Behavioral Finance and Investments

Complete a report on your observations of your first client, Violet (see scenario below). The report should be 2-3 pages in length, double-space, Times New Roman 12 point font; reference page(s) do not count in the page limit. Your report should include the following: 1) Describe Siosan?s utility function. Contrast her utility function with that assumed in traditional finance theory, 2) Discuss what biases Siosan?s behavior reflects, 3) Explain how a rational economic individual in traditional finance would behave differently with respect to each bias, and 4) Determine whether your observation about Siosan?s retirement portfolio allocation is correct. Justify your response.

Scenario: Applied Behavioral Finance

Upon your happy return to your small flat on the west side of town, you sleep well after the couple of pints you enjoyed with your friends and the long day at work. You are awaken early by your neighbor?s barking dog and you have an opportunity to review the file for your first client of the day. Impressed by your description of Prospect theory, Stephanie has rewarded you with your first client. Mrs. Violet Siosan is a 42-year-old lawyer at a prestigious law firm. She needs you to organize her finances.

You jump in your Honda Accord and head to the office, it is raining today, but fortunately your parking space is near to the door as you forgot your umbrella. Violet enters your office shortly after you arrive and you begin to get to know each other. During the interview process, Violet tells you that she has been purchasing short-term, out-of-the-money call and put options. Violet acknowledges these options have a low probability of paying off and that the expected return from her options trading is negative. However, she states that she is attracted by the possibility of high returns when she can exercise in-the-money options. At the same time, you note that Violet has been purchasing low-payoff earthquake insurance on her home, which is located in a low-probability earthquake zone.

Additionally, Violet purchases a new luxury vehicle every two years and takes expensive annual vacations. She has a reputation for paying the entire bill at the upscale restaurants where she dines regularly with her friends. Violet?s annual consumption, options trading, and housing expenditures are paid for entirely out of her salary income and half of her modest annual bonus. She deposits the other half of her annual bonus and any other non-salary sources of income into her relatively small retirement account, which excludes her options trading. Violet is reluctant to incur debt and has only a small mortgage on her home, despite the fact that she will soon be made a partner in her firm and will have much higher earnings. Having recently read, Beyond Markowitz: A comprehensive Wealth Allocation Framework for Individual Investors which covered some of the key concepts of behavioral finance, such as mental accounting, or an approach people use to organize their financial assets by creating separate compartments for money they?ve designated for specific purposes. You are concerned that Violet exhibits behavioral biases that interfere with an optimal savings and consumption allocation.

Finally, Violet?s retirement portfolio is allocated 50% to money-market securities and 50% to a few speculative stocks that she read about in an investment newsletter. Believing that behavioral finance can aid in identifying deficiencies in modern portfolio theory when applied to real clients in the real world. You observe that Violet?s retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean?variance framework.

Behavioral Finance and Investments Complete a report on your observations of your first client, Violet (see scenario below). The report should be 2-3 pages in length, double-space, Times New Roman 12 point font; reference page(s) do not count in the page limit. Your report should include the following: 1) Describe Siosan's utility function. Contrast her utility function with that assumed in traditional finance theory, 2) Discuss what biases Siosan's behavior reflects, 3) Explain how a rational economic individual in traditional finance would behave differently with respect to each bias, and 4) Determine whether your observation about Siosan's retirement portfolio allocation is correct. Justify your response. Scenario: Applied Behavioral Finance Upon your happy return to your small flat on the west side of town, you sleep well after the couple of pints you enjoyed with your friends and the long day at work. You are awaken early by your neighbor's barking dog and you have an opportunity to review the file for your first client of the day. Impressed by your description of Prospect theory, Stephanie has rewarded you with your first client. Mrs. Violet Siosan is a 42-year-old lawyer at a prestigious law firm. She needs you to organize her finances. You jump in your Honda Accord and head to the office, it is raining today, but fortunately your parking space is near to the door as you forgot your umbrella. Violet enters your office shortly after you arrive and you begin to get to know each other. During the interview process, Violet tells you that she has been purchasing short-term, out-of-the-money call and put options. Violet acknowledges these options have a low probability of paying off and that the expected return from her options trading is negative. However, she states that she is attracted by the possibility of high returns when she can exercise in-the-money options. At the same time, you note that Violet has been purchasing low-payoff earthquake insurance on her home, which is located in a lowprobability earthquake zone. Additionally, Violet purchases a new luxury vehicle every two years and takes expensive annual vacations. She has a reputation for paying the entire bill at the upscale restaurants where she dines regularly with her friends. Violet's annual consumption, options trading, and housing expenditures are paid for entirely out of her salary income and half of her modest annual bonus. She deposits the other half of her annual bonus and any other non-salary sources of income into her relatively small retirement account, which excludes her options trading. Violet is reluctant to incur debt and has only a small mortgage on her home, despite the fact that she will soon be made a partner in her firm and will have much higher earnings. Having recently read, Beyond Markowitz: A comprehensive Wealth Allocation Framework for Individual Investors which covered some of the key concepts of behavioral finance, such as mental accounting, or an approach people use to organize their financial assets by creating separate compartments for money they've designated for specific purposes. You are concerned that Violet exhibits behavioral biases that interfere with an optimal savings and consumption allocation. Finally, Violet's retirement portfolio is allocated 50% to money-market securities and 50% to a few speculative stocks that she read about in an investment newsletter. Believing that behavioral finance can aid in identifying deficiencies in modern portfolio theory when applied to real clients in the real world. You observe that Violet's retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean-variance framework