Joyce Siosan is a 42-year-old lawyer at a prestigious law firm. She is meeting w
ID: 1228366 • Letter: J
Question
Joyce Siosan is a 42-year-old lawyer at a prestigious law firm. She is meeting with Joel Murray, a financial advisor, to organize her finances. During the interview process, Siosan tells Murray that she has been purchasing short-term, out-of-the-money call and put options. Siosan 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, Murray notes that Siosan has been purchasing low-payoff earthquake insurance on her home, which is located in a low-probability earthquake zone. Describe Siosan’s utility function. Contrast her utility function with that assumed in traditional finance theory. Siosan 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. Siosan’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. Siosan 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. Murray believes that Siosan exhibits behavioral biases that interfere with an optimal savings and consumption allocation. In particular, he thinks that she is not saving enough for retirement.
Discuss how Siosan’s behavior reflects the bias of
i self-control.
ii. mental accoun
Explain how a rational economic individual in traditional finance would behave differently with respect to each bias.
Siosan’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. Murray observes that Siosan’s retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean–variance framework.
Determine whether Murray’s observation about Siosan’s retirement portfolio allocation is correct. Justify your response with two reasons.
Explanation / Answer
i) Siosan is a person with strong beliefs and she seems to have given little thought about her savings. Most of her money is spent on speculation rather than savings. Even if more money comes out of such speculation her consumption is so high that she would eventually consume all of it
ii) Her beahavior is totally different from savings perspective, She is debt free and does not want to have any burden on her, She enjoys her life and freedom. She can afford such high speculative stocks only because of her behvaior traits
Murray have observed that siosan is not saving enough for her retirement, Today yields on investments are historically low, So it takes a lot of money to retire. Beside being a high earning member of society she is vulnerable to financial cycles in the economy, Cycles like current recession or any volatality in stock market can wipe out her retirement funds in moments
Money market securities are very much risky and speculative stocks are even more risky. So certainly you must not save in riskier options when it comes to retirement.
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