Section III.B.

Question 1

What is Prospect Theory?

Answer 1

–
A descriptive theory based on experimental evidence. (Kahneman
and Tversky 1979)
–
Most individuals are more risk averse vs. pleasure seeking by a ratio
of roughly 2:1.

Question 2

What are key tenets of Prospect Theory?

Answer 2

• People make decisions based more on probabilities than potential outcomes
• People make decisions using mental heuristics (e.g., mental shortcuts and biases)
• Loss aversion: the tendency to feel the impact of losses more than gains
• This value function can be illustrated graphically using an asymmetrical s shaped curve

Question 3

What is Cognitive Dissonance?

Answer 3

confusion or frustration that arises when an individual receives new information that does not match up with or conform to preexisting beliefs or experiences

“Beliefs don’t match up with actions”

Question 4

What is Conservatism?

Answer 4

• bias where people cling to their prior views or forecasts at the expense of acknowledging new information
• individuals are inherently slow to change

Question 5

What is Confirmation Bias?

Answer 5

cognitive bias where people observe,
overvalue, or actively seek out information
that confirms what they believe while ignoring
or devaluing information that contradicts their
beliefs

Question 6

What is Representativeness?

Answer 6

• a cognitive bias through which individuals process new information using pre existing ideas or beliefs
• an investor views a particular situation or information a certain way because of similarities to other examples even if it does not really fit into that category

Question 7

What is “Illusion of Control’?

Answer 7

a cognitive bias where people believe they
can control or influence investment outcomes
when in reality they cannot

Question 8

What is Hindsight Bias?

Answer 8

• cognitive bias where investors perceive investment outcomes as if they were predictable, even if they were not
• sometimes gives investors a false sense of security when making investment decisions leading them to excessive risk taking

Question 9

What is Mental Accounting?

Answer 9

a cognitive bias in which individuals treat various sums of money differently based on where these monies are mentally categorized (e.g., retirement, college, etc.)

Question 10

What is Anchoring?

Answer 10

• a cognitive bias where investors are influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or
  sell and investments
• individuals often rely too heavily on certain information (often the first data points received) when making decisions

Question 11

What is Framing?

Answer 11

cognitive bias where an individual responds to similar situations differently based on the context in which the choice is presented

Question 12

What is Availability?

Answer 12

a cognitive bias where easily recalled outcomes (often from more recent information) are perceived as being more likely than those that are harder to recall or understand

Question 13

What is Self-Attribution?

Answer 13

a cognitive bias where people ascribe
successes to their innate talents and blame failures on outside influences

Question 14

What is Outcome Bias?

Answer 14

a cognitive bias in which people often make decisions or take action based on the outcome of past events rather than by observing the process by which that outcome occurred

Question 15

What is Recency Bias?

Answer 15

• investors tend to believe that patterns, trends and movements in the recent past are likely to repeat themselves
• individuals put too much weight on and make decisions based on inputs and feedback they have recently received

“Recent results, indication of upcoming results”.

Question 16

What is Loss Aversion?

Answer 16

• emotional bias where an investor finds the idea of losses twice as painful as the pleasure of gains
• core tenet of Prospect Theory

Question 17

What is Overconfidence?

Answer 17

emotional bias where an investor has
unwarranted faith in his or her own thoughts
and abilities

Question 18

What is Self-Control Bias?

Answer 18

• human tendency to focus on instant
  gratification due to lack of discipline
• consequently failing to act in the best interest of long term goals

Question 19

What is Status Quo Bias?

Answer 19

an emotional bias where when faced with an array of options, an investor is predisposed to select the option that keeps conditions the same

Question 20

What is Endowment Effect?

Answer 20

• an emotional bias where an individual assigns a greater value to an object already held or owned, or an object that he may actually lose
• example: investors may assign additional value to stocks they have inherited

Question 21

What is Regret Aversion?

Answer 21

emotional bias where investors avoid taking decisive action because they are afraid that when looking back at the course they select, it will prove less than optimal

“Fear of making the wrong choice”

Question 22

What is Affinity?

Answer 22

• an emotional bias where investors make decisions based on how they believe a product or service reflects their values
• example: individuals with affinity bias are prone to purchase stocks that reflect their self image

Question 23

What is the Disposition Effect?

Answer 23

investors typically hold on to losing investments too long but sell winning investments too early.

The tendency to hold onto losing investments too long can be tied back to the so called “snake bit effect” where investors are seeking to avoid losses.

Question 24

What is the Sunk-Cost Fallacy?

Answer 24

Investors may continue to hold an investment and even invest more (e.g., double down) in large part because of the time, effort and energy they have
already invested in the idea behind the investment. Thus, they are emotionally tied to the initial choice.

The sunk-cost fallacy is often tied back to the following biases: anchoring and status quo bias.

Question 25

What is Get-Even-Itis?

Answer 25

Investors will often hold losing investments, hoping that the value will rise back up to the point at which
they purchased the asset at which time they would plan to sell. They do so in an effort to prevent realizing a loss and the negative feelings or pain associated with losses.

Question 26

What is the Snake-bit Effect?

Answer 26

This occurs when investors experience losses and then become more risk adverse, even to the extent of not wanting to invest in the same investment or even asset class, based on their painful experience in the past.

The snake bit effect is often associated with a number of biases including anchoring, recency, conservatism, and representativeness.

Question 27

What is the House Money Effect?

Answer 27

Investors often take more chances (take on more risk) once they have gained, won, or experienced profits.
It’s as though they feel that they are now playing with someone else’s money and feel more comfortable taking on additional risk.

Question 28

What are “Preservers”?

Answer 28

• passive investors who place emphasis on financial security and preserving wealth rather than taking risks to grow wealth
• preservers are often subject to endowment bias, loss aversion, status quo bias, anchoring, and mental accounting

Question 29

What are “Followers”?

Answer 29

• passive investors who don’t have their own ideas about investing so they follow the lead of friends and colleagues
• prone to follow the herd and look for the most popular investments
• followers are often subject to recency bias, hindsight bias, framing, regret, cognitive dissonance, and outcome bias

Question 30

What are “Independents”?

Answer 30

• active investors with a higher tolerance for risk than they have need for security
• tend to get involved with investment decisions and maintain some amount of control of their own investments
• likely to be more contrarian
• subject to conservatism bias, availability bias, confirmation bias, representativeness, and self-attribution

Question 31

What are Accumulators?

Answer 31

• active investors who are often entrepreneurial and the first generation to create wealth
• they can often be even more strong willed and confident than independent investors
• often have a higher tolerance for risk
• subject to overconfidence, less self control, affinity bias, and illusion of control

Question 32

Bailard, Biehl, and Kaiser Model - Adventurer?

Answer 32

–“People who are willing to put it all on one bet and go for it because they have
confidence. They are difficult to advice, because they have their own ideas about investing. They are
willing to take risks, and they are volatile clients from an investment counsel point of view.” (BB&K
Five Way Model)

Question 33

Bailard, Biehl, and Kaiser Model - Celebrity?

Answer 33

––“These people like to be where the action is. They are afraid of being left out. They really
do not have their own ideas about investments. They may have their own ideas about other things in
life, but not investing. As a result, they are the best prey for maximum broker turnover.” (BB&K Five
Way Model)

Question 34

Bailard, Biehl, and Kaiser Model - Individualist?

Answer 34

––“These people tend to go their own way and are typified by the small business person
or independent professionals such as lawyer, engineer or CAs. These are people who are trying to
make their own decisions in life, carefully going about things, having a certain degree of confidence
about them, but also being careful, methodical and analytical. These are clients whom everyone is
looking for rational investors with whom the portfolio manager can talk sense.” (BB&K Five Way
Model)

Question 35

Bailard, Biehl, and Kaiser Model - Guardian?

Answer 35

––“Typically as people get older and begin considering retirement, they approach this
personality profile. They are careful and a little bit worried about their money. They recognize that they
face a limited earning time span and have to preserve their assets. They are definitely not interested in
volatility or excitement. Guardians lack confidence in their ability to forecast the future or to understand
where to put money, so they look for guidance.” (BB&K Five Way Model)

Question 36

Bailard, Biehl, and Kaiser Model - Straight Arrow?

Answer 36

––“These people are so well balanced; they cannot be placed in any specific quadrant,
so they fall near the center. On average this group of clients is the average investor, relatively
balanced composite of each of the other four investor types, and by implication a group willing to be
exposed to medium amount of risk.” (BB&K Five Way Model)