John is a financial advisor who specializes in behavioral finance. He recently attended a seminar on Behavioral Portfolio Theory, which emphasizes that investors construct their portfolios in a manner that reflects their individual goals, attitudes toward risk, and the psychological factors influencing their investment behavior. After the seminar, John reflected on how different investors might approach portfolio construction based on their behavioral tendencies. He considered three clients: Alice, who is risk-averse and prefers stable, low-volatility investments to ensure her retirement fund grows at a steady pace. Bob, who is more of a risk-seeker, enjoys high-volatility investments that could potentially yield substantial returns, even though he understands the risks involved. Cathy, who experiences emotional reactions to market fluctuations, often causing her to panic sell when prices drop. Given the characteristics of Alice, Bob, and Cathy, how can Behavioral Portfolio Theory explain the likely differences in their portfolio constructions?

Exam

CFA Level 3

Section

Difficulty

Portfolio Management and Wealth Planning

Behavioral Portfolio Theory Application

Easy Behavioral Finance Behavioral Portfolio Theory

John is a financial advisor who specializes in behavioral finance. He recently attended a seminar on Behavioral Portfolio Theory, which emphasizes that investors construct their portfolios in a manner that reflects their individual goals, attitudes toward risk, and the psychological factors influencing their investment behavior.

After the seminar, John reflected on how different investors might approach portfolio construction based on their behavioral tendencies. He considered three clients:

Alice, who is risk-averse and prefers stable, low-volatility investments to ensure her retirement fund grows at a steady pace.
Bob, who is more of a risk-seeker, enjoys high-volatility investments that could potentially yield substantial returns, even though he understands the risks involved.
Cathy, who experiences emotional reactions to market fluctuations, often causing her to panic sell when prices drop.

Given the characteristics of Alice, Bob, and Cathy, how can Behavioral Portfolio Theory explain the likely differences in their portfolio constructions?

Alice will construct a portfolio focusing on high-risk assets to maximize her chances for growth.

Bob will likely diversify his portfolio across various asset classes while seeking high-reward investments.

Cathy’s portfolio will overly concentrate in assets she is familiar with, resulting in a lack of diversification.

Hint

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