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SS Own Cards > Lesson 1 of Investment Planning: Fundamentals of Investments > Flashcards

Lesson 1 of Investment Planning: Fundamentals of Investments Flashcards

1
Q

Forms of Underwriting!

A
  • Best Efforts
  • Firm Commitment
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2
Q

Best Efforts

A
  • The underwriter agrees to sell as much of the offering as possible.
  • The risk of the issue of not selling resides with the firm because any shares not sold to the public are returned to the company.
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3
Q

Firm Commitment

A
  • The underwriter agrees to buy the entire issuance of stock from the company.
  • The underwriter may buy the stock from the company for $18 per share and sell to the public at $20 per share, thus making the spread.
  • The risk that an issuance may not sell resides with the underwriter.
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4
Q

Key Documents!

A
  • Prospectus
  • Red Herring
  • 10K and 10Q
  • Annual Report
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5
Q

Prospectus

A
  • Outlines the
    • risk,
    • management team,
    • business operations,
    • fees, and expenses.
  • A prospectus must be issued by an investment company prior to selling shares to an investor.
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6
Q

Red Herring

A
  • A preliminary prospectus
  • issued before the SEC approval and
  • is used to determine investors’ interest in the security.
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7
Q

10K and 10Q

A
  • A 10K is an annual report of financial statements filed with the SEC.
  • The 10K is audited.
  • A 10Q is a quarterly report that is filed with the SEC.
  • The 10Q is not audited.
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8
Q

Annual Report

A
  • Contains a message from the Chairman of the Board on the progress in the past year and the outlook for the coming year.
  • The annual report is sent directly to shareholders.
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9
Q

Liquidity vs. Marketability

A

Liquidity

  • is how quickly something can be turned into cash, with little to no price concession.
  • Generally, short-term investment assets are considered liquid.
  • Stocks, bonds, stock mutual funds, and stock-bond funds are not considered liquid because an investor could suffer price concessions.

Marketability

  • exists when there is a ready-made market for something.
  • Real estate is marketable, but not very liquid.
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10
Q

Price Concessions

A
  • A concession can also be defined as the
    • difference between the selling price of the securities for investors and
    • the amount the issuing entity receives from the trade.
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11
Q

Types of Orders

A

Market Order

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12
Q

Market Order

A
  • Timing and speed of execution are more important than price.
  • A market order is most appropriate for stocks that are not thinly traded.
  • Thinly traded is low volume or increased volatility.
  • Low volume is not traded often.
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13
Q

Limit Order

A
  • The price at which the trade is executed is more important than the timing.
  • A limit order is most appropriate for stocks that are extremely volatile and are not frequently traded.
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14
Q

Stop Order

A
  • The price hits a certain level and turns into a market order.
  • A stop order to sell means that once the stop order price is reached, the stock is sold at that price or possibly less because it has become a market order.
  • The primary risk is that the investor may receive significantly less than anticipated if the market is moving too quickly.
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15
Q

Stop-Limit or Stop-Loss Limit Order

A
  • The investor sets two prices:
    • The first price is the stop-loss price, once the price is reached the order turns to a limit order.
    • The second price is the limit price. An investor will not sell below the second price.
  • The risk is that if the market moves quickly, the order may not fill and the investor will be left with the stock at a significantly lower price.
  • A stop-loss limit order is appropriate
    • for investors with a significant gain built into the stock, but may not want to sell the stock during a period of significant volatility based on short-term news.
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16
Q

EXAMPLE of Market Order

A
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17
Q

Short-Selling!

A
  • Selling first at a higher price, in the hopes of purchasing a stock back at a lower price.
  • The goal is to SELL HIGH and BUY LOW.
  • The investor makes a profit when the asset’s price decreases in value.
  • Short selling is the opposite of a long position, where the investor anticipates making a profit when the price of the asset increases in value.
  • Investors must have a margin account and deposit cash or securities to protect against any price appreciation of the stock.
  • There is no time limit on how long an investor can maintain the short position.
  • Dividends paid by a corporation must be covered by the short seller.
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18
Q

Short Selling Example

A
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19
Q

Margin Definition!

A
  • Initial Margin
  • Maintenance Margin
  • Margin Position
  • (At What Price Does an Investor Receive a Margin Call Price)
  • (How Much Equity Must An Investor Contribute?)
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20
Q

Initial Margin

A
  • The initial margin
    • reflects the amount of equity an investor must contribute to enter a margin transaction.
  • Regulation T set the initial margin at 50% and was established by the Federal Reserves.
  • The initial margin can be more restrictive based on the volatility of the stock.
  • It is possible to have a margin call within the day purchase if the price swings greatly.
  • On the exam assume 50% margin requirement unless stated otherwise in the question.
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21
Q

Initial Margin Example

A

To purchase 100 shares of Starbucks trading at $50 per share with an initial margin requirement of 75%, Joe must contribute 100 x $50 x .75 = $3,750, and he will borrow $1,250 (100 x $50 x .25) from his broker.

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22
Q

Maintenance Margin

A
  • The maintenance margin is the minimum amount of equity required before a margin call.
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23
Q

Margin Position

A
  • Represents the current equity position of the investor.
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24
Q

Other Definitions

Margin Call

A
  • A margin call
  • is a demand from a broker or lender for an investor to deposit additional money or securities into their margin account.
  • It occurs when the value of securities held in the margin account falls below a certain level, known as the maintenance margin.
  • The maintenance margin
    • is the minimum amount of equity that must be maintained in the account to continue trading on margin.
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25
Q

Margin Position

A

Represents the current equity position of the investor.

Margin Position = Equity ÷ Fair Market Value

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26
Q

Example Of Margin Position

Joe bought a Starbucks stock when it was $50 per share, using a 75% initial margin. Within two minutes of Joe’s purchase of Starbucks, the price fell to $40 per share. What is Joe’s new margin position?

75% is what they put in so the 25% would be the loan.

A

Margin Position = Equity ÷ Fair Market Value

Margin Position = ($40.00 - $12.50) ÷ $40.00
=68.75%

Equity = Stock Price - Loan
Equity = $40 - ($50 x 0.25)
Equity = $27.5

Margin Position = ( SP - Loan) ÷ SP

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27
Q

At What Price Does an Investor Receive a Margin Call Price

A
  • The Formula is used to determine the price that investor will receive a margin call.

Formula not provided.

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28
Q

Margin Call Formula

A
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29
Q

Example of What Price an Investor Should Receive Margin Call

Bob purchased 100 shares od Starbucks trading at $50 per share with an initial margin requirement of 75% and a maintenance margin of 25%. At what price would bob receive a margin call?

A

Loan = 50 x (1 - .75)
Loan = $12.50 per share

Price to Receive Margin Call:
= $12.50 ÷ (1 - 0.25)

Price to Receive Margin Call:
=$16.67

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30
Q

How Much Equity Must An Investor Contribute?

A
  • When a stock price falls below the stock price at which the investor will receive a margin call, the investor receives a margin call and must contribute equity to restore their equity position.
  • For the purposes of the exam, an investor must restore their equity position to the maintenance margin.
  • A margin call is the deficiency and a call price is the price where that call may initiate.
  • Questions for “What will my margin call be”
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31
Q

Example of How Much Equity Must An Investor Contribute?

Bob purchased 100 shares of Starbucks trading at $50 per share with an initial margin requirement of 75% and a maintenance margin of 35%. The price fell to $15 per share. How much equity must Bob contribute?

A

Required Equity:
Stock Price: $15.00
Main. Margin: x 0.35
Required Equity: $5.25

Actual Equity:
Stock Price: $15.00
Debt: <$12.50> ($50 x (1-.75))
Actual Equity: $2.50

Bob must contribute the difference between Required Equity and Actual Equity.
$5.25 - $2.50 = $2.75

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32
Q

Exam Question

Lisa purchased 500 shares of XYZ stock trading at $40 per share, with an initial margin requirement of 60% and a maintenance margin of 30%. At what Price would Lisa receive a margin call?

a) $20.00
b) $22.86
c) $57.14
d) $80.00

A

ANSWER B
Price to receive a margin call =
( Loan ÷ (1 - MM) )

= ($40 x (1 - 0.60) ) ÷ (1 - 0.30)
=$16 ÷ 0.70
=$22.86

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33
Q

Exam Question

Laureen purchased 1,000 shares of CWC stock for $80 per share with an initial margin requirement of 65% and a maintenance margin of 40%. Assuming the stock price falls to $30 per share, how much equity must Laureen contribute?

a) $2 per share
b) $8 per share
c) $10 per share
d) $12 per share

A

ANSWER: C

Required Equity:
Stock Price: $30.00
Main. Margin: x 0.40
Required Equity: $12.00

Actual Equity:
Stock Price: $30.00
Debt: <$28.00> ($80 x (1-.65))
Actual Equity: $2.00

Laureen must contribute $10 per share.

Requireed Equity - Actual Equity
=($12 - $2)
=$10

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34
Q

Research Reports!

A
  • Value Line
  • Morningstar
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35
Q

Value Line

A
  • Ranks stocks on a scale of 1 to 5 for timeliness and safety.
  • A ranking of 1 represents the highest rating for timeliness and safely (signal to buy).
  • A ranking of 5 represents their lowest ranking (signal to sell).
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36
Q

Morningstar

A
  • Ranks mutual funds, stocks, bonds, and ETFs using 1 to 5 stars.
  • 1 star represents the lowest ranking (lowest ranking)
  • 5 star represents the highest ranking (highest ranking)
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37
Q

Exam Tip

A
  • Know that the value line is stocks
  • Morningstar ranks primarily in mutual funds.
  • Know ranking and whether to buy or sell.
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38
Q

Dividend Dates!

A
  • Dividends are declared by the Board of Directors and are typically paid quarterly.
  • There are two important dates to know regarding dividend payments.
    • Ex-Dividend Date
    • Date of Record
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39
Q

Ex-Dividend Date

A
  • The date the stock trades without the dividend.
  • If you sell the stock on the ex-dividend date, then you will receive the dividend.
  • If you buy the stock on or after the ex-dividend date, then you will NOT receive the dividend.
  • The ex-dividend date is one business day before the date of record.
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40
Q

Date of Record

A
  • Date of record is the date in which you must be a registered shareholder in order to receive the dividend.
  • The date of record is one business day after the ex-dividend date.
  • An investor must purchase the stock two buisness days prior to the date of record in order to receive the dividend.
  • Purchases made on ex-dividend date will not receive the dividend (ex-date = trades without dividend)
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41
Q

Exam Tip

A
  • To receive the dividend, an investor must purchase the stock prior to the ex-dividend date or 2 business days prior to the date of record.
  • Remember Business days and holidays
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42
Q

Exam Question

MSFT declared a dividend payable to shareholders on the record date of Wednesday, May 15th. Which is the last possible date an investor could purchase the stock and still receive the dividend?

a) Stock purchase on May 13th.
b) Stock purchase on May 12th.
c) Stock purchase on May 11th.
d) Stock purchase on May 10th.

A

ANSWER A

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43
Q

Exam Question

If June 4 is the date of record, when must Joe purchase the stock in order to receive the dividend?

a) June 1
b) June 2
c) June 3
d) June 4

A

ANSWER: B

Date of record minus two business days.

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44
Q

Dividends & Splits!

A
  • Cash Dividends
  • Stock Dividends
  • Stock Splits
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45
Q

Cash Dividends

A
  • Qualified dividends receive capital gains treatment.
  • A cash dividend is taxed upon receipt.
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46
Q

A qualified dividend

IMPORTANT TO KNOW

A
  1. Paid by an American company or qualifying foreign company.
  2. Not listed as a dividend that doesn’t qualify by the IRS.
  3. Held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Minimum amount of time holding it.

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47
Q

Stock Dividends

A
  • A stock dividend is
    • when a company distributes additional shares of its own stock to existing shareholders instead of paying them cash.
    • It doesn’t change the total value of an investor’s stake, but it increases the number of shares they hold.
  • Not taxable to the shareholders until the stock is sold.
48
Q

Stock Splits

A

Increase shares outstanding and reduce stock price.

  • 2-for-1 split
  • 3-for-2 split
49
Q

2-for-1 split

A
  • A 2-for-1 split for an investor with 100 shares at $50 per share.

How many shares after the split?

  • Answer: 100 shares x 2 = 200

How much is the stock after the split?

  • Answer: $50 per share ÷ 2 = $25 per share.

100 x 2/1 and reciprocal 50 x 1/2

50
Q

3-for-2 split

A
  • A 3-for 2 split for an investor with 100 shares at $60 per share.

How many shares after the split?

  • Answer: 100 shares x 1.5 (3÷2) = 150 shares

How much is the stock after the split?

  • Answer: $60 ÷ 1.5 (3÷2) = $40.
51
Q

Security Regulations!

A

Have to know these well!!!

  • Securities Act of 1933
  • Securities Act of 1934
  • Investment Company Act of 1940
  • Investment Advisors Act of 1940
  • Securities Investors Protection Act of 1970
  • Insider Trading and Securities Fraud Enforcement Act of 1988
52
Q

Securities Act of 1933

Paper Act

A
  • Regulates the issuance of new securities (Primary Markets)
  • Requires new issues are accompanied by a prospectus before being purchased.
53
Q

Securities Act of 1934

People Act

A
  • Regulates the secondary market and trading of securities.
  • Created the SEC to enforce compliance with security regulations and laws.
54
Q

Investment Company Act of 1940

A

Authorized the SEC to regulate investment companies.

  • Three types of investment companies:
    • Open
    • Closed
    • Unit Investment Trusts
55
Q

Investment Advisors Act of 1940

A
  • Required investment advisors to register with the SEC or state.
56
Q

Securities Investors Protection Act of 1970

A
  • Established SIPC to protect investors from losses resulting from brokerage firm failures.
  • Does not protect investors from incompetence or bad investment decisions.
  • Protects accounts member firms open for clients, regardless of the client’s citizenship.
  • Losses are limited to $500K, including $250K of cash.
57
Q

Insider Trading and Securities Fraud Enforcement Act of 1988

A
  • Defines an insider as anyone with information that is not available to the public.
  • Insiders cannot trade on that information.
58
Q

Money Market Securities!

A

EXAM TIP: Any questions on money market securities will be very definition-oriented and surround the key terms above.

  • Treasury Bills
  • Commercial Paper
  • Bankers Acceptance
  • Eurodollars
59
Q

Certificates of Deposit

A
  • Time deposit at a bank with a set interest rate and maturity date.
60
Q

Treasury Bills

A
  • Issued in varying maturities up to 52 weeks.
  • Denominations in $100 increments through Treasury Direct up to $55 million per auction. Larger amount is available through a competitive bid.
  • “Treasury bills (T-bills) are short-term debt securities issued by the U.S. Department of the Treasury to
    • raise funds and meet the government’s short-term financing needs.
    • These instruments are considered to be one of the safest investments because they are backed by the “full faith and credit” of the U.S. government.”
61
Q

Commercial Paper

A
  • Short-term loans between corporations.
  • Maturities of 270 days or less and it does not have to register with the SEC.
  • Commercial paper has denominations of $100,000 and are sold at a discount.
62
Q

Bankers Acceptance

A
  • Facilities imports/exports.
  • Maturities of 9 months or less.
  • Can be held until maturity or traded.
63
Q

Eurodollar

A
  • Deposits in foreign banks that are denominated in US dollars.
64
Q

Investment Policy Statement!

A
  • Establishes:
    • A client’s objectives.
    • Limitations on investment manager.
  • Used to measure investment manager’s performance.
  • The investment policy statement does NOT include investment selection.
  • IPS establishes “RR TTLLU”
    • OBJECTIVES:
      • Risk & Return
    • CONSTRAINTS:
      • and Taxes, Timeline, Liquidity, Legal, and Unique circumstances.
  • The primary goal is to understand an investor’s attitute toward risk so that an appropriate portfolio asset allocation can be developed.

EXAM TIP:

  • RR TTLLU
65
Q

Return Requirements

A
  • The return requirement can be a specific goal such as education or retirement.
66
Q

Risk Tolerance

A
  • Clearly defining an investor’s risk tolerance is key prior to making any investment selections.
67
Q

Time Horizon

A
  • When the client anticipates needing the money.
68
Q

Liquidity

A
  • Coincides with the time horizon.
  • Investment liquidity should be appropriate for the time horizon remaining.
69
Q

Taxes

A
  • Whether the account is taxable or nontaxable.
70
Q

Laws & Regulations

A
  • This could be if the assets are held in trust and in terms of the trust.
71
Q

Unique Circumstances

A
  • Anything unique to the client.
72
Q

Market Averages and Indices

A
  • Dow Jones Industrial Average
  • S&P 500
  • Russell 2000
  • Wilshire 5000
  • EAFE
73
Q

Dow Jones Industrial Average

A
  • A simple price-weighted average.
  • The DJIA does not incorporate market capitalization.
74
Q

Example of Simple Price-Weighted Average

A

Assume there are three stocks in our ABC average and their values are $44, $60, and $100. Our price average would be
($44 + $60 + $100) ÷ 3 = $68. Therefore, our price-weighted average would be $68. Simple price-weighted averages do not take into account the percent allocation of the position within the portfolio.

75
Q

S&P 500

A
  • A value-weighted average index.
    • Incorporates market capitalization of individual stocks into the average.
  • Most appropriate for conducting comparisons between a
    • large cap,
    • blue chip portfolio, and
    • the securities market.
76
Q

Russell 2000

A
  • A value-weighted index of the smallest market capitalization stocks in the Russell 3000.
  • Russell 3000 is a benchmark for the entire US Stock Market.
77
Q

Wilshire 5000

A
  • The broadest index, that measures the performance of over 3,000 stocks. The last time the Wilshire 5000 actually contained 5,000 or more stocks was December 2005.
  • Wilshire 5000 is also a value-weighted index.
78
Q

EAFE

A
  • A value-weighted index that tracks stocks in Europe, Australia, Asia (“Australasia”), and the Far East.
79
Q

Behavioral Finance

A
  • Can be best understood by comparison with the four basic premises of Traditional Finance.
    • Investors are Rational
    • Markets are Efficient
    • Mean-Variance Portfolio Theory Governs
    • Returns are Determined by Risk
80
Q

Investors are Rational

A

Investor decisions are

  • logical,
  • centered on a clearly defined goal free from the unsteady influences of emotion or irrationality, and
  • take into account all available information.
81
Q

Markets Are Efficient

A

At any given time, a

  • stock’s share price in the market incorporates and reflects all relevant information about that stock.
  • Stocks are deemed at all times to trade at their fair value on stock exchanges.
82
Q

The Mean-Variance Portfolio Theory Governs

A
  • Mean-variance investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios.
83
Q

Returns are Determined by Risk

A
  • The CAPM is the basic theory that links return and risk for all assets by combining a risk-free asset with risky assets from an efficient market.
84
Q

Investors Are “Normal”

A

Normal investors have normal wants and desires,

  • but may commit cognitive errors (through biases or otherwise).
  • Normal investors may be misled by emotions while they are trying to achieve their wants.
85
Q

Markets Are Not Efficient

A
  • There can be deviations in price from fundamental value so
  • that there are opportunities to buy at a discount or sell at a premium.
  • As a result, markets can be tough to beat, but they are not efficient.
86
Q

The Behavioral Portfolio Theory Governs

A
  • Under this theory, investors segregate their money into various mental accounting layers.
  • This mental process occurs when people “compartmentalize” certain goals to be accomplished in different categories based on risk rather than viewing their entire portfolio as a whole.
  • This may result in having very different risk preferences for the same value depending on the goal or situation.
87
Q

Risk Alone Does Not Determine Returns

A

The Behavioral Asset Pricing Model determines

  • the expected return of a stock using 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.
88
Q

Biases or Heuristics (mental shortcuts or rules of thumb) that have been observed or linked to normal investors

A
  • Affect Heuristic
  • Anchoring
  • Availability Heuristic
  • Bounded Rationality
  • Confirmation Bias
  • Cognitive Dissonance
  • Disposition Effect
  • Familiarity Bias
  • Gambler’s Fallacy
  • Herding
  • Hindsight Bias
  • Illusion of Control Bias
  • Overconfidence Bias
  • Overreaction
  • Prospect Theory
  • Recency
  • Similarity Heuristic
89
Q

Affect Heuristic

A

Affect Heuristic

  • Deals with judging something, whether it is good or bad. Do they like or dislike some company based on non-financial issues.
90
Q

Anchoring

A

Anchoring

  • 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.
91
Q

EXAM QUESTION

You are interviewing James Smith, CFP® to manage your investments and provide financial guidance in other areas of your life. James states that his investment philosophy is as a contrar-ian; he buys securities that are losing favor and sells securities that are gaining favor. You review his previous track record, which is about equal with the market. His investments are typically in a security that has lost at least 10% from its most recent high. What type of bias is James exhibiting?

a) Anchoring
b) Herding
c) Overconfidence
d) Hindsight Bias

A

Answer: A
He is subject to anchoring. His belief is a stock that falls 10% from its high is likely to return to that high. He is fixated on that high price.

92
Q

Availability Heuristic

A

Availability Heuristic

  • When a decision maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as “availability” is invoked.
  • This may cause investors to overweight recent events or patterns while paying little attention to longer-term trends.
93
Q

Bounded Rationality

A

Bounded rationality

  • When individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision.
  • Decision-makers in this view act as “satisficers” , seeking a satisfactory solution rather than an optimal one.
  • One consequence of this concept is that having additional information does not lead to an improvement in decision-making due to the inability of investors to consider significant amounts of information
94
Q

Confirmation Bias

A

Confirmation Bias

  • A commonly used and popular phrase is that “you do not get a second chance at a first impression.”
  • People tend to filter information and focus on information supporting their opinions and difficult to dislodge once affirmed.
95
Q

Cognitive Dissonance

A

Cognitive Dissonance

  • The tendency to misinterpret information that is contrary to an existing opinion or only pay attention to information that supports an existing opinion.

EXAMPLE:

  • Your best friend Alex came to your house party for the football game. During the game he starts telling you about his amazing portfolio performance. He tells you about several positions that experienced double digit returns in a matter of days.
  • He says that he lost on a few but not very much.
  • Impressed you decide to invest some money with him. What behavioral finance bias does your friend Alex portray?
96
Q

Disposition Effect or Regret Avoidance or Full Framing

A

“Regret Avoidance or Full Framing”

Disposition Effect

  • 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 market prices have changed.
97
Q

Familiarity Bias

A

Familiarity Bias

  • Investors tend to overestimate/underestimate the risk of investments with which they are unfamiliar/ familiar.

98
Q

Gambler’s Fallacy

A

Gambler’s Fallacy

  • Investors often have an incorrect understanding of probabilities which can lead to faulty predictions. Investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue its upward trend.
99
Q

Herding

A

Herding

  • This cognitive bias is explained just by looking at the word. People tend to follow the masses or the “herd.”
  • Herd Mentality is the process of buying what and when others are buying and selling.

Herd Mentality leads to:

  • Buying high
  • Selling Low
100
Q

Hindsight Bias

A

Hindsight Bias

  • Another potential bias for an investor.
  • Hindsight is looking back after the fact is known and assuming they can predict the future as readily as they can explain the past.
101
Q

Illusion of Control Bias

A

Illusion of Control Bias

  • The tendency for people to overestimate their ability to control events; for example,
  • it occurs when someone feels a sense of control over outcomes that they demonstrably do not influence.
102
Q

Overconfidence Bias

A

Overconfidence Bias

  • Usually concerns an investor that listens mostly to himself or herself, overconfident investors mostly rely on their skills and capabilities to do their own homework or make their own decisions.
  • This effect causes many investors to overstate their risk tolerance.
103
Q

Overreaction

A

Overreaction

  • A common emotion towards the receipt of news or information.
104
Q

Prospect Theory

A

Prospect Theory

  • Provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses.
  • Investors are “loss averse” and have an asymmetric attitude to gains and losses, getting less utility from gaining, say, $100 than they would lose if they lost $100.
  • This explains why investors may avoid higher-risk investments even if they offer strong risk adjusted returns.
  • It also explains why they over insure against risks through low deductibles.
105
Q

Recency

A

Recency

  • Giving too much weight to recent observations or stimuli; for example, focusing on short-term past performance.
106
Q

Similarity Heuristic

A

Similarity Heuristic

  • Used when a decision or judgment is made
  • when an apparently similar situation occurs even
  • though the situations may have very different outcomes.
107
Q

Why Advisors Should Study Behavioral Science?

A
  • Behavioral Finance does not abandon many of the concepts and use of scientific methods from Traditional Finance.
  • Advisors who study or educate themselves in Behavioral Finance may be able to improve their clients’ outcomes by
  • providing prudent recommendations tailored to the goals of the client in a way that increases the chances that the clients will use the recommendations.
108
Q

Example

A

Bryan, after extensive analysis, purchases a security that he believes will experience a 30% return over the next two years. After the first year, Bryan’s investment increases by 12%. Bryan is so pleased with his return, he sells the investment after experiencing a 12% return.

Joe, after extensive research, believes a security will increase 25% over two years. Three months after making the investment, the investment decreases 50%. Joe continues to hold the investment in the hopes of the security returning to his original purchase price and breaking even.

109
Q

Other Areas Behavioral Finance

  1. Naive Diversification
  2. Representativeness
  3. Familiarity
A
  1. Naive Diversification:
  • This is the process of investing in every option available to the investor.
  • This is common with 401(k) or other employer-sponsored retirement plans.
  • A plan participant thinks they are adequately diversified if they invest an equal amount in all the funds.
  • Also known as 1/n diversification.

2. Representativeness

  • is thinking that a good company is a good investment without regard to an analysis of the investment.

3. Familairty

  • causes investment in companies that are familiar, such as an employer.
  • Clearly, this can cause devastating effects on a portfolio (e.g. Enron).
110
Q

Loss Aversion

A

Suggests investors prefer avoiding losses more than experiencing gains.

  • An unwillingness to sell a losing investment, in the hopes it will turn around.
  • In other words, investors feel more pain from losses, than enjoying gains.
111
Q

Managing Biases

A
  • It is natural and common that individuals will have biases.
  • It will be important that the financial planner
  • recognizes and/or understands that the client may have
  • as it will shape their decision-making process.
  • The goal of the planner will be to
    • assist the client with not making irrational or emotional decisions that do not align with the stated goals and objectives.
  • Techniques to assist with removing the focus of the bias can include
    • changing the environment in which the decision is being made,
    • educating the client on the topic,
    • having the client pay devil’s advocate for the same opposing viewpoint, and
    • reviewing the client’s stated goals and objectives.
112
Q

Socialization and Client Planner Values, Attitudes, and Beliefs

A
  • Socialization
  • Multicultural Psychology
  • Social Consciousness
113
Q

Socialization

A

the process of acquiring

  • values,
  • beliefs, and
  • behaviors that are acceptable and or expected by society.
114
Q

Multicultural Psychology

A

is defined as “an extension of general psychology that recognizes that multiple aspects of identity influence a person’s worldview,

  • including race,
  • ethnicity,
  • language,
  • sexual orientation,
  • gender,
  • age,
  • disability,
  • class status,
  • education,
  • religious or
  • spiritual orientation, and
  • other cultural dimensions, and
  • that both universal and culture-specific phenomena should be taken into
  • and justice, and
  • conducting research.
  • consideration when psychologists are helping clients,
  • training students,
  • advocating for social change within society.
115
Q

Social Consciousness

A
  • an awareness of and sense of responsibility for problems or injustices that exist within society.
116
Q

Behavioral Finance Summary

A
  • Both the client and the planner will enter the relationship with their own values, attitudes, and beliefs.
  • The planner will tasked with having an understanding and an appreciation of the values, attitudes, and beliefs.
  • The planner will be tasked with having an understanding and an appreciation of the client’s views along with their degree and depth.
  • The planner must be careful to avoid imposing their own values on the client and must avoid influencing the client’s goals and decisions with his or her own values or beliefs.
117
Q

EXAM QUESTION

Kevin has subscribed to various investment magazines and data resources, which he religiously reads and analyzes. Kevin utilizes this analysis to make shifts in his high beta portfolio on a daily basis. Which behavioral finance bias is Kevin subject to?
a) Hindsight bias
b) Overconfidence
c) Regret Avoidance
d) Herd mentality

A

Answer: B
This is a classic example of overconfidence. Kevin believes that his information is perfect, that his analysis is perfect, so he trades too often and has a very risky portfolio (high beta).

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