LUBS 1240: Optimal Timing Notes

Consider an investment opportunity where your initial investment k will increase in value according to the formula

Vinv = ke

0.75 t

12

Whereas the continuously compounded rate of interest that can be gained in a bank account is 5%. This means that an amount of money k in the bank increases in value according to

Vbank = ke0.05t
We can plot the value of these two opportunities over time for an initial amount of 100

Notice that for the first 18 or 19 years money in the bank is outperformed by the investment. So for some amount of time it is sensible to put your money in to the investment. When should you sell the investment and put your money into the bank? An obvious time to sell might appear to be where the two lines cross. But notice that if you waited until this time to sell the investment, you will end up with exactly the same amount as if you had just left your money in the bank. You might as well have just put your money in the bank from the beginning and left it there. The time to sell is when the investment is worth the maximum extra than if you had left you money in the bank. This is difficult to see exactly on the graph above. What if we re-draw the graph so that we plot the value of each opportunity in comparison with the value of the bank investment. To do this we can simply divide the value shown on the lines above by the increase in value if wed left our money in the bank. For the investment in the bank this simply means well get a line y=k because

Vbank _ relative =

ke0.05t =k e0.05t

Whereas for the investment opportunity we get

Vinv _ relative

12 0.75 ke = = ke 0.05t e

0.75 t

12

0.05t

When we plot this extra value of the investment in comparison with money in the bank we get the following graph. It is as though both lines have been bent down in order to make the blue line flat.

So we begin with 100 whether we put it in the bank or in the investment opportunity. For the first few years (approx 5 years) the investment opportunity performs a lot better than if wed left the money in the bank. Then the relative benefit of our investment opportunity decreases, until after approx 18 years (where the lines cross in first figure and in this figure) we have no additional benefit from our investment it is exactly as if wed left it in the bank. After approx 18 years, the investment is worse than leaving money in the bank. We are effectively losing money. So the best time to sell is at the maximum relative benefit. At the maximum of this curve. The solution to an optimal timing problem is therefore to find the maximum of this curve, using the first derivative test we covered in previous lectures. So if we take the investment opportunity then sell at the optimal time and put all the resulting money in the bank we follow the red line (investment) then sell at t=4.6875, and put our money in the bank which tehn grows along the black dashed line.