CFA Level I · CFA Level I Exam · The Behavioral Biases of Individuals
An investor holds a stock that has fallen well below its purchase price and refuses to sell, hoping to recover the loss, even though she believes its prospects are poor. Compared with the expected utility framework, this behavior is best described as:
This is a departure from rationality. Expected utility theory says sunk purchase cost should be irrelevant and only future prospects matter. Judging the position against the purchase price, driven by loss aversion, is a behavioral pattern known as the disposition effect.
- Aa rational response to transaction costs
- Bconsistent with maximizing expected utility based on future prospects
- Ca departure from rationality because decisions depend on the purchase price as a reference pointCorrect
Explanation
Under expected utility, past cost is sunk and only future prospects matter. Holding because of the purchase reference point and loss aversion reflects the disposition effect, a departure from rationality. Nothing in the stem points to transaction costs.
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