Behavioral Finance

Question 1

How do people really decide (i.e., make financial decisions)?

Answer 1

based on behavioral principles and biases

Question 2

People often use these to make quick decisions which can lead to financial mistakes.

Answer 2

heuristics

Question 3

Prospect Theory demonstrates loss aversion with ___________________.

Answer 3

an asymmetrical s-curve

Question 4

Two significant implications of Prospect Theory include _______________________________.

Answer 4

the endowment effect and mental accounting

Question 5

The following holds that individuals will value something more once they own it.

Answer 5

the endowment effect

Question 6

The following term describes when individuals apply heuristics inappropriately which can negatively influence the decision-making process.

Answer 6

biases

Question 7

The following concept explains the potential relative gain or loss to an individual based on his/her actual choice compared to an option he/she did not choose.

Answer 7

opportunity cost

Question 8

__________________ (as demonstrated through the gambler’s fallacy) is the belief that even small samples should be representative of the population.

Answer 8

representativeness

Question 9

According to Zauberman, “people often display _________________ discounting of future outcomes.”

Answer 9

extremely high

Question 10

People think that __________ slack will grow in the future at a faster rate than will __________ slack.

Answer 10

time, money

Question 11

Andrew Lo’s “Adaptive Markets Hypothesis” reconciles…

Answer 11

Efficient Markets Hypothesis with research in behavioral economics.

Question 12

What are the conclusions and results of Andrew Lo’s “Adaptive Markets Hypothesis?”

Answer 12

opportunities for arbitrage; value in quantitative, fundamental, technical strategies; survival is primary objective, profit and utility secondary; innovation is key to survival and growth.

Question 13

Which type of bias allows investors to discount facts and feel better about decisions they made and the outcomes they experienced? It can also be used to place blame on their investment professional if results are not acceptable to them by recounting past events and second-guessing decisions that were made.

Answer 13

hindsight bias

Question 14

_____________ bias can often lead investors to hold unbalanced portfolios and take on too little or too much risk. This bias is sometimes associated with or linked to “get-even-itis” and the “sunk-cost fallacy.” This bias is also tied directly to conclusions from Prospect Theory in which case individuals feel pain more than they enjoy gains.

Answer 14

loss aversion bias

Question 15

Which of the primary investor personality types is commonly subject to the following biases: recency bias, framing bias, cognitive dissonance, and regret aversion?

Answer 15

followers

Question 16

What are the outcomes of the paradox of choice?

Answer 16

people are easily overwhelmed with information; numerous biases come into play; people often do nothing if confused; optimal decisions are not made (mistakes are made).

Question 17

______________ bias can cause investors to cling to a view or a forecast, behaving too inflexibly when presented with new information. When ______________-biased investors do react to new information, they often do so too slowly. ______________ bias can relate to an underlying difficulty in processing new information. Because people experience mental stress when presented with complex data, an easy option is to simply stick to a prior belief.

Answer 17

conservatism

Question 18

What is anchoring and adjustment bias?

Answer 18

a cognitive bias where investors are influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or sell; “get-even-itis,” “snake-bit effect,” and “sunk-cost fallacy.”

Question 19

What is confirmation bias?

Answer 19

People observe, overvalue, or actively seek out information that confirms what they believe while ignoring or devaluing information that contradicts their beliefs.

Question 20

One of your clients owns a small services company and has made tens of millions of dollars over the last 5 years. You manage the profit-sharing plan for his 12-employee-closely-held-business and a multi-million dollar after-tax portfolio for this client as well. He does however manage investments on his own that roughly equal the amount of money that you manage for him. This client trades more often than most, and the money he manages on his own would not be considered by most as well-diversified. Which bias is your client probably experiencing?

Answer 20

illusion of control

Question 21

What are the four common categories used to help describe and explain availability bias?

Answer 21

retrievability, categorization, narrow range of experience, and resonance.

Question 22

You have just finished interviewing a potential new client and learned the following during your meeting with him: he follows momentum oscillators, he does not understand the benefits of rebalancing, and he believes we are most likely living in a new paradigm as it relates to the economy and financial markets. This individual exhibits which of the following biases?

Answer 22

recency bias

Question 23

Which of the behavioral biases is most likely to lead individuals to deny or discount the value of compounding, dollar-cost averaging, and/or maintaining a disciplined investment strategy?

Answer 23

self-control bias

Question 24

All of the following actions:

choosing a mutual fund based on the manager’s prior track record,
allocating capital to an asset class or sector that has done well historically,
based on positive past experiences several years ago, one invests in funds that are riskier than their risk-profile would otherwise suggest is appropriate
… may be tied to what bias or heuristic?

Answer 24

outcome bias

Question 25

Investors may continue to hold an investment and even invest more (e.g., double down) in large part because of the time, effort and energy they have already invested in the idea behind the investment. This is often referred to as the:

Answer 25

sunk-cost fallacy

Question 26

During your annual review with Paul, a client you’ve had for only a couple of years now, he asks you to reposition the portfolio to take on more risk. The market grew last year by 20% and his portfolio grew by 30%. You are not aware of any life changes that may be driving his decision, so you inquire as to why he would like to be more aggressive. He tells you that you’ve done a fantastic job with his money and he has gained great confidence in your ability to manage his money; therefore, he would like to give you his blessing to “go for it.” Paul may be being influenced by something called the:

Answer 26

house money effect

Question 27

The following asserts that value is segmented into gains and losses relative to a reference point and that losses hurt more than gains bring pleasure.

Answer 27

Prospect Theory

Question 28

The following describes the way in which people categorize, evaluate and keep track of financial activities.

Answer 28

mental accounting

Question 29

People demonstrate the following when they make estimates or decisions starting from an initial value or belief.

Answer 29

anchoring

Question 30

“Readily available events in memory affect the judgment of frequency” describes the following heuristic?

Answer 30

availability

Question 31

________________ is the tendency to search for, interpret and recall information in a way that reinforces one’s preexisting beliefs.

Answer 31

confirmation bias

Question 32

This condition where taking action and losing feels worse than doing nothing and losing is attributed to __________________.

Answer 32

regret aversion

Question 33

Wealth managers can influence the results of client risk questionnaires with the use of more positive or negative wording, opt-in or opt-out answer choices, the use of timing and the order of questions (just to name a few). The impact of these elements can be explained by which of the following?

Answer 33

framing