2019 CFA level 3 qbank reading 7 the behavioral finance perspective answers

10/11/2018 Learning Management System Question #1 of 18 Which of the following actions is most likely the result of applying Bayes' theorem of conditional probability? A fundamental analyst revises a stock recommendation when: A) the rm experiences a major re that destroys its production line B) the rm issues a revised earnings report C) she revises her in ation expectations .in Explanation bo ok c (Study Session 4, Module 7.1, LOS 7.a) en tre A fundamental analyst bases recommendations on rm or market fundamentals such as expected earnings The re would signal an unexpected change in the rm's fundamentals as would a revised earnings announcement Revising a recommendation based on the probability of a given level of in ation is an example of applying a Bayesian framework to an expectation That is, the rm's performance is based conditionally on the probability of a given level of in ation Related Material m SchweserNotes - Book o Question #2 of 18 w w What is the purpose of using Baye's formula in the investment decision making process? A) Incorporate new information into previous forecasts updating those forecasts w which aids in the investment decision making process B) Assign probabilities to various outcomes helping the investor gain insight into the range of those possible outcomes C) Incorporate some quantitative aspects into the portfolio construction process Explanation Baye's formula measures the probability of an event occurring given the probability of some other event occurring It is used in the forecasting process, for example new information about a stock would be incorporated into a revised forecast aiding in determining whether or not to buy or sell the stock Using Baye's formula should result in more accurate forecasts (Study Session 4, Module 7.1, LOS 7.a) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 1/10 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #3 of 18 When an investor considers wealth fungible: A) he may create and hold a single portfolio to meet lifetime consumption designated to meet a speci c goal en tre C) he will put investments into separate mental accounts .in B) he will create a layered portfolio with each layer consisting of di erent assets Explanation bo ok c Fungible means that wealth is interchangeable By assuming individuals create a single portfolio to meet their lifetime obligations, for example, individuals must assume wealth is fungible The same wealth can be used to meet any needs By thinking of wealth in terms of separate mental accounts, the individual implicitly assumes it is not fungible; speci c wealth is dedicated to speci c goals This is also the concept behind layered portfolios (Study Session 4, Module 7.3, LOS 7.d) Related Material w w o m SchweserNotes - Book Question #4 of 18 w According to prospect theory, investors are generally more concerned with: A) fear of regret, which suggests that the prospect for outperforming a benchmark is the primary concern for these investors B) avoiding losses, which suggests that risk of loss may be the best measure of risk C) diminishing marginal utility, which suggests that expected return is more important than risk to these investors Explanation Behavioral investors are generally more concerned with avoiding losses, which implies that risk of loss may be the best measure of risk (Study Session 4, Module 7.2, LOS 7.b) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 2/10 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #5 of 18 Which of the following statements best de nes satis ce? A) The investor gathers adequate information to make the utility maximizing choice B) Making a decision in which you are satis ed .in C) Investors make a satisfactory choice based on the information gathered en tre Explanation bo ok c Satis ce means the investor gathers what they consider to be an adequate amount of information and apply heuristics to analyze the information into an acceptable decision which is not necessarily the optimal decision from a traditional nance perspective The traditional nance perspective would instead gather and meticulously analyze all relevant information to make the utility maximizing choice (Study Session 4, Module 7.2, LOS 7.c) Related Material o m SchweserNotes - Book w w Question #6 of 18 Which of the following statements most correctly describes the shift in focus when moving w from a traditional nance to a behavioral nance investment process, and what is the most pronounced result of this shift? A) The de nition of investor motives shifts to a focus on emotions, and the most pronounced result is that the de nition of risk changes from dispersion-based h b bili h h d bj i ill b li d B) The de nition of investor motives shifts to a focus on emotions, and the most pronounced result is the development of measures to quantify how emotions h ll i C) The goal de nition shifts from statistical measures of risk and return to lifestylebased objectives, and the most pronounced result is that the de nition of risk Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 3/10 10/11/2018 Learning Management System The primary shift is from the traditional performance concepts of expected return and dispersion-based measures of risk, to de ning performance in terms of the realization of lifestyle-based objectives The most pronounced result is that new measures of risk are required, and the new risk measures are concerned with whether or not the stated objectives are realized (Study Session 4, Module 7.1, LOS 7.a) Related Material SchweserNotes - Book in Question #7 of 18 en tre Which of the following statements best describes bounded rationality? A) Individuals make rational decisions within the nes of knowing they don’t have all the information or the ability to fully interpret it bo ok c B) Individuals act rationally within de ned limits C) Individuals recognize they not have all the information necessary to make a rational decision Explanation m Bounded rationality means individuals act as rationally as possible realizing they not have all the available information or the cognitive ability to fully interpret the information w w Related Material o (Study Session 4, Module 7.2, LOS 7.c) w SchweserNotes - Book Question #8 of 18 Martina Blackwood has not been doing well with her investments She consults Ben Haifen, CFA, for some advice Which of Haifen's following statements indicates that Blackwood is using heuristics? A) Blackwood's most valuable lessons were learned through her own mistakes B) Blackwood doesn't like xed-income investments because she doesn't understand them https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 4/10 10/11/2018 Learning Management System C) Blackwood tends to hold onto her losers too long Explanation Blackwood developed her investment style through trial and error, learning from her own mistakes called heuristics The other statements could be true of many types of investors who are not bound by heuristic-driven bias (Study Session 4, Module 7.2, LOS 7.c) Related Material in SchweserNotes - Book en tre Question #9 of 18 Basing trading decisions on available public information, Carla Maplewood, CFA, is consistently able to identify and pro t on mispriced securities Based on her successful trading strategy, we A) weak-form e cient B) semi-strong form e cient C) strong-form e cient m Explanation bo ok c would most likely conclude that the market is at best: w w o In a semi-strong form e cient market, where prices incorporate all available public information, investors should not be able to consistently generate excess returns by using public information alone If the market is not semi-strong form e cient, it cannot be strongform e cient At best, the market could be considered weakly e cient (Study Session 4, Module 7.3, LOS 7.d) w Related Material SchweserNotes - Book Question #10 of 18 The tendency for individuals to identify outcomes as gains or losses in the editing phase of decision making would most likely be an example of: A) simpli cation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 5/10 10/11/2018 Learning Management System B) combination C) codi cation Explanation Classifying outcomes as gains or losses is an example of codi cation, during which investors code outcomes and place probabilities on their occurrence Investors combine outcomes with identical values to gain clarity among choices Investors also simplify by rounding For example, very similar probabilities might be made equal (Study Session 4, Module 7.2, LOS 7.b) Related Material en tre in SchweserNotes - Book Question #11 of 18 bo ok c The isolation e ect seen in the editing phase of prospect theory is thought to be the result of: A) combination B) cancellation C) dominance m Explanation w w w o Prospect theory proposes that investors make decisions in two phases: editing and evaluation In the editing phase, investors clarify choices using some combination of six possible steps: codi cation, combination, segregation, cancellation, simpli cation, and detection of dominance In the cancellation step, investors eliminate (ignore) possible outcomes common to choices, so they might focus on low-probability, large outcomes By focusing on the large, low-probability outcomes, they exhibit isolation (i.e., they isolate and make decisions based on certain outcomes) (Study Session 4, Module 7.2, LOS 7.b) Related Material SchweserNotes - Book Question #12 of 18 The inability of technical trading rules to consistently provide excess returns is most likely used as proof that a market is at least: https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 6/10 10/11/2018 Learning Management System A) semi-strong form e cient B) weak-form e cient C) strong-form e cient Explanation In a weakly e cient market, prices incorporate all past price and volume information, so technical trading rules will fail to consistently produce excess returns Although by de nition a market that is semi-strong form or strong-form e cient will also be weak-form e cient, we cannot say that the inability to generate excess returns using technical data would in itself indicate semi- or strong-form e ciency (Study Session 4, Module 7.3, LOS 7.d) in Related Material en tre SchweserNotes - Book bo ok c Question #13 of 18 Which of the following steps is least likely to be included in the process of developing heuristicdriven bias? A) Receiving bad advice w w Explanation o C) Making mistakes m B) Reliance on rules of thumb for investment decisions w The process of developing heuristic-driven bias starts with developing investment principals through experience, followed by reliance on heuristics (rules of thumb) to make decisions At this point, imperfect heuristics start to sway investment decisions, and investors make errors Bad advice can contribute to all of these steps, but it is not a part of the development of heuristic-driven bias (Study Session 4, Module 7.2, LOS 7.c) Related Material SchweserNotes - Book Question #14 of 18 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 7/10 10/11/2018 Learning Management System An individual is presented with a number of choices, with only two outcomes each: one positive and one negative If the individual's selection is a ected by whether only the positive or negative outcome of each choice is stated, the individual is most likely subject to the behavioral characteristic known as: A) self-control bias B) framing C) mental accounting Explanation bo ok c (Study Session 4, Module 7.3, LOS 7.d) en tre in Framing refers to the way information is presented or perceived and can a ect the way individuals view choices Due to loss aversion, an investor's selections will be a ected by whether the outcome is stated in terms of the possible loss or in terms of the possible gain Self-control bias refers to the individual's inability to resist the expected utility of current consumption Consuming now and not saving for the future can lead to suboptimal lifetime consumption Mental accounting refers to the individual's tendency to place goals into mental les with a portion of wealth dedicated to each goal In this way, it leads to layered portfolios Related Material m SchweserNotes - Book o Question #15 of 18 w w Which of the following statements best exempli es the di erence between behavioral and traditional nance? Traditional nance: w A) does not take into consideration the behavioral aspects of investing which if considered would lead to better portfolio construction B) assumes investors make rational decisions whereas behavioral nance attempts to explain why investors act the way they C) views portfolio construction from an historical perspective whereas behavioral nance incorporates modern up-to-date techniques in the portfolio construction Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 8/10 10/11/2018 Learning Management System Traditional nance assumes investors exhibit risk aversion and make unbiased, utilitymaximizing rational decisions Behavioral nance assumes investors employ some combination of traditional nance and psychological biases when making investment decisions and attempts to explain why investors make the decisions they (Study Session 4, Module 7.1, LOS 7.a) Related Material SchweserNotes - Book in Question #16 of 18 en tre To satis ce means the investor: A) takes steps to achieve intermediate goals that help them get closer to the desired goal B) achieves intermediate goals that lead to the utility maximizing choice bo ok c C) gathers all the relevant information available to them and using heuristics they make the optimally maximizing decision Explanation o m To satis ce is the process of gathering and utilizing information that helps the investor take intermediate steps towards their goals They not gather and analyze all the information available to them but instead use heuristics, trial and error learned behavior, and the information they have gathered to make a decision they are satis ed with which is most likely not the optimally maximizing portfolio w w (Study Session 4, Module 7.2, LOS 7.c) Related Material w SchweserNotes - Book Question #17 of 18 Assume there are two investments to choose from: investment A has an expected return of 10% and a standard deviation of 15%, and investment B also has an expected return of 10% but its standard deviation is 20% The risk neutral investor would: A) not choose investment B because it has a higher level of risk with no additional compensation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 9/10 10/11/2018 Learning Management System B) choose either investment A or B since they are not concerned about the level of risk but only with the level of return C) choose investment A because it has a higher return for a given level of risk Explanation Given two alternatives with the same expected return but di erent levels of risk (i.e., di erent standard deviations), the risk-neutral investor would be indi erent between the two alternatives, the risk-averse investor will select the alternative with less risk, and a riskseeking investor would actually prefer (derive more utility from) the riskier alternative (Study Session 4, Module 7.2, LOS 7.b) Related Material en tre in SchweserNotes - Book Question #18 of 18 bo ok c Which of the following is least likely a heuristic learning process? A) Research B) Trial and error m C) Experimentation .o Explanation w w Trial and error, and experimentation are heuristic learning processes Heuristic learners pick up information simply, through their own e orts or from sources simple to access They don't research w (Study Session 4, Module 7.2, LOS 7.c) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415687/print 10/10 ... https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 156 87/ print 9/10 10/11/2018 Learning Management System B) choose either investment A or B since they are not concerned about the level. .. https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 156 87/ print 3/ 10 10/11/2018 Learning Management System The primary shift is from the traditional performance concepts... goals They not gather and analyze all the information available to them but instead use heuristics, trial and error learned behavior, and the information they have gathered to make a decision they