Reading 65: the behavioral biases of individuals Flashcards
Which of the following would most likely be classified as an emotional bias?
The investor has difficulty interpreting complex new information.
The investor only partially adjusts forecasts when he receives new information.
The investor has a tendency to value the same assets higher if he owns them than if he does not own them.
This describes the endowment bias, where individuals place a higher value on assets they own than if they did not own those same assets. The other two answer choices describe cognitive errors that are due to the inability to analyze all the information. (Modules 65.1, 65.2, LOS 65.a, 65.b)
Which of the following would most likely indicate that an investor is subject to an emotional bias?
Regularly basing decisions on only a subset of available information.
Reacting spontaneously to a negative earnings announcement by quickly selling a stock.
Remaining invested in a profitable technology stock even though new information indicates its P/E ratio is too high.
Emotional biases tend to elicit more of a spontaneous reaction than cognitive errors. Making a decision based only on partial information is indicative of a cognitive error. Ignoring a high P/E ratio could be indicative of the conservatism bias, which is reacting slowly to new information or avoiding analyzing new information. It could also indicate confirmation bias, where the investor focuses on positive information and ignores negative information. Both conservatism and confirmation biases are cognitive errors. (Modules 65.1, 65.2, LOS 65.a, 65.b)
A cognitive error is most likely indicated by which of the following?
A client is the chief executive officer of a public company that she founded and insists she will not diversify her holding of the company stock.
The spouse of a now-deceased company founder becomes upset when it is recommended the portfolio holdings in that company need to be diversified.
A client who initially resists recommendations to diversify the portfolio later thanks the manager for explaining the benefits of diversification.
Individuals making cognitive errors are more likely to respond rationally when new information is provided. The client initially resists a rational recommendation but then reverses their thoughts when given more information.
There are rational reasons a CEO may want to hold a large block of her company’s stock. Those include legal restrictions on sale or a desire to take concentrated risk in a situation where she has a lot of control. A rational decision is not an error. Alternatively, the “insists” could indicate an emotional bias. Neither interpretation suggests a cognitive error.
The spouse who becomes upset at a rational recommendation to diversify is likely showing an emotional bias. (Module 65.1, LOS 65.a)
Abby Lane has investments scattered across many different accounts, from bank savings to before- and after-tax retirement accounts to taxable nonretirement accounts. She has multiple investing goals ranging from important short-term goals to longer-term “wish list” goals. She looks at her financial assets and views each holding as designed to meet specific goals. Lane has been very successful in her investment decisions for several decades and believes she can continue to achieve reasonable results. Lane most likely exhibits:
framing bias.
mental accounting.
overconfidence bias.
Viewing each asset in light of meeting a specific goal is mental accounting. There was no indication of framing (the way data is provided overly affects the decision process). An investor with decades-long success who expects to produce reasonable results is acting rationally and is not necessarily overconfident. (Module 65.2, LOS 65.b)
Twenty years ago, Jane Ivy set up her initial asset allocation in her defined contribution plan by placing an equal amount in each asset class and never changed it. Over time, she increased her contribution by 1% per year until she reached the maximum amount allowed by law. Due to her steadfastness and good fortune, coupled with matching funds from her employer, she now finds herself in her early 40s with a million-dollar retirement account. Which of the following biases does Ivy most likely exhibit?
Representativeness.
Status quo bias.
Availability bias.
Ivy is exhibiting status quo bias, where investors leave their asset allocation alone and don’t change it according to changing market conditions or changes in their own circumstances. Her actions do not suggest representativeness (placing something in a category and assuming it will have the characteristics associated with that category) or availability (putting undue emphasis on information readily available or easily recalled). (Module 65.2, LOS 65.b)
The halo effect suggests that investors tend to overvalue stocks:
from their own country or region.
with which the investors are most familiar.
that have experienced rapid growth and price appreciation.
The halo effect suggests investors will view a stock that has experienced rapid growth and price appreciation as a good stock to own, which may result in these stocks being overvalued. Home bias is the tendency for investors to favor stocks from their own country or region because they are more familiar with those stocks. (Module 65.2, LOS 65.c)
