Reading The Behavioral Biases of Individuals FinQuiz.com FinQuiz.com CFA Level III Item-set - Question Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz.com FinQuiz Item-set ID: 16910 Questions (16911) through 6(16916) Roseanna Bright Case Scenario Roseanna Bright recently established an asset management firm by the name of Bright Investments (BIN), a firm that specializes in both stock and bond markets Bright worked as a financial advisor for fifteen years at numerous investment management firms before establishing her own firm Since BIN is relatively young, it offers only a few products to its clients and has a total of nine senior portfolio managers One of the products offered by BIN is the “Growth Fund” and Quinn Walter is in charge of the fund’s management According to Walter, to qualify for inclusion in the fund, a company needs to have a five-year cumulative forecasted growth rate of more than 10%, R&D expenditure that increases by 2% or more every year, a high P/E ratio, and should belong to a growth industry Any company not meeting these criteria is not eligible for further analysis Recently, Bright recommended a stock to Walter for the Growth Fund, which he believes (based on an analysis of fundamentals), has a high probability of achieving an above-normal growth rate in the future Walter stated that since the stock does not belong to a growth industry, it cannot serve as an attractive investment for the fund Walter recently purchased a stock for the fund after considerable analysis of the company’s fundamentals and expected future growth rate However, a few months back, the company announced that its future growth rate might be 7%-8% lower than expected because of the interaction of certain industry factors and company fundamentals When discussing these changed circumstances with Bright, Walter made the following comment: “I don’t think that the value that will be derived from interpreting this new information with be worth the cost and efforts involved in processing the information and making a decision accordingly.” Walter continued his day with an assessment of two of his clients’ portfolios; one of Jeremy Jack, and the other of Ellen Cross Walter discovered that over the past few years, Jack’s portfolio has been inadequately diversified leading to an excessive exposure to risk Walter decided to hold a meeting with Jack to discuss the consequences of such an under-diversified portfolio Walter also examined Cross’s portfolio’s returns over the past three years He discovered that the portfolio’s returns were considerably lower than a broad-market based index return measured over the same period Upon further assessment, Walter ascertained that the cause of such an inferior performance was excessive trading and a high turnover FinQuiz.com © 2018 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz.com After the analysis, Walter met with Bright to talk about behavioral biases He made the following comments: Statement 1: “Individuals subject to the conservatism bias tend to overweight the base rates, and those subject to the representativeness bias tend to underweight the base rates.” Statement 2: “A useful step in correcting for the confirmation bias is to get corroborating support for an investment decision.” Bright is assessing the performance of equity mutual funds over the past seven years Bright determined that investors tend to buy into a fund immediately following rapid price appreciation Also, these periods tend to precede a subsequent decline in the fund’s performance Bright is analyzing the reasons for such investor behavior FinQuiz Question ID: 16911 With regard to his response to Bright’s recommendation for the Growth fund, Walter is most likely subject to the: A conservatism bias B confirmation bias C representativeness bias FinQuiz Question ID: 16912 With regard to the recent stock inclusion to the growth fund, Walter is most likely subject to the: A confirmation bias B conservatism bias C representativeness bias FinQuiz Question ID: 16913 Jack is least likely subject to the: A confirmation bias B illusion of control bias C representativeness bias FinQuiz Question ID: 16914 Cross is least likely subject to the: A confirmation bias B illusion of control bias C representativeness bias FinQuiz.com © 2018 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz.com FinQuiz Question ID: 16915 Walter is most accurate with respect to: A Statement only B Statement only C Both statements and FinQuiz Question ID: 16916 The performance of equity mutual funds most likely indicates that investors are subject to the: A conservatism bias B confirmation bias C representativeness bias FinQuiz.com © 2018 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz.com FinQuiz Item-set ID: 17018 Questions (17019) through 6(17024) Neil Brown Case Scenario Neil Brown works as a portfolio manager at Money-Wise Investment Management (MWIM), an asset management firm established in Florida, USA Brown works with a team of research analysts and financial advisors to determine appropriate asset allocations for the firm’s clients About a year ago, Brown invested in the stock of Agricultural Group of Industries (Agri-Group) at a time when its price was $67/share When determining the investment’s current value, Brown found out that the share price had risen significantly resulting in a holding period return of 18% When Stacey Turner, one of Brown’s colleagues, found out about the remarkable performance, she requested Brown to give her some details about the stock’s characteristics She then used that information to select stocks for her own portfolio Brown had also invested in a technology stock about the same time he invested in the stock of Agri-Group Based on analysis of the company’s industry, competition, and fundamentals, Brown had set a target price of $88/share for the stock Just recently, Brown’s broker called to inform him that the share price had risen to $90/share, and asked if he should sell the stock Thinking that the share price had already exceeded the target he set, and that chances of the price rising even more were high, Brown decided to wait further before selling the stock Turner is responsible for the management of a private wealth fund worth seven million dollars The fund came under the management of Turner around six months ago, at which time she performed a thorough analysis of the portfolio’s composition and the client’s objectives and constraints Turner found out that the portfolio had experienced little or no turnover over the past seven years, and the frequency of trading was very low This was true even though the return and risk objectives of the client altered significantly over the same period When Turner brought this to the attention of the client, he asked her to identify only those investments in his portfolio that had gained and to sell them immediately After her meeting with the client, Turner met Brown to discuss the effects of behavioral biases on optimal portfolio construction She posed the following question: “What kind of behavioral biases lead individuals to engage in the tendency of ascribing their successes to personal skills and failures to exogenous factors, and to engage in herding behavior?” Brown then stated comments made by two of his clients: Client A: “When deciding which mutual fund to invest in, I usually make my decision based on name recognition or word-of-mouth.” FinQuiz.com © 2018 - All rights reserved Reading Client B: The Behavioral Biases of Individuals FinQuiz.com “When any of my investments drops in value and I am unsure if it will come back, I usually wait for the share price to rise at least to my purchase price before I sell the stock.” Brown just decided to invest $15,000 in one of the following two companies: White Inc and Black Inc White Inc is a large, well-established firm that has been in business since the past ten years Most of the firm’s shareholders are institutional investors Black Inc., on the other hand, is a newly established firm, and although it has managed to generate high profits in the past two years, it still has a long way to go before acquiring the public profile that White Inc has achieved Brown performed a few calculations using information about each company’s fundamentals and was surprised to find that, according to his calculations, the two firms had equal risk and return payoffs Brown decided to invest in White Inc because it was backed by large institutional investors FinQuiz Question ID: 17019 With respect to the Agri-Group investment, Turner is most likely subject to: A overconfidence bias B confirmation bias C representativeness bias FinQuiz Question ID: 17020 With respect to the technology stock, Brown is most likely subject to: A loss-aversion bias B regret-aversion bias C representativeness bias FinQuiz Question ID: 17021 The client that owns the $7 million fund that Turner is responsible for managing is most likely subject to: A status quo and loss-aversion bias B regret-aversion and loss-aversion bias C endowment and regret-aversion bias FinQuiz Question ID: 17022 10 The most appropriate response to Turner’s questions is that the biases are: A hindsight and loss-aversion B overconfidence and regret-aversion C regret-aversion and illusion of control FinQuiz.com © 2018 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz.com FinQuiz Question ID: 17023 11 Assuming that both Clients A and B have a high level of wealth and low standard of living risk, for whom should the appropriate approach to asset allocation include adapting to the bias? A Client A only B Client B only C Both Clients A and B FinQuiz Question ID: 17024 12 With respect to his investment in White Inc., Brown is most likely subject to: A hindsight bias B confirmation bias C regret-aversion bias FinQuiz.com © 2018 - All rights reserved .. .Reading The Behavioral Biases of Individuals FinQuiz. com FinQuiz Item- set ID: 169 10 Questions ( 169 11) through 6( 169 16) Roseanna Bright Case Scenario Roseanna... representativeness bias FinQuiz. com © 20 18 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz. com FinQuiz Item- set ID: 17018 Questions (17019) through 6( 17 024 ) Neil Brown Case Scenario... control FinQuiz. com © 20 18 - All rights reserved Reading The Behavioral Biases of Individuals FinQuiz. com FinQuiz Question ID: 170 23 11 Assuming that both Clients A and B have a high level of