Chapter 2 - Understanding a Client's Risk Tolerance - 5%

Question 1

What is Behavioural Finance?

Answer 1

Behavioural finance is commonly defined as the application of psychology to understand human behaviour in finance or investing. It can be split into two - Behavioural Finance Micro and Behavioural Finance Macro

Question 2

What is the difference between Behavioural Finance Micro (BFMI) and Behavioural Finance Macro (BFMA)?

Answer 2

BFMI examines the behavioural biases of individual investors. It compares irrational investors to rational investors.

BFMA describes anomalies or irregularities in the overall market that contradict the efficient market hypothesis.

Question 3

What is Homo Economicus?

Answer 3

Homo Economicus is a model of human economic behaviour that hypothesizes that three principles rule economic decisions made by individuals:
Perfect rationality
Perfect self-interest
Perfect information

Question 4

What is efficient market hypothesis? What are its three forms?

Answer 4

The efficient market hypothesis was developed from the doctoral dissertation of Professor Eugene Fama of the University of Chicago. He believed in a securities market populated by many well-informed investors, investments will be accurately priced and reflect all available information. There are three forms –

a) Weak form: all past market prices and data are fully reflected in current securities prices; that is technical analysis is of little or no value.
b) Semi-strong form: all publicly available information is fully reflected in current securities prices; that is fundamental and technical analysis are of no value.
c) Strong form: all information (including insider information) is fully reflected in current securities prices.

Question 5

What are the three main types of market anomalies?

Answer 5

1. Fundamental anomaly: is an irregularity in a security’s current price when compared to a fundamental assessment of its intrinsic value.
2. Technical anomaly: is rooted in a form of market examination called technical analysis. Technical analysis attempts to forecast securities prices by studying past prices.
3. Calendar anomaly: is an irregular securities pattern that emerges during certain times of the year, such as the January Effect.

Question 6

What are the fundamental characteristics that a successful advisory relationship shares?

Answer 6

1. The advisor clearly understands the client’s financial goals.
2. The advisor uses a structured, consistent approach to advising the client.
3. The advisor delivers what the client expects.
4. Both the client and the advisor benefit from the relationship.

Question 7

What are the differences between Cognitive and Emotional Biases?

Answer 7

A cognitive bias can be technically defined as basic statistical, information processing or memory errors that are common to all human beings. One of the most common cognitive bias is anchoring bias.

Emotional biases originate from impulse or intuition rather than from conscious calculations, they are difficult to correct. They include endowment, loss aversion and self-control.

Question 8

What are the 20 common biases?

Answer 8

Fourteen of the below are cognitive biases and six are emotional:

COGNITIVE BIASES

1. Overconfidence
2. Representativeness
3. Anchoring and Adjustment
4. Cognitive Dissonance
5. Availability
6. Self-Attribution
7. Illusion of Control
8. Conservatism
9. Ambiguity Aversion
10. Mental Accounting
11. Confirmation
12. Hindsight
13. Recency
14. Framing

EMOTIONAL BIASES

15. Endowment
16. Self-Control
17. Optimism
18. Loss Aversion
19. Regret Aversion
20. Status Quo

Question 9

Which of the following is an emotional bias?

a) Framing
b) Recency
c) Optimism
d) Hindsight

Answer 9

Optimism is an emotional bias; the others are cognitive biases.

Question 10

Classify the phenomenon that occurs when the highest Book Value/Market Value stocks outperform the lowest Book Value/Market Value stocks.
A.	Technical anomaly.		 	 
B.	Fundamental anomaly.		 
C.	Calendar anomaly.		 	 
D.	Behavioural anomaly.

Answer 10

B) Fundamental anomaly.
A fundamental anomaly is an irregularity in a security’s current price when compared to a fundamental assessment of its intrinsic value. Technical anomalies are patterns that emerge in technical analysis. A calendar anomaly is an irregular securities pattern that emerges during certain times of the year.

Question 11

Carmen works on commission as a salesperson for a jewellery retailer. The jeweller gave her the option of withholding her income taxes at source or paying her the full commissions with Carmen being responsible for making income tax payments to Canada Revenue Agency. Carmen opted for the withholding option. Which of the following biases would apply to Carmen?
A.	Loss Aversion.		 	 
B.	Self Control.	 	 
C.	Framing.		 	 
D.	Conservatism.

Answer 11

B) Self Control.
Carmen probably does not want to run the risk of spending the money that should be set aside to make income tax payments to CRA.

Question 12

Samantha went to see an advisor a few years back. She was happy with the asset allocation he recommended, so she never went back to see him even when he suggested that they review her portfolio and take into consideration new investment opportunities. Samantha believed that her portfolio was well invested and liked the fact that she had invested in some companies dear to her heart.

Which of the following biases does Samantha demonstrate?

A. Regret Aversion.
B. Illusion of Control.
C. Status Quo.
D. Conservatism.

Answer 12

c) Status Quo.

When Samantha was presented with the opportunity to re-evaluate her holdings, she chose not to because she feels comfortable with her current asset allocation.

Question 13

An investor who falls into the “idealism” investor personality dimension is generally susceptible to which of the following biases?
A. Conservatism; Mental Accounting; Framing.
B. Overconfidence; Optimism; Self-Attribution.
C. Cognitive Dissonance; Endowment; Self-Control.
D. Hindsight; Framing; Optimism.

Answer 13

B.

Overconfidence in that he/she overestimates his/her investing capabilities; Optimism in that he/she generally believes that his/her investments will do well; Self Attribution in that he/she would attribute his/her portfolio’s success to his/her superb investing capabilities.

Question 14

Ricardo has a degree in finance and works as a controller in an engineering firm. He believes that he is more than capable of successfully managing his investment portfolio. He is a very organized individual. His money is as well organized as his closet, with certain investments earmarked for his dream to buy a restaurant, others for buying a condo, some for emergencies and so on. Ricardo does not hesitate to make changes in his portfolio if he hears that certain investments have performed very well and realizes that some holdings are not performing as well as expected.

In which of the following investor personality dimensions does Ricardo fit?
A. Pragmatism; Framing; Reflecting (PFT).
B. Pragmatism; Integrating; Reflecting (PNT).
C. Idealism; Integrating; Realism (INR).
D. Idealism; Framing; Realism (IFR).

Answer 14

D.

Idealism in that he overestimates his investment capabilities; Framing in that his portfolio is divided into unique “pots” of money; Realism in that he is a quick decision maker and moves swiftly to adjust his portfolio as required.

Question 15

Jeff is a new client. He is 50 years old with modest savings in the low six figures, and wants to reinvest his portfolio to ensure that he can retire comfortably at age 65. In his meeting with Jeff, the advisor uncovered some of Jeff’s biases. Jeff displayed several strong emotional biases along with a few weak cognitive biases. Which of the following best states what the advisor should do?
A. The advisor should moderate Jeff’s emotional biases.
B. The advisor should adapt to Jeff’s cognitive biases.
C. The advisor should moderate and adapt to Jeff’s cognitive biases.
D. The advisor should moderate and adapt to Jeff’s emotional biases.

Answer 15

D.

Jeff belongs in the lower right quadrant because he has a relatively low level of wealth and strong emotional biases; that’s why the advisor should moderate and adapt to Jeff’s emotional biases.

Question 16

Which statements are true regarding risk tolerance questionnaires?

I. They may work well for institutional investors.
II. They provide guidelines for asset allocation and should not be interpreted too literally.
III. They can produce different results if worded slightly differently.

Answer 16

A.
Risk tolerance questionnaires may work well for institutional investors but often fail psychologically biased individuals. In addition to ignoring behavioural issues, risk tolerance questionnaires can generate different results when administered in slightly varying formats to the same individual investor. They only provide guidelines for asset allocation, and should be used in concert with behavioural assessment tools.

Question 17

Which statements are true regarding cognitive biases?

I. They are also called ‘blind spots’ in the human mind.
II. Anchoring bias is an example of a cognitive bias.
III. They result from intellectual predisposition towards a certain judgment.

Answer 17

A.

A cognitive bias can be technically defined as basic statistical, information processing or memory errors that are common to all human beings. They can be thought of also as “blind spots” or distortions in the human mind. One of the most common cognitive biases is anchoring bias, where clients get anchored to the price of a stock or the level of the market and hold on to that price before being willing or able to make an investment decision. Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgement, but rather from subconscious mental procedures for processing information.

Question 18

Which cognitive bias are women generally more susceptible to?
A. Availability bias.		 	 
B. Cognitive dissonance bias.		 	 
C. Representativeness bias.		  	 
D. Regret aversion bias.

Answer 18

C. Representativeness bias.

Availability bias and cognitive dissonance bias are cognitive biases that men are more susceptible to. Regret aversion bias is an emotional bias that women are more susceptible to. Representation bias is a cognitive bias that women are more susceptible to.

Question 19

Which of the following statements regarding behavioural finance is NOT correct?
A. Behavioural finance identifies with and learns from behaviour demonstrated by individual investors in financial markets.
B. Homo economicus refers to the model of a rational economic individual that is studied in Behavioural Finance Macro (BFMA).
C. Homo economicus refers to a person with perfect rationality, perfect self-interest and perfect information.
D. A technical anomaly is noted when inconsistencies with respect to the efficient market hypothesis are found when studying securities’ past prices.

Answer 19

B.

Homo economicus refers to the model of a rational economic individual that is studied in Behavioural Finance Micro (BFMI), and not in Behavioural Finance Macro (BFMA), which looks at the overall market.

Question 20

Which of the following biases is of concern when formulating questions to determine a client's level of risk tolerance?
A.	Endowment.	 
B.	Ambiguity Aversion.		 	 
C.	Framing.	  	 
D.	Optimism.

Answer 20

C. Framing.

The way a question is framed (i.e., worded or formulated) may have an effect on a client’s response.

Question 21

Which of the following statements regarding cognitive biases and emotional biases is NOT correct?
A. Only emotional biases lead to irrational judgments.
B. Cognitive biases stem from information processing or memory errors.
C. Emotional biases originate from impulse or intuition.
D. Cognitive biases can be thought of as “blind spots” in the human mind.

Answer 21

A.

Both emotional and cognitive biases lead to irrational judgments.