CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 02 behavioral finance answers

BEHAVIORAL FINANCE ANSWERS Question Statement When he first started investing, he thought his MBA gave him the expert knowledge needed to be a proficient investor Historically, X-wire has performed well and this led Clark to believe it would continue to so in the future After buying the Xwire stock it continued to well for a short period of time and then decreased in price below Clark’s original purchase price Clark is reluctant to sell it in hopes of at least breaking even in the near future State the most likely behavioral bias being exhibited Explain one consequence of the behavior from a portfolio perspective  Overconfidence bias Representativeness bias Loss aversion bias   Trade too frequently leading to higher transactions costs and lower returns Under-diversified portfolios Under estimate risk and overestimate return    Hold on to or buy recent winners Sell or avoid recent losers Excessive turnover Candidate discussion: Investors base decisions on the recent past rather than unbiased expectations of future performance, placing too much emphasis on new information received and too small of a data set  Hold onto losing stocks in hopes of breaking even  Sell winners too soon to capture gains  Trade too frequently leading to higher transactions costs and lower returns  Incur too much risk holding onto assets that have lost value Candidate discussion: Fear of regret or regret is a hindsight bias where the investor feels an opportunity has passed them by thinking they should have bought or sold a particular investment Myopic loss aversion is overemphasizing short-term potential losses and underemphasizing long-term return, resulting in a risk premium on stocks that is too high given long-term characteristics and under-weighting stocks Sample Scoring Key: point for each behavioral trait points for any one consequence from a portfolio perspective Question Part A Status quo bias is when the investor leaves their asset allocation the same over time without regard to changing circumstances such as age, wealth, and risk tolerance 1/n naïve diversification is investing equally amount various investment options within a defined contribution plan Sample Scoring Key: point each for correctly identifying the behavioral trait point each for describing each trait Part B An advantage of pyramiding is (1) it’s easier for the investor to understand and (2) more likely they will maintain the asset allocation, leading to their goals A disadvantage of pyramiding is the correlation of assets is ignored, leading to a less-thanoptimal asset allocation from a traditional finance perspective Sample Scoring Key: points each for one advantage and one disadvantage of pyramiding Question A    Statement 1: Traditional finance is normative (or proscriptive) and explains how investors should invest (Or: Behavioral finance is descriptive in explaining how investors actually invest.) Statement 2: Behavioral finance assumes investors are limited in their cognitive ability (Or: Traditional finance assumes no limits to decision-making ability.) Statement 2: Behavioral finance does not assume investors are always risk seekers, only that, at some times or under some conditions, they could be Sample Scoring Key: Any two of the three items identified and restated can be used One point for each identification and each restatement B  Utility theory assumes that satisfaction (utility) depends on level of wealth, while loss aversion assumes it depends on perceived gain versus loss   Utility theory assumes investors are always risk averse, while loss aversion assumes risk aversion for gains and risk seeking for loses Utility theory focuses on total portfolio value, while loss aversion focuses on each position and increase or decrease in value (i.e., increasing or decreasing gain or loss) Sample Scoring Key: Any two of the three items can be used for points each C    Markets can be inefficient and exhibit technical momentum effects, where a period of increasing stock price leads to further increases and, eventually, highly overvalued (bubble) conditions Investors can exhibit herding, where all investors take the same action (buying), which increases stock prices and leads to overvalued markets Investors may fear regret if they not buy whatever is increasing in price, engage in trend chasing and buy whatever is going up in price, or assume available positive information on securities is representative of everything relative to their valuation; in the process, investors push prices to unreasonably overvalued levels Sample Scoring Key: One point for any one item discussed and two points for a discussion of how it leads to highly overvalued conditions Potentially, there are other acceptable answers to such an open-ended question If you review the CFA text and use an item directly discussed in the CFA text as tied to a market bubble, it should be accepted However, it is not acceptable to pick an item not directly discussed in this context and apply your own “inherent” logic of why you think it should be acceptable In other words, you must answer based directly on the most relevant taught material D Each member brings their own individual biases, and in a poorly run group setting, the group setting itself creates new issues as individuals feel inhibited in speaking freely or talk too much The chairman can:  Establish an environment where members feel safe to voice their views  Encourage all members to speak up and voice dissenting opinions  Establish and stick to a relevant agenda  Require clear decisions be made and document those decisions  Require members to treat each other with professional respect Sample Scoring Key: Two points for making it clear the group setting itself can be the problem as social proof, peer pressure, and herding behavior inhibit free discussion One point each for any two of the actions the chairman can take Candidate discussion: Recruiting diverse and qualified members is also an appropriate chairperson action but will receive no credit in this question Reread the case facts; it is not an issue for this committee ... (Or: Behavioral finance is descriptive in explaining how investors actually invest.) Statement 2: Behavioral finance assumes investors are limited in their cognitive ability (Or: Traditional finance. .. allocation from a traditional finance perspective Sample Scoring Key: points each for one advantage and one disadvantage of pyramiding Question A    Statement 1: Traditional finance is normative (or... there are other acceptable answers to such an open-ended question If you review the CFA text and use an item directly discussed in the CFA text as tied to a market bubble, it should be accepted