Chapter 3

Question 1

What is the meaning of “homo economiucs”?

Answer 1

“rational economic human being”

Question 2

Homo economicus is a model of human economic behaviour hypothesizing that these three principles dictate individuals economic decisions:

Answer 2

1. Perfect rationality
2. Perfect self interest
3. Perfect information

Question 3

What is the difference between standard finance and behavioural finance?

Answer 3

Standard finance is grounded in idealized financial behaviour and behavioural finance in observed financial behaviour.

Question 4

Successful advisory relationships share what four fundamental characteristics?

Answer 4

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

Question 5

Describe overconfidence bias

Answer 5

• cognitive bias

- an unwarranted faith in one’s intuitive reasoning, judgements, and cognitive abilities

Question 6

Describe representativeness bias

Answer 6

• cognitive bias
• when confronted with new circumstances that may be inconsistent with existing classification systems, people rely on a “best fit” process to determine which category should house and form the basis for understanding for this new circumstance
• when the classification reflex is wrong it produces an incorrect understanding of the new element that often persists and biases further interactions with that element

Question 7

Describe anchoring and adjustment bias

Answer 7

• cognitive bias
• if a person is asked to estimate a value in an area they have little to no familiarity with and is presented with an initial default number (anchor) they will typically adjust this figure up or down to reflect subsequent information and analysis

Question 8

Describe cognitive dissonance bias

Answer 8

• cognitive bias
• when people are presented with information that conflicts with pre-existing beliefs, they usually experience mental discomfort
• a state of mental imbalance that occurs when contradictory cognitions bump into one another

Question 9

Describe availability bias

Answer 9

• cognitive bias
• a heuristic that allows people to estimate the probability of an outcome based on how prevalent or familiar it appears in their lives

Question 10

Describe self attribution bias

Answer 10

• cognitive bias
• the tendency of individuals to ascribe their successes to personal traits and to blame their failures on outside influences

Question 11

Describe illusion of control bias

Answer 11

• cognitive bias

- tendency to believe that you can control random outcomes when in reality you cannot

Question 12

Describe conservatism bias

Answer 12

• cognitive bias
• a mental state in which people cling to a prior view or forecast and do not acknowledge or obtain new information that might change an existing view

Question 13

Describe ambiguity aversion bias

Answer 13

• cognitive bias
• people avoid making an investment or taking risks when probability distributions seem uncertain to them because they hesitate in situations of ambiguity

Question 14

Describe mental accounting bias

Answer 14

• cognitive bias

- people’s tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible mental accounts

Question 15

Describe confirmation bias

Answer 15

• cognitive bias
• a type of selective perception in which people emphasize ideas that confirm their beliefs and discount ideas that contradict their beliefs

Question 16

Describe hindsight bias

Answer 16

• cognitive bias

- after the outcome of an event is known, some people believe it was predictable even if it was not

Question 17

Describe recency bias

Answer 17

• cognitive bias
• causes people to recall and emphasize recent events more prominently than those that occurred in the near or distant past

Question 18

Describe framing bias

Answer 18

• cognitive bias

- tendency to respond to various situations differently base don the context in which a choice is presented

Question 19

Describe endowment bias

Answer 19

• emotional bias

- placing more value on an asset you hold property rights to

Question 20

Describe self control bias

Answer 20

• emotional bias

- tendency to consume today at the expense of saving for tomorrow

Question 21

Describe optimism bias

Answer 21

• emotional bias

- most people tend to rate themselves as surpassing the population mean for personal traits perceived as positive

Question 22

Describe loss aversion bias

Answer 22

• emotional bias

- people generally feel a stronger impulse to avoid losses than to acquire gains

Question 23

Describe regret aversion bias

Answer 23

• emotional bias

- avoid making decisions because you fear in high-sight that whatever you decide will result in a bad decision

Question 24

Describe status quo bias

Answer 24

• emotional bias

- when faced with a variety of options, people choose to keep things the same

Question 25

What are the three investor personality dimensions?

Answer 25

1. Idealism vs pragmatism
2. Framing vs integrating
3. Reflecting vs realism

Question 26

Describe idealism vs pragmatism

Answer 26

I- discern patterns where none exist and believe their their above avg market acumen gives them an exaggerated degree of control over the outcomes of their investments
P- display realistic grasp of their own skills and limitations

Question 27

Describe framing vs integrating

Answer 27

F- evaluate investments individually and do not consider how each of them fits into an overall portfolio plan
I- characterized by an ability to contemplate broader contexts and externalities

Question 28

Describe reflecting (T) vs realism

Answer 28

T- have difficulty living with the consequences of their decisions and taking action to rectify their behaviours
R- assume responsibility for their mistakes and move on

Question 29

Define best practical allocation

Answer 29

Adjusting risk and return levels depending upon the client’s behavioural tendencies (Pompian)

Question 30

What are the two principles for creating a best practical allocation in light of behavioural biases ?

Answer 30

1. Moderate biases in less wealthy clients; adapt to biases in wealthier ones
2. Moderate cognitive biases; adapt to emotional ones