Behavioral Finance Questions Flashcards
A client invested in a stock recommended by a friend who worked in a bank. The stock provided the client with an 80% return within a year. When the client called his financial planner to discuss investments, the client wanted to add some new stocks to his portfolio. The client explained that he had been so successful in selecting the stock that appreciated by 80% that he wanted to make some additional selections. Which of the behavioral finance biases is most likely present in this client’s situation?
Overconfidence
Anchoring
Confirmation bias
Recency
Solution: The correct answer is A.
The client displays the bias of overconfidence. The client has been successful with one stock selection that was the recommendation of a friend. The client then thinks that he can select other stocks based on that one success. This overestimation of one’s ability to perform a specific task is a bias that can lead to irrational risk taking.
One could argue that other biases are also present but overconfidence seems to be the bigger concern.
Anchoring - Attaching or anchoring one’s thoughts to a reference point even thought here may be no logical relevance or is not pertinent to the issue in question.
Confirmation bias - A commonly used and popular phrase is that “you do not get a second chance at a first impression”.
Recency - Giving too much weight to recent observations or stimuli.
Over the previous several months, Mathew Arkins, CFP®, has presented senior executives at West-Ark Financial Planning with numerous research reports indicating that several of the recommendations West-Ark has been making to their clients are no longer in favor with the analysts providing the research reports. Despite this apparent change in heart by the analysts, West-Ark has yet to adjust its advice to clients. Which behavioral bias is most evident for West-Ark?
Belief perseverance.
Herd mentality.
Hindsight bias.
Overconfidence.
Solution: The correct answer is A.
Belief perseverance is evident when people are unlikely to change their views given new information.
B is incorrect. Herd mentality is the process of buying what and when others are buying and selling.
C is incorrect. Hindsight bias is a form of overconfidence related to an investor’s belief that they had predicted an event that, in fact, they did not predict.
D is incorrect. Overconfidence suggests that investors overestimate their ability to successfully predict future market events.
An old Wall Street saying is, “Cut your losses and let your profits run.” However, investors often do the opposite. It seems that people are reluctant to admit they made a mistake in purchasing a stock that subsequently performs poorly. This behavior is most consistent with:
anchoring.
herd mentality.
regret avoidance.
representativeness.
Solution: The correct answer is C.
Regret avoidance (also known as the disposition effect) leads investors to take action or to refuse to act in hopes of minimizing any regret over their actions or inactions. In investments, it leads people to sell winners too soon and to hold on to losers too long.
A is incorrect. Anchoring represents the investor’s inability to objectively review and analyze new information.
B is incorrect. Herd mentality is the process of buying what and when others are buying and selling.
D is incorrect. Representativeness is thinking that a good company is a good investment without regard to an analysis of the investment.
