo Island, so I am certain that the total returns produced by the bonds will cover my parents’ spending needs for many years to come. There should be no exchange rate risk because the bonds are denominated in local currency. I want to buy the Pogo Island bonds, but am not willing to distort my portfolio’s long-term asset allocation to do so. The overall mix of stocks, bonds, and other investments should not change. Therefore, I am considering selling one of my U.S. bond funds to raise cash to buy the Pogo Island bonds. One possibility is my High Yield Bond Fund, which has declined 5% in value year to date. I am not excited about this fund’s prospects; in fact I think it is likely to decline more, but there is a small probability that it could recover very quickly. So I have decided instead to sell my Core Bond Fund that has appreciated 5% this year. I expect this investment to continue to deliver attractive returns, but there is a small chance this year’s gains might disappear quickly.
Once that shift is accomplished, my investments will be in great shape. The sole exception is my Small Company Fund, which has performed poorly. I plan to sell this investment as soon as the price increases to my original cost.
Identify three behavioral finance concepts illustrated in Pierce’s comments and describe each of the three concepts. Discuss how an investor practicing standard or traditional finance would challenge each of the three concepts.