Chapter 2 Homework

Question 1

Active Listening

Answer 1

Requires the listener’s undivided attention. Active listening involves concentration to what the speaker is saying. The listener must put aside irrelevant thoughts.

Question 2

Affect Heuristic

Answer 2

Deals with judging something, whether its good or bad.

Question 3

Anchoring

Answer 3

Attaching or anchoring one’s thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question. Anchoring is also known as conservatism or belief perseverance.

Question 4

Availability Heuristic

Answer 4

When a decision maker relies upon knowledge that is readily available in his or he memory, the cognitive heuristic known as “availability” is invoked.

Question 5

Behavioral Finance

Answer 5

Contains much of the scientific framework and lessons learned from Traditional Finance, amends some of it with basic assumptions based on normal, more human-like behavior, and supplements other aspects of it with notions from psychology and sociology.

Question 6

Closed Questions

Answer 6

Seek a response that is very specific and commonly involves an answer that can be accomplished with a single word or two. Closed questions lead with is, are do, did, could, would, have, or “it is not true that…”

Question 7

Cognitive-Behavioral Paradigm

Answer 7

Humans are beings that are subject to the same learning principles that were established in animal research. The basic principles of classical and operant conditioning are assumed to account for an individuals’ behavior and understandings throughout their lives.

Question 8

Confirmation Bias

Answer 8

A commonly used and popular phrase that “you do not get a second chance at a first impression.” People tend to filter information and focus on information supporting their opinion.

Question 9

Developmental Paradigm

Answer 9

Believes that human development occurs in stages over time. Relationships that are formed early in life become a template for establishing relationships in adulthood. As to emotions, the Developmental Paradigm assumes that all humans develop and progress in a predictable sequence.

Question 10

Disposition Effect

Answer 10

The cognitive bias was “faulty framing” where normal investors do not mark their stocks to market prices. Investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after the market prices have changed.

Question 11

Gambler’s Fallacy

Answer 11

One of the incorrect assumptions from the world of probabilities; in the realm of probabilities, misconceptions can lead to faulty predictions as to the occurrences of events.

Question 12

Herding

Answer 12

This cognitive bias is explained just by looking at the world. People tend to follow the masses or the “herd.”

Question 13

Hindsight Bias

Answer 13

Another potential bias for an investor. Hindsight is looking back after the fact is known.

Question 14

Human Communications

Answer 14

Comprised of fundamental elements. Societal groups use a system of signs in their communication process. A sign could be a word, object, gesture, tone, quality, image, substance or other reference according to a code of shared meaning among those who use that sign for communication purposes

Question 15

Humanistic Paradigm

Answer 15

Dominator by theorists whose models have their origin from a shared philosophical approach. For a client to grow, the relationship requires a transparent and genuine counselor. The advisor needs a philosophical stance that humankind is basically good, and that people have the inherent capability of self-direction and growth under the right set of circumstances.

Question 16

Nonverbal Behaviors

Answer 16

Nonverbal cues, or body language, can communicate feelings, and attitudes from the client to the financial advisor and are mainly provided from the body and the voice. Body position and body movement are important, while voice tone and voice pitch are also telling.

Question 17

Open Questions

Answer 17

Result in a person answering with a lengthy response that usually begins with words such as how what, when, where, who and why.

Question 18

Overconfidence Bias

Answer 18

Usually concerns an investor that listens mostly to himself or herself, overconfident investors mostly rely on their skill and capabilities to do their own homework or make their own decisions.

Question 19

Overreaction

Answer 19

A common emotion towards the receipt of news or information.

Question 20

Passive Listening

Answer 20

Described as listening in the normal or usually conversations or conversational setting to which most people are accustomed at seminars, in class, at social gatherings, or at sermons.

Question 21

Prospect Theory

Answer 21

Provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses.

Question 22

Similarity Heuristic

Answer 22

Used when a decision or judgment is made when a similar situation occurs.

Question 23

Traditional Finance

Answer 23

Also describes in the literature as though some of the concepts of the theory are not necessarily modern and have been subject to much debate and change over recent decades. Traditional finance is premised on four basic premises: (1) Investors are Rational; (2) Markets are Efficient; (3) The Mean-Variance Portfolio Theory Governs; and (4) Returns are Determined by Risk(Beta).

Question 24

Identify and discuss the 3 general schools of thought for counseling.

Answer 24

There are three (3) general and noteworthy schools of counseling: Developmental, Humanistic and Cognitive-
Behavioral. The Developmental Paradigm believes that human development occurs in stages over time and
that all humans develop and progress in a predictable sequence. Disruptions, whether by trauma, incident or
otherwise, at a particular stage of that individual’s development will result in predictable problems, symptoms and behavior. Counseling in the Developmental Paradigm has an overall aspiration to recount or correct earlier, disrupted development to foster change in the client or the client’s behavior. Once the client can resolve those earlier conflicts or disruptions, there is more understanding and self-awareness, allowing the client to grow.

The Humanistic Paradigm requires a transparent and genuine counselor with a philosophical stance that
humankind is basically good and that people have the inherent capability of self-direction and growth under
the right set of circumstances. A Humanistic counselor would define mental health as having congruent and
aligned thoughts, feelings and behavior. Goals in treatment are centered on establishing congruence and
acceptance of personal responsibility, for clients are experts on themselves.

In the Cognitive-Behavioral Paradigm, humans are beings are subject to the same learning principles that were established in animal research. All behavior is subject to the principles of reinforcement by environmental conditions that reinforce or fail to reinforce a given behavior. The counselor’s challenge lies in performing a sound evaluation of how reinforcers are maintaining problematic self-talk and behaviors. The counselor is the expert in the Cognitive-Behavioral Paradigm, but the counselor and client have a working alliance where the client must be actively engaged.

Question 25

What are some examples of open questions versus closed questions?

Answer 25

Open questions usually begin with words such as how, what, when, where, who and why. Closed questions lead with is, are, do, did, could, would, have, or “is it not true that …”

Question 26

Discuss the benefits and drawbacks to the “why” question of a client?

Answer 26

“Why” questions are tempting and may help understand the client’s motives. Knowing the client’s motives
may help understand biases or goals of the client. However, the “why” question may be ill-advised because it could have limited benefit for the client. It could place the client in a position of having to justify what was
done or it could put the client in a defensive posture.

Question 27

What are your options if you sense a client is saying one thing but believes another?

Answer 27

If there is an ambiguous meaning, it is best to clarify the statement from the client to insure accuracy or to

clear up the ambiguity. Clarifying a client’s statement is part of the process of feedback under active listening.
The advisor can offer a question that paraphrases something the client said, which may bring out a clarification by the client if the paraphrase is incorrect. By repeating a key word or phrase, the advisor can help verify correctly an understanding of what the client is communicating. A direct method to clarify a statement or a more diplomatic method of asking questions that are pertinent to the statement can be used. Closed questions can help confirm some beliefs that the advisor has understood, while open questions may help the counselor obtain more information. The optimal time for a clarification, or “checkout,” is before leaving a subject matter area during the session.

Question 28

Identify and discuss the 4 basic premises for Traditional Finance.

Traditional Finance is premised on four basic premises:

1. Investors are Rational;
2. Markets are Efficient;
3. The Mean-Variance Portfolio Theory Governs; and
4. Returns are Determined by Risk (Beta).

Answer 28

Rational investors are hypothetical machine-like people that prefer more wealth as compared to less wealth,
irrespective of manner or form. Efficient market theory posits that, at any given time, a stock’s share price in
the market incorporates and reflects all relevant information about that stock. There are no “mispricings” in an efficient market. When combining all rational investors into the “marketplace,” the market is then seen as a “rational market” where stock prices are equal to their intrinsic value. Mean-Variance Portfolio Theory fostered in the process of scientific method into the world of finance. Each question or thought about a company or the economy would invoke a common retort by Traditional Finance proponents, with the retort simply
questioning the company’s asset price. Risk, in financial analysis and decision-making, is measured by “Beta,”
a concept from the CAPM which calculates the relationship of risk and return for an individual security by
combining a risk-free asset with risky assets from an efficient market. Stated differently, Beta is the measure of
an asset’s risk in correlation to the market or to an alternative benchmark. This inquiry into Beta and risk-
return was the main goal of Traditional Finance.

Question 29

Identify and discuss the 4 basic premises for Behavioral Finance.

Behavioral Finance is premised on four basic premises:

1. Investors are Normal;
2. Markets are Inefficient;
3. The Behavioral Portfolio Theory Governs; and
4. Risk Alone Does Not Determine Returns.

Answer 29

Unlike a rational, number-crunching automaton, investors are “normal” with normal wants and desires who

but make commit cognitive errors (through biases or otherwise). Normal investors may be misled by emotions
while they are trying to achieve their wants. Also, the price of a stock is not necessarily equal to its fundamental value at all times. While markets can be difficult to beat, the key concept is that there can be deviations in price from fundamental value so that there are opportunities to buy at a discount or sell at a premium. Conversely, there are times when an investor buys at a premium and sells at a discount.

The “Behavioral Portfolio Theory” is a goal-based theory where investors segregate or compartmentalize their
assets into various mental accounting layers based on risk. These goals could include food and shelter, a secure retirement, paying for college education, paying for children’s expenses like weddings, or being rich enough to fulfill a lifelong dream or desire. This is different from investors under the Mean-Variance Portfolio Theory who view their portfolios as a whole at all times.

In its simplest form, the Capital Asset Pricing Model could be expressed in the following equation.

However, the Behavioral Finance’s model reaches far beyond the CAPM’s objective simplicity. The Behavioral
Asset Pricing Model determines the expected return of a stock to Beta, book to market ratios, market capitalization ratios, stock “momentum”, the investor’s likes or dislikes about the stock or company, social responsibility factors, status factors, and more. In its simplest form, the Behavioral Asset Pricing Model is expressed in
the following equation:

Expected return = F (market factor)

Expected return = F (market factor, book to market ratio,
market capitalization, momentum, affect factor,
social responsibility factor, status factor, and more)

The realm of subjective risk is prevalent with Behavioral Finance.

Question 30

Identify and describe some differences between a rational investor and a normal one.

Answer 30

Rational investors are not confused by the form of wealth and are not moved by emotions or biases. Normal
investors are prone to making cognitive mistakes due to their beliefs or cognitive biases. Many biases or heuris-
tics have been observed or linked to normal investors. Heuristics can lead to biases or can lead to investment
decisions that are less than optimal.

Question 31

Discuss what you believe are the reasons how someone can buy lottery tickets and insurance at the same time.

Answer 31

At first glimpse, there appears to be a contradiction in the actions of purchasing lottery tickets and purchasing
insurance policies. In a study of people who bought lottery tickets and also purchased insurance policies, the
authors concluded that those who bought lottery tickets were risk-seeking through buying them, but were also
averting risk by purchasing insurance. They reasoned that the lottery ticket purchase was to achieve higher
social classes, yet the insurance protection safeguarded against dropping into lower social classes. While this
could be seen as inconsistent behavior, it can be explained through the process of mental accounting that
occurs when one places goals in separate layers with different degrees of risk on the pyramid.

Question 32

Discuss the difference between evaluating a portfolio as a whole versus evaluating a portfolio in mental layers.

Answer 32

BPT investors segregate their assets into various mental accounting layers, with each layer having a goal and a
level of risk. BPT investors hence view their portfolios in distinct mental account layers in a pyramid of assets.
This is different from investors under the Mean-Variance Portfolio Theory who view their portfolios as a
whole at all times.

Mean-Variance investors choose portfolios by evaluation and decisions based on mean and variance. Mean-
Variance investors consider covariance.

Behavioral investors, instead, choose portfolios by evaluation and decisions based on expected wealth, desire for security, aspiration levels, and probabilities of aspiration levels. These mental accounting layers reflect attitudes or leanings of the investor towards risk from layer to layer. Though risk is considered within each layer,
BPT investors tend to overlook or ignore covariance among these differing mental accounts.

Question 33

What should you do as a financial advisor if you believe that a client’s heuristic is clouding his or her judgment?

Answer 33

The first task is to understand the various types of heuristics. Next, the advisor must be able to recognize the heuristic. Finally, if the advisor believes that a heuristic is clouding the client’s judgment, the advisor must (in applying the proper counseling school of thought) use his or her best judgment to communicate to the client what is flawed in the client’s reasoning or in the client’s decision making process. The use of questions, open or closed, direct or indirect, may be used to aid in this process. Keeping the client’s best interests should guide the well-intentioned advisor.