Challenging Behavioral

Question 1

Statement: Prospect Theory assumes that utility is derived from final wealth levels, not from gains and losses relative to a reference point.

Answer 1

False –
Why: Prospect Theory explicitly rejects final wealth as the sole basis of utility. Instead, it introduces reference dependence: people evaluate outcomes as gains or losses relative to a reference point, not as final asset levels.

Question 2

Statement: According to the Efficient Market Hypothesis, all known behavioral biases are already priced into the market.

Answer 2

False –
Why: The Efficient Market Hypothesis (EMH) assumes rational agents and information-efficient pricing. However, behavioral finance emerged specifically to critique this assumption, showing that systematic biases (like overreaction, anchoring, herding) can lead to predictable mispricings (Slide 3 and 4). Therefore, EMH does not account for behavioral biases being priced in; it assumes they don’t exist or don’t persist.

Question 3

Statement: Myopic loss aversion implies that increasing the frequency of portfolio evaluation may decrease willingness to invest in risky assets.

Answer 3

True –
Why: This is the core insight of Benartzi and Thaler (1995) (Slide 10). Frequent evaluations increase the visibility of short-term losses. Because of loss aversion, this causes investors to underweight equities despite their favorable long-term profile. This is a powerful behavioral explanation of the Equity Premium Puzzle.

Question 4

Statement: The “Sell in May and Go Away” effect is a behavioral anomaly that violates the weak form of market efficiency.

Answer 4

True –
Why: The “Sell in May” strategy (Slides 8–9) exploits a seasonal pattern in returns. According to weak-form EMH, all historical price and return information is already reflected in prices. Therefore, predictable patterns like this should not exist. The existence of such a strategy suggests markets may not be weak-form efficient and supports behavioral explanations like overreaction, anchoring, or mood effects.

Question 5

Statement: Structured products designed with derivative overlays can replicate investor-specific utility functions more accurately than traditional portfolio optimization.

Answer 5

True –
Why: This is well-supported in Slides 35–40. Behavioral utility curves (non-linear, asymmetric) cannot be matched by simple mean-variance optimization. But structured products (e.g., combining long equity, puts, and short calls) can be custom-designed to mirror a specific utility function, including loss floors and capped gains, yielding a much closer fit to individual preferences.