101-2 Behavioral Finance

Question 1

Behavioral Finance

Answer 1

A field of study which relates behavioral and cognitive psychology to financial planning and economics in an a attempt to understand why people act irrationally during the financial decision making process

Question 2

Cognitive errors

Answer 2

Due to faulty reasoning and could arise from a lack of understanding of proper statistical analysis techniques, information processing mistakes, faulty reasoning, or memory errors

Question 3

Illusion of control bias

Answer 3

Exists when market participants think they can control or affect outcomes when they cannot

Question 4

Conservatism bias

Answer 4

Occurs when market participants initially form a rational view but fail to change that view as new info becomes available
They overweight the initial probabilities and do not adjust for new information

Question 5

Hindsight bias

Answer 5

A selective memory of past events, actions, or what was knowable in the past

Question 6

Confirmation bias

Answer 6

Occurs when market participants look for new information or distort new information to support an existing view

Question 7

Representativeness

Answer 7

Based on a belief that the past will persist and new information is classified based on past experience or classification

Question 8

Mental accounting

Answer 8

Aka money jar mentality
Involves the tendency of individuals to put their money into separate accounts based on the function of these accounts

For example: savings, debt reduction, and a future vacation
Money set aside for a vacation while carrying a considerable amount of debt is poor money management

Question 9

Self-attribution bias

Answer 9

An ego defense mechanism

Analysts take credit for their successes and either blame others or external factors for failures

Question 10

Anchoring

Answer 10

Involves individuals making irrational decisions based on information that should have no influence on the decisions at hand

Question 11

Adjustment

Answer 11

May include market participants who stay anchored to an initial estimate and do not adjust for new information

Question 12

Outcome bias

Answer 12

The tendency for individuals to take a course of action based on the outcomes of prior events

Question 13

Framing bias

Answer 13

Asserts that people are given a frame of reference, a set of beliefs or values that they use to interpret facts or conditions as they make decisions

Question 14

Recency bias

Answer 14

Aka availability bias

Recent info is given more importance because it is most vividly remembered

Question 15

Herding

Answer 15

When investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available

Question 16

Emotional biases

Answer 16

Not related to conscious thought and stem from feelings, impulses, or intuition

Question 17

Prospect theory

Answer 17

Results in making choices that favor certain outcomes versus probable outcomes

Question 18

Loss aversion theory

Answer 18

Involves clients valuing gains and losses differently and, as a result, making decisions based on perceived gains rather than perceived losses

Question 19

Self-control bias

Answer 19

Occurs when individuals lack self-discipline and favor immediate gratification over long-term goals

Question 20

Status quo bias

Answer 20

Occurs when comfort with an existing situation leads to an unwillingness to make changes

Question 21

Endowment bias

Answer 21

Occurs when an asset is felt to be special and more valuable simply because it is already owned

Question 22

Regret-aversion bias

Answer 22

Occurs when market participants do nothing out of excess fear that actions could be wrong

Question 23

Affinity bias

Answer 23

Refers to the tendency to favor things that can be identified with emotionally because they are similar to us

Question 24

Attitudes

Answer 24

Reflect a person’s opinions, values, and wants

Question 25

Beliefs

Answer 25

A type of attitude because they reveal the understanding of some aspect of a person’s life

Question 26

Values

Answer 26

Attitudes and beliefs for which a person feels strongly and considered values and represent what he believes to be right

Question 27

Myers-Briggs assessment

Answer 27

Evaluates personalities based whether the individual is:

• introverted or extroverted
• driven by senses or intuition
• influenced by thinking or feeling
• apt to perceive or judge

Question 28

Perception

Answer 28

An individual’s personal awareness of things, people, events, or ideas

Question 29

Judgment

Answer 29

Involves making conclusions about what has been perceived

Question 30

3 types of learning styles

Answer 30

Visual
Auditory
Kinesthetic

Question 31

Financial counseling

Answer 31

A process that helps clients change poor financial behavior through education and guidance

Question 32

Financial counseling approach A:

Economic and resource approach

Answer 32

Clients are assumed to be rational and will change to the most favorable behavior if given the appropriate counseling

The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and debt

Question 33

Financial counseling approach B:

Classical economics approach

Answer 33

Clients choose among alternatives based on objectively defined cost-benefit and risk-return tradeoffs

The belief in this approach is that increasing financial resources or reducing financial expenditures results in improved financial outcomes.

Question 34

Financial counseling approach C:

Strategic management approach

Answer 34

A client’s goals and values drive the client-planner relationship

SWOT analysis (identifying Strengths, Weaknesses, Opportunities, Threats)

Question 35

Financial counseling approach D:

Cognitive-behavioral approach

Answer 35

Clients’ attitudes, beliefs, and values influence their behavior

Question 36

Financial counseling approach E:

Psychoanalytic approach

Answer 36

Rarely used, based on psychoanalytic theory

Question 37

Kinesthetic learning style

Answer 37

Understands concepts better using a hands-on approach

Writing down goals and objectives with bullet points as they are formulated engages clients with this learning style

Question 38

Risk capacity

Answer 38

The degree to which a client’s financial resources can cushion risk

Question 39

Risk perception

Answer 39

The client’s assessment of the magnitude of the risks being traded-off

Question 40

Risk tolerance

Answer 40

The tradeoffs that clients are willing to make between potential risks and rewards

Question 41

Risk capacity

Answer 41

The degree to which a client’s financial resources can cushion risks