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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

A Mumbai investor refuses to sell a share that has fallen 30% below her purchase price, although she would not buy it at today's price. Which behavioural concept best explains her reluctance to sell?

Loss aversion explains it. People feel losses more strongly than equivalent gains, so she avoids realising the loss and holds the share even though she would not buy it at today's price. A rational, forward-looking investor would ignore the purchase price.

  1. ALoss aversion, in which losses are felt more strongly than equivalent gainsCorrect
  2. BRational expectations, in which all available information is already priced in
  3. CDiminishing marginal utility of wealth under risk neutrality
  4. DThe law of one price applied across exchanges
  5. Comparative advantage in portfolio selection

Explanation

Behavioural economics, through prospect theory, holds that people weigh losses more heavily than equal gains. This makes holders reluctant to realise losses (the disposition effect). Rational expectations would imply she judges the share only on its future prospects, not on her purchase price.

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