Behavioral Finance

Question 1

Heuristic

Answer 1

Any approach to problem-solving that employs a more practical method that is not guaranteed to be optimal or rational, but is sufficient for reaching a short-term goal or approximation (e.g. rules of thumb, educated guess)

Question 2

Anchoring

Answer 2

Investor sets value at the initial point of information (e.g. buy price)

Question 3

Prospect Theory

Answer 3

Suffer more from losses than benefit from gains

Question 4

Recency bias

Answer 4

Makes investor focus more on the most current events, leading to faulty predictions that this is always how it will be

Question 5

Overconfidence

Answer 5

Leads investors to overestimate their knowledge, underestimate risks and exaggerate ability to control events and predict outcomes.

Factors leading to overconfidence: choice, task familiarity, information, active involvement, past success

Question 6

Disposition Effect

Answer 6

People seek pride and avoid regret.

Sell winners to quickly and hold losers too long

Question 7

House Money Effect

Answer 7

Take more risk

Question 8

Snakebite Effect

Answer 8

Take less risk

Question 9

Break-evenitis

Answer 9

Take more risk

Question 10

Mental Accounting

Answer 10

Leads to naive diversification (e.g. the assumption that simply investing in enough unrelated assets will reduce risk sufficiently to make a profit)

Question 11

Home Bias

Answer 11

Familiarity with something leads to stock concentration (e.g. Blair and Shell holding %)

Question 12

Herd Mentality

Answer 12

Natural bias to follow the crowd and invest how others are

Question 13

Optimism

Answer 13

Leads to exuberance, which can lead to market bubbles

Question 14

Attachment Bias

Answer 14

Holding onto an investment for emotional reason rather than considering more practical applications for the inheritance (eg Anita with parent’s investments)

Question 15

Cognitive Dissonance

Answer 15

The challenge of reconciling two opposing beliefs

Question 16

Confirmation Bias

Answer 16

Natural human tendency to accept any information the confirms our preconceived position or opinion and to disregard any information that does not support that preconceived notion.

Question 17

Diversification Errors

Answer 17

Investors tend to diversify evenly across whatever options are presented to them

Question 18

Fear of Regret

Answer 18

Tendency to take no action rather than risk making the wrong one
(Mom and Ray with investments)

Question 19

Gambler’s Fallacy

Answer 19

An individual erroneously believes that the onset of certain random event is likely to happen following an event or a series of events (e.g. after falling on black for 5 turns, believing the ball will land on red)

Question 20

Hindsight Bias

Answer 20

The 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not

Question 21

Inappropriate Extrapolation

Answer 21

Tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely

Question 22

Mental Accounting

Answer 22

Entails looking at sums of money differently; depending on their source or intended use

Question 23

Outcome Bias

Answer 23

Tendency to make a decision based on the desired outcome rather than on the probability of that outcome

Question 24

Overreaction

Answer 24

Investors emotionally react towards new market information

Question 25

Self-Affirmation Bias

Answer 25

Belief that when something goes right, it’s because you’re smart and you made the right decision. But if it doesn’t work, it’s because of someone else or bad luck.

Question 26

Spotting Trends That Are Not There

Answer 26

Investors seek patterns that help support decisions sometimes without adequate confirming research

Question 27

Status Quo Bias

Answer 27

Tendency of investors to do nothing when action is actually called for.

Question 28

Economic and Resource Approach

Answer 28

Financial planner is an agent of change. The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and debt.

Question 29

Classical Economics Approach

Answer 29

Clients choose among alternatives based on objectively defined cost-benefit and risk-return trade offs. The belief is that increasing financial resources or reducing financial expenditures results in improved financial outcomes.

Question 30

Strategic Mgmt Approach

Answer 30

A clients goals and value drive the client-planner relationship. Conducting a SWOT analysis is done early in the FP process. The financial planner serves as a consultant.

Question 31

Cognitive-Behavioral Approach

Answer 31

Clients’ attitudes, beliefs, and values influence their behavior. Planners using this approach attempt to substitute negative beliefs that lead to poor financial decisions with positive attitudes, which should result in better financial results.

Question 32

Endowment Bias

Answer 32

Valuing an asset more when you own it than when you don’t.

Question 33

Framing Bias

Answer 33

You answer/solve a question based on how it was presented to you.

Question 34

Conservatism Bias

Answer 34

Maintaining your previous views by not including new contradicting information.

Question 35

Illusion Control Bias

Answer 35

Thinking you can control/affect an outcome when you really cannot.

Question 36

Self-Control Bias

Answer 36

Opting to short-term satisfaction over long-term goals.

Question 37

Representative Bias

Answer 37

Urge to categorize new information based on previous experiences.

Question 38

Halo Effect

Answer 38

One’s own impression of a person (e.g. looks, clothes, etc.) impacts judgements, thus align with more visually appealing persons and opinions.

Question 39

Extension Neglect Bias

Answer 39

Refers to a very small sample sizes that are extended well beyond the reason for interpolation. This bias is often seen in clients with limited experience.

Question 40

Dunning-Krueger Effect

Answer 40

Overconfidence of a person in their abilities

Question 41

Baader-Meinhof Phenomenon

Answer 41

Awareness of a particular item or action that makes it seem much more prevalent than it actually is

Question 42

Backfire Effect

Answer 42

Idea or argument has the opposite impact than intended

Question 43

Bounded rationality

Answer 43

Making a good but not perfect decision based upon imperfect info, often with a trade off btwn convenience and excellence

Question 44

Homo Economicus

Answer 44

Theoretical human that rationally and coldly calculates based upon perfect information to make optimal decisions

Question 45

A rational, perfect allocation between various investments in a portfolio regardless of emotion aligns with what bias?

Answer 45

Homo Economicus

“Econ = rational”

Question 46

Zero-sum theory

Answer 46

One’s gain or loss is balanced exactly by another’s gain or loss

Question 47

Game theory

Answer 47

Study of strategy decisions

Question 48

Baader-Meinhof phenomenon

Answer 48

Aka Frequency Illusion

Where an event that is discussed is noticed more after the discussion thereof, and as such, action to purchase life insurance increases in times of very visible events such as 9/11 and COVID

Question 49

Why would an investor be slow to sell and underlying stock?

Answer 49

Confirmation bias