General Financial Planning Principles Sections 11

Question 1

When it comes to behavioral finance, clients actions are organized into two groups, what are they?

Answer 1

Cognitive errors and Emotional biases

Question 2

Cognitive Errors - What is Illusion of control bias?

Answer 2

It is when investors think that they can influence outcomes when they cannot.

Question 3

Cognitive Errors - Describe Conservatism bias?

Answer 3

Its when clients initially assume a rational view but fail to change that view as new information becomes available.

Question 4

Cognitive Errors - What is Hindsight bias?

Answer 4

Its when clients have a selective memory of past events, actions, or what was knowable in the past. Clients tend to remember their correct views and forget the errors.

Question 5

Cognitive Errors - What is Confirmation bias?

Answer 5

It when investors look for new information or distort new information to support an existing view.

Question 6

Cognitive Errors - What is Representativeness belief based on?

Answer 6

Its based on a belief that the past will persist, and as a result, new information is classified based on previous experiences. While this may be efficient, the new information can be misunderstood.

Question 7

Cognitive Errors - What are the two forms of Representativeness?

Answer 7

Base rate neglect and Sample size neglect

Question 8

Cognitive Errors, Representativeness - What is Base Rate Neglect?

Answer 8

Its when the base rate (probability) of the initial classification is not adequately considered (they assumed to be 100% correct).

For example, a stock could be classified as a value stock and new information about the stock is analyzed based of the classification. In reality, the stock may not be value stock.

Question 9

Cognitive Errors, Representativeness - What is Sample-Size Neglect?

Answer 9

Sample-size neglect makes the initial classification based on an overly small and potentially unrealistic sample of data.

For example, the initial classification based on the dividend yield without considering any of the other typical characteristics of a value stock.

Question 10

Cognitive Errors - What is Mental Accounting?

Answer 10

Its when individuals put their money into separate accounts (or money jars) based on the function of these accounts.

For example, amount of money may be earmarked separately for savings or future vacations.

Question 11

Cognitive Errors - Self-Attribution Bias is an…

Answer 11

ego defense used to avoid having to admit a mistake

Question 12

Cognitive Errors - Describe Anchoring?

Answer 12

Its when individuals make irrational decisions based on information that should have no influence on the decision at hand

Question 13

Cognitive Errors - Adjustment involves clients….

Answer 13

clinging on to an initial estimate and not adjusting for new information.

Question 14

Cognitive Errors - Outcome Bias is the….

Answer 14

tendency for individuals to take a course of action based on the outcomes of prior events.

Question 15

Cognitive Errors - Describe Framing bias?

Answer 15

It assert that people are given a frame of reference, a set of beliefs or values, which they use to interpret facts or conditions as they make decision. Under this theory , people will generally choose what they perceive is positive versus negative, winning vs losing.

Question 16

Cognitive Errors - What is Recency bias?

Answer 16

Its when recent information is given more importance because its most vividly remembered.

Question 17

Cognitive Errors - What is Herding?

Answer 17

Its when investors tend to follow the group and trade in the same direction or in the same securities as the rest

Question 18

Emotional Bias - What is Prospect Theory?

Answer 18

Its when clients fear losses much more than valuing gains. Accordingly, they will often choose the small of two potential gains if it avoids a sure loss

Question 19

Emotional Bias - What does Loss Aversion Theory involve?

Answer 19

It involves clients valuing gains and losses differently and as a result, will make decisions based on perceived gains rather than perceived losses.

Question 20

Emotional Bias - Describe Overconfidence.

Answer 20

Its when investors believe that they can control random events simply by acquiring more knowledge and they consider their abilities to be much better than they are.

Question 21

Emotional Bias - Self-Control Bias is when individuals…

Answer 21

lack self-discipline and favor immediate gratification over long-term goals.

Question 22

Emotional Bias - When does Status Quo Bias occur?

Answer 22

It occurs when comfort with an existing situation leads to an unwillingness to make changes.

Question 23

Emotional Bias - Endowment Bias occur when an…

Answer 23

asset is deemed special and more valuable simple because it is already owned

Question 24

Emotional Bias - When does Regret-aversion bias occur?

Answer 24

It occurs when market participants do nothing out of excess of fear that their actions could be wrong

Question 25

Emotional Bias - What does Affinity Bias refer to?

Answer 25

It refers to the tendency to favor things that one can identify with emotionally because they are familiar. This bias can lead to irrational decisions because the investor perceives a product or investment opportunity to be a reflection of their values and associations. Ethic, religious , or alumni affiliations can be the source of affinity bias.