Chapter 6

Question 1

Amos Tversky

Answer 1

Amos Tversky - A founding father of behavioral finance who developed prospect theory and the importance of loss aversion.

Question 2

Anchoring

Answer 2

Anchoring - A cognitive error in which the investor uses the first available piece of information to make a decision, especially if the information is irrelevant or immaterial.

Question 3

Asset Bubble

Answer 3

Asset Bubble - A capital market mis-pricing in which asset prices rise far too quickly than would be expected based on fundamental or intrinsic values.

Question 4

Behavioral Finance

Answer 4

Behavioral Finance - A combination of economics, finance, and psychology disciplines that offers an explanation of human errors in financial decision making, particularly cognitive errors and emotional biases shown to be evident in capital markets.

Question 5

Beta

Answer 5

Beta - The measure of systematic risk of a financial security, which explains the manner in which changes in economic variables affect stock returns.

Question 6

Bounded Rationality

Answer 6

Bounded Rationality - A behavioral finance concept in which investors are bound by the amount of information they can locate and by their cognitive ability to process this information.

Question 7

Capital Asset Pricing Model

Answer 7

Capital Asset Pricing Model - A theoretical model developed by William Sharpe that describes the relationship between individual stock returns and broad market returns.

Question 8

Clustering Illusion

Answer 8

Clustering Illusion - A cognitive error in which investors see patterns in small samples of data where none exist, especially over the long term.

Question 9

Cognitive Dissonance

Answer 9

Cognitive Dissonance - An uncomfortable state of mind in which an investor is faced with mutually exclusive thoughts regarding a financial decision and resolves the conflict by eliminating one option through irrational short cuts.

Question 10

Cognitive Errors

Answer 10

Cognitive Errors - One of the two main behavioral mistakes made by investors, in which brain patterns distort information regarding an investment and leads investors to biased decisions.

Question 11

Confirmation Bias

Answer 11

Confirmation Bias - A cognitive error in which an investor searches for information that confirms earlier beliefs.

Question 12

Daniel Kahneman

Answer 12

Daniel Kahneman - A founding father of behavioral finance who developed prospect theory and the importance of loss aversion.

Question 13

Efficient Markets Hypothesis

Answer 13

Efficient Markets Hypothesis - A modern portfolio theory developed by Eugene Fama that describes an efficient market as one in which prices reflect all relevant information.

Question 14

Emotional Bias

Answer 14

Emotional Bias - One of the two main behavioral mistakes made by investors, in which emotions play a critical role in framing an investment and leads to biased decisions.

Question 15

Equity Premium Puzzle

Answer 15

Equity Premium Puzzle - A mystery describing the difference between the returns on government bonds and the returns on equity securities that are much higher than the risk differential would predict.

Question 16

Framing

Answer 16

Framing - A cognitive error in which investors are influenced in their financial decision making by the manner in which a decision is presented or framed.

Question 17

Fundamental Analysis

Answer 17

Fundamental Analysis - A framework under which investors use basic investment tools to analyze the macro and micro economic environments to make financial decisions.

Question 18

Gambler’s Fallacy

Answer 18

Gambler’s Fallacy - A cognitive error in which investors believe in a decreased probability of an event occurring in the future if the event has recently occurred more frequently than expected.

Question 19

Harry Markowitz

Answer 19

Harry Markowitz - A founding father of finance who identified the important relationship between the expected return on a portfolio and its volatility by creating the efficient frontier.

Question 20

Herd Mentality

Answer 20

Herd Mentality - An emotional bias in which investors are greatly influenced by the actions and decisions of their peers.

Question 21

Heuristics

Answer 21

Heuristics - An approach to solving problems that is sufficient to satisfy short-term needs but is not likely to be optimal in the long term. It is a short cut method to solving problems when individuals do not have access to complete information sets or do not have the resources to process the complete information set.

Question 22

Hindsight Bias

Answer 22

Hindsight Bias - A cognitive error in which investors tend to forget the feelings of regret from poor investment outcomes but clearly remember the feelings of pride from successful outcomes. One consequence is that investors tend to believe that major financial events should have easily been predictable even in the absence of any prior evidence.

Question 23

Illusion of Control

Answer 23

Illusion of Control - A cognitive error in which investors believe they have the ability to significantly influence or even control the outcome of a randomly occurring event.

Question 24

Irrational Escalation -

Answer 24

Irrational Escalation - An emotional bias in which investors investment even when there are no rational reasons to do so.

Question 25

Loss Aversion

Answer 25

Loss Aversion - The sense that investors are more averse to the pain of a loss than to the joy of a gain, which leads to biased financial decisions.

Question 26

Market Anomalies

Answer 26

Market Anomalies - Situations in which predictable stock price reactions occur that are inconsistent with the efficient markets theory.

Question 27

Mental Accounting

Answer 27

Mental Accounting - A cognitive error in which investors tend to file their money into separate accounts, each used for a unique purpose instead of gathering all accounts into one diversified portfolio.

Question 28

Modern Portfolio Theory

Answer 28

Modern Portfolio Theory - A fundamental hypothesis in which security returns are functions of the level of relevant risk taken, in which investors form well-diversified and efficient portfolios, and in which investors maximize their expected utilities.

Question 29

Myopic Loss Aversion

Answer 29

Myopic Loss Aversion - A coupling of an investor’s aversion to losses with frequent decisions regarding their investments, leading to short-term inefficiencies in portfolio management.

Question 30

Optimism Bias

Answer 30

Optimism Bias - An emotional bias in which investors believe they will be exposed to less risk when compared to others or experience greater gains.

Question 31

Overconfidence

Answer 31

Overconfidence - An emotional bias in which investors expect to outperform others because of their superior ability to predict future outcomes, and this overconfidence tends to increase with the amount of information processed by the investor.

Question 32

Prospect Theory

Answer 32

Prospect Theory - An investment choice theory in which individuals prefer certainty over risk, they make decisions to avoid losses, they evaluate outcomes based on relative performance, and they discount low probability events.

Question 33

Regret Aversion

Answer 33

Regret Aversion - An emotional bias in which investors anticipate the feeling of regret and attempt to avoid this feeling when making financial decisions.

Question 34

Representativeness

Answer 34

Representativeness - A cognitive error in which investors tend to believe that short-term performance represents the true long-term performance of a financial security, which means they tend to overweight recent news about a security while they discount historical information.

Question 35

Richard Thaler

Answer 35

Richard Thaler - A founding father of behavioral finance who was a primary stock market anomaly researcher.

Question 36

Self-Control Bias

Answer 36

Self-Control Bias - An emotional bias in which investors value short-term satisfaction at the expense of their long-term rational goals.

Question 37

Semi-Strong Form Efficiency

Answer 37

Semi-Strong Form Efficiency - A degree of market efficiency in which security prices reflect all relevant publicly available information.

Question 38

Stephen Ross

Answer 38

Stephen Ross - A founding father of finance who developed the arbitrage pricing model.

Question 39

Strong Form Efficiency

Answer 39

Strong Form Efficiency - A degree of market efficiency in which security prices reflect all relevant information, including information that is publicly available and information that is considered to be private.

Question 40

Systematic Risk

Answer 40

Systematic Risk - The variability in security returns due to changes in economic factors (undiversifiable risk).

Question 41

Technical Analysis

Answer 41

Technical Analysis - A trading system in which historical information on security prices and trading volume is used to predict future security prices.

Question 42

Weak Form Efficiency

Answer 42

Weak Form Efficiency - A degree of market efficiency in which security prices reflect historical price and volume information only.

Question 43

William Sharpe

Answer 43

William Sharpe - A founding father of finance who developed the capital asset pricing model and identified the importance of beta as a measure of the systematic risk of diversified portfolios.