2019 CFA level 3 qbank reading 8 the behavioral biases of individuals answers

10/11/2018 Learning Management System Question #1 of 21 Which of the following would be considered emotional biases? A) Status quo and endowment biases B) Con rmation, control, and availability biases C) Anchoring and adjustment bias Explanation in Status quo and endowment biases are emotional biases whereas the other biases fall under the category of cognitive errors en tre (Study Session 4, Module 8.1, LOS 8.b) Related Material Question #2 of 21 bo ok c SchweserNotes - Book m Which of the following statements best describes the availability bias? An investor: A) associates new information with an easily recalled past event .o B) bases a decision on how the information is presented w w C) only notices information that agrees with their perceptions or beliefs Explanation w In the availability bias individuals estimate future probabilities by how easily they recall a past event An easily recalled event is more quickly associated with ( t to) new information The problem is worsened by the fact that individuals' memories can be incomplete or biased The rmation bias is when individuals tend to notice only information that agrees with their perceptions or beliefs They look for rming evidence while discounting or even ignoring evidence that contradicts their beliefs or their perceptions In the framing bias individuals view information di erently depending on the way it is presented and received (Study Session 4, Module 8.1, LOS 8.c) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 1/14 10/11/2018 Learning Management System Question #3 of 21 Which of the following most closely de nes base rate neglect? A) Found in conservatism bias where the investor places too little weight on new information B) A type of representativeness bias in which the probability of the categorization is not adequately considered C) When the investor considers the long run average of data and how new information relates to the past data .in Explanation bo ok c en tre When the investor exhibits base rate neglect, he does not (neglects to) consider the probability that the information does not t the category into which it has been placed and places too little weight on the base rate Conservatism can also be explained in terms of Bayesian statistics where the investor forms probabilities or base rates With the receipt of new information, the rational investor updates those probabilities to re ect the new information When the analyst is subject to conservatism, however, he places too much weight on the base rates (prior probabilities) and too little on the new information (Study Session 4, Module 8.1, LOS 8.d) Related Material o m SchweserNotes - Book w w Question #4 of 21 Which of the following would be considered biases due to cognitive errors? w A) Loss aversion, self-control, and regret-aversion biases B) Representativeness, mental accounting, and overcon dence biases C) Conservatism, hindsight, and framing biases Explanation Loss aversion, self-control, regret-aversion, and overcon dence are all emotional biases The other biases would fall under the category of cognitive errors (Study Session 4, Module 8.1, LOS 8.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 2/14 10/11/2018 Learning Management System Question #5 of 21 Which of the following cognitive errors would be due to belief persistence? A) Control, rmation, and conservation biases B) Conservatism, representativeness, and hindsight biases C) Mental accounting, framing, and availability biases Explanation (Study Session 4, Module 8.1, LOS 8.b) Related Material Question #6 of 21 bo ok c SchweserNotes - Book en tre in Mental accounting, framing, and availability biases are information processing biases whereas conservatism, representativeness, and hindsight biases are belief persistence biases The conservation bias is made up m What kind of behavioral bias is an investor most likely displaying when they tend to hold on to forecast? w w A) Hindsight bias .o their earlier beliefs and fail to fully incorporate new information about a stock into their B) Conservatism bias w C) Anchoring and adjustment bias Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 3/14 10/11/2018 Learning Management System In the conservatism bias individuals unconsciously place more emphasis on the information they used to form their original forecast than on new information They have di cultly pulling away from an original forecast as they subconsciously place less value on new information In anchoring and adjustment individuals are anchored to a value, such as an expected price or other forecast, as if it has a gravitational pull Unlike the conservatism bias that has similar e ects but is based on how investors relate "new" information to "old" information, anchoring is based on a target number; once individuals have these targets in their minds, they seem to be unduly a ected by them Hindsight bias is when individuals perceive outcomes as reasonable and expected It's like saying, "This is what happened, and this is why it happened." Their explanation is biased by the fact that the outcome actually did occur; their explanation is not a prediction, so it's di cult to argue with (Study Session 4, Module 8.1, LOS 8.c) Related Material en tre in SchweserNotes - Book Question #7 of 21 bo ok c Which of the following cognitive errors would be due to information processing? A) Status quo, endowment, and regret-aversion biases B) Anchoring and adjustment bias m C) Loss aversion, overcon dence, and self-control biases .o Explanation w w Anchoring and adjustment is a cognitive information processing bias whereas all the other biases listed are emotional biases (Study Session 4, Module 8.1, LOS 8.b) w Related Material SchweserNotes - Book Question #8 of 21 Which of the following statements would most likely be classi ed as a cognitive error? The investor: A) has a tendency to place information into categories B) tends to take more risk rather than sell a stock at a loss https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 4/14 10/11/2018 Learning Management System C) acts defensively when asked why he made a poor investment decision Explanation This describes the cognitive error of "representativeness bias" where investors classify information into the most appropriate subjective category based on "if-then" heuristics The other two answer choices describe "loss aversion" and "regret aversion." (Study Session 4, Module 8.1, LOS 8.a) Related Material in SchweserNotes - Book en tre Question #9 of 21 An investor is averse to experiencing losses Which of the following behaviors will result from the loss aversion? It will lead to: B) risk-seeking behavior C) the buying of loser stocks Explanation bo ok c A) risk-aversion behavior .o m If an investor is loss averse, they may become risk-seeking in order to make up their losses quickly They would so by investing in more risky assets that have a chance of high returns that would cover the losses w w (Study Session 4, Module 8.2, LOS 8.d) Related Material w SchweserNotes - Book Question #10 of 21 Which of the following best describes myopic loss aversion and a way to address its a ect? A) The investor focuses too much on long term strategic asset allocation without considering tactical asset allocation The remedy is to periodically review and adjust h i f li i j i ih i l k i https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 5/14 10/11/2018 Learning Management System B) The investor becomes too focused on short term pro ts without keeping the long term strategic asset allocation in mind The remedy is to create an IPS that i l l d f li i h l C) Investors tend to focus too much on the short term and view investments separately instead of in a portfolio context A remedy is to perform fundamental l i Explanation h i h ld l l d ll i bo ok c (Study Session 4, Module 8.2, LOS 8.d) en tre in Myopic loss aversion combines the e ects of time horizon and framing First, investors tend to focus on the short run; thus, they are more likely to estimate risk using recent performance Next, investors tend to segment (frame) di erent investments and look at their risk characteristics separately Thus, they tend to view stocks and bonds, for instance, from a standalone perspective rather than combined in a portfolio Rather than base buy/sell decisions on fundamentals (unbiased expectations), investors focus on current gains and losses They might continue to hold a loser, for example, in hopes of at least breaking even rather than have to accept the loss They also tend to sell winners to capture the gain and avoid the potential of loss (reduce perceived risk) Selling winners, without considering what the fundamentals indicate, tends to increase portfolio turnover at the same time that it limits the growth of the portfolio To avoid loss aversion the investor should perform a thorough fundamental analysis in an attempt to base investment decisions on expectations rather than past performance Related Material m SchweserNotes - Book w w o Question #11 of 21 Tom Roberts loves to read about stocks He subscribes to the Los Angeles Times, the New York Times, and Smart Money Magazine He respects the various publications but places more w emphasis on Smart Money magazine because it specializes in investment issues What behavioral characteristic does Roberts have as the basis for his decision making? A) Framing B) Representativeness C) Anchoring Explanation Roberts uses framing as the basis for his decision making He places more weight on the nancial publication just because it specializes in investments without evaluating the investment advice on its own merits (Study Session 4, Module 8.1, LOS 8.b) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 6/14 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #12 of 21 Bu alo Manufacturing has just announced earnings that are 3% higher than analysts' forecasts Panda Technologies has just announced earnings that are 4% less than analysts' forecasts According to the representative heuristic description of investor behavior, what is the most in likely future performance of each stock as they revert to their intrinsic values? A) Bu alo Manufacturing stock will underperform in the future while Panda en tre Technologies stock will outperform in the future B) Both Bu alo Manufacturing stock and Panda Technologies stock will outperform in the future C) Bu alo Manufacturing stock will outperform in the future while Panda Technologies bo ok c stock will underperform in the future Explanation w w o m Bu alo Manufacturing stock will underperform in the future because investors will think that the good earnings announcement "represents" good future performance for the stock and bid the price too high The Bu alo Manufacturing stock will become overpriced and its future performance will be weak as a result Similarly, investors will think that the bad Panda Technologies earnings announcement "represents" poor future performance for the stock and force the price too low As a result, Panda Technologies stock will become underpriced and its future performance will be strong (Study Session 4, Module 8.1, LOS 8.b) w Related Material SchweserNotes - Book Question #13 of 21 Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them She believes that if she just holds on to them a little longer they will recover, at which time she will sell them What behavioral characteristic does Davis have as the basis for her decision making? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 7/14 10/11/2018 Learning Management System A) Conservatism B) Representativeness C) Loss aversion Explanation Davis uses loss aversion as the basis for her decision making She holds on to stocks that are down from the purchase price in the hopes that they will recover She is reluctant to accept a loss (Study Session 4, Module 8.2, LOS 8.d) Related Material en tre in SchweserNotes - Book Question #14 of 21 bo ok c Some proponents of behavioral nance believe that investors structure their portfolios as pyramids Which of the following best represents the resulting structure of their portfolios? A) Several pyramids of di erent sizes will be formed, each representing a di erent funding requirement m B) The bottom layer of an investor’s pyramid will be invested in stock with higher o layers invested in bonds and cash C) The bottom layer of an investor’s pyramid will be invested in bonds and cash with w w higher layers invested in stock Explanation w Investors will structure their portfolios as pyramids, with the bottom layer invested in less risky assets to fund necessities Once necessities are funded, higher levels of the pyramid are dedicated towards riskier investments (Study Session 4, Module 8.1, LOS 8.d) Related Material SchweserNotes - Book Question #15 of 21 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 8/14 10/11/2018 Learning Management System Which of the following is the best course of action an investor can take to reduce the overcon dence bias? A) Seek the opinions of others to nd contrary viewpoints allowing for further scrutiny of predictions B) Increase the dence interval of forecasts since overcon dence tends to lead to dence intervals that are too narrow C) Keep detailed records of trades developing a track record of performance relative to strategy determining when strategy led to success as compared to luck Explanation bo ok c en tre in In the overcon dence bias investors tend to hold under-diversi ed portfolios because they underestimate the downside while overestimating the upside They may also trade excessively, leading to high costs and underperformance Because they are prone to remembering only their better investments, investors should keep detailed records of trades, including the motivation for each trade By doing so, the investor develops a track record of investment performance relative to strategy Both successes and losses should be analyzed relative to the strategy used to generate them to determine when strategy produced the results and when luck (market forces) produced the results Overcon dence does lead to too narrow of a dence interval for predicted forecasts but simply increasing the dence interval is not as e ective at reducing overcon dence as keeping detailed records of trades and reviewing those records Seeking the opinions of others to nd contrary viewpoints allowing for further scrutiny of predictions is something the CFA curriculum suggests analysts to reduce overcon dence in their forecasts m (Study Session 4, Module 8.1, LOS 8.d) o Related Material w w w SchweserNotes - Book Question #16 of 21 Assuming a stock will perform well in the future because the company just released a good earnings report usually results in: A) the stock becoming overpriced and underperforming B) the stock becoming a “winner” and outperforming C) no change in value since in an e cient market the intrinsic value of the stock is already re ected in its price Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 9/14 10/11/2018 Learning Management System Representativeness can lead investors to make incorrect projections based upon stereotypes Since investors' perceptions are based upon current or historical information rather than unbiased expectations, stocks can be temporarily mispriced An example is assuming a stock will perform well in the future because the rm just unexpectedly announced good earnings over the last period Assuming the good announcement implies good future performance (a winner), investors buy the stock and push its price up Likewise, a bad earnings announcement (a loser) may be met with selling pressure, which drives the price down The result is that overpriced "winners" will tend to underperform and underpriced "losers" will tend to outperform, as their prices return to their intrinsic values (Study Session 4, Module 8.1, LOS 8.b) Related Material en tre in SchweserNotes - Book Question #17 of 21 Tommy Shaver is saving for his retirement Shaver invests as behavioral nance would predict bo ok c According to behavioral nance, which of the following best represents how Shaver will fund this objective? A) Shaver will use a pyramid approach and fund it with safe investments at the bottom of the pyramid m B) Shaver will use a pyramid approach and fund it with safe investments at the top of o the pyramid C) Shaver will use a modern portfolio approach and diversify across global stocks, w w bonds, and alternative assets Explanation w If Shaver invests as behavioral nance would predict, he will use a pyramid approach and fund it with safe investments at the bottom of the pyramid (Study Session 4, Module 8.1, LOS 8.d) Related Material SchweserNotes - Book Question #18 of 21 Which of the following statements best describes cognitive errors and emotional bias? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 10/14 10/11/2018 Learning Management System A) A cognitive error is the result of the inability to analyze all the information or from a lack of information whereas an emotional bias is caused by individuals' feelings, i l i ii B) A cognitive error is an error in faulty reasoning whereas an emotional bias is based on feelings C) A cognitive error is the result of having inadequate information whereas an emotional bias is having a decision be unduly in uenced by feelings Explanation Related Material SchweserNotes - Book o m Question #19 of 21 bo ok c (Study Session 4, Module 8.1, LOS 8.a) en tre in Cognitive errors are the result of mechanical or physical limitations; they result from the inability to analyze all available information or from basing decisions on incomplete information Emotional biases are caused by individuals' psychological predispositions and can a ect how individuals see information and make decisions Think of an emotional bias as decisions based on individuals' feelings, impulses or intuition rather than the mechanical or physical process used to analyze and interpret it Emotional biases are not deliberate but can result in spontaneous reactions Although all the answer choices are technically correct the correct answer choice has the best overall explanation Which of the following does NOT re ect the most likely asset allocation as a result of w w incorporating behavioral biases into the portfolio construction process? A) Create a portfolio that accommodates the investor’s behavioral risk and return w preferences B) Create a portfolio in which all of the investor’s assets are viewed together taking the correlation between those assets into consideration assigning a single measure of i k h f li C) Arrange the assets that relate to the investor’s speci c goals in layers resembling a pyramid with the most conservative assets in the bottom layer and the most risky Explanation h https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 11/14 10/11/2018 Learning Management System The correct answer choice re ects portfolio construction based on traditional nance theory which assumes investors make rational decisions and are not in uenced by behavioral biases .in In attempting to either mitigate or accommodate behavior biases goals-based investing recognizes that individuals are subject to loss aversion and mental accounting Applying goals-based investing, the investor builds a portfolio in layers, one layer at a time Each layer of the portfolio consists of assets used to meet individual goals or subsets of goals Looking at the portfolio as if it were a pyramid, the bottom layer of the pyramid is constructed rst and is comprised of assets designated to meet the investor's most important goals Once this foundation layer is constructed, the investor moves to the next layer Each successive layer as you move up the pyramid consists of increasingly risky assets used to meet less and less import goals Structuring the portfolio in this manner provides the investor with the ability to see risk more clearly Although from an e cient frontier perspective the portfolio probably won't end up e cient, it will tend to be fairly well diversi ed (Study Session 4, Module 8.2, LOS 8.d) bo ok c Related Material en tre Behaviorally modifying a portfolio simply means constructing it according to the investor's behavioral risk and return preferences The strategy portfolio is probably not e cient from a modern portfolio theory perspective, but the investor is comfortable with it and will, thus, be more likely to adhere to the strategy The construction of the modi ed portfolio considers the investor's emotional and cognitive behavioral biases and current wealth m SchweserNotes - Book o Question #20 of 21 w w Dan Chechele is getting nervous that the market has experienced several consecutive days of losses and is getting uncomfortable having experienced many market downturns throughout his lifetime Based on his past experience he is subconsciously putting the recent market w activity into the category of a market trend Which of the following biases is Chechele exhibiting? A) Loss aversion bias B) Representativeness bias C) Con rmation bias Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 12/14 10/11/2018 Learning Management System in In the representativeness bias individuals classify information into subjective categories using heuristics; they place new information into the most appropriate category based on personal experiences Think of representativeness as an if-then or stereotype heuristic Investors feel that "if" information looks a certain way, "then" it ts into a certain category The if-then heuristic is based on past experiences and on relationships the investor has witnessed, such as a past market trend In that case, recent upward or downward movements in the market are classi ed as market trends with implications for performance of the market and individual stocks The rmation bias is when individuals tend to notice only information that agrees with their perceptions or beliefs They look for rming evidence while discounting or even ignoring evidence that contradicts their beliefs or their perceptions The loss aversion bias is when individuals focus on potential gains and losses relative to risk rather than returns relative to risk They place more "value" on losses; the reduction in utility caused by a loss is greater than the increase in utility provided by a gain of the same magnitude Thus, when considering a risky investment, investors exhibit loss aversion rather than risk aversion, as assumed in portfolio theory en tre (Study Session 4, Module 8.1, LOS 8.c) Related Material Question #21 of 21 bo ok c SchweserNotes - Book Which of the following statements resembles the behavioral trait of conservatism bias most m accurately? o A) Rather than sell at a small gain, the investor waits for the stock to reach his forecasted target price w w B) The investor tends to avoid or ignore information that is contrary to his beliefs C) The investor places an incorrect value on information because it readily ts into a w category with which he has recent experience Explanation Conservatism is not updating an initial view that was rationally determined It is very closely tied to rmation which seeks out only rming information and ignores information that contradicts the initial view So ignoring information contrary to initial beliefs can be labeled conservatism Trying to reach a set price target is reference dependence Focusing on recent experience has elements of both representativeness (a cognitive error) and availability (an emotional bias) (Study Session 4, Module 8.1, LOS 8.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 13/14 Learning Management System w w w o m bo ok c en tre in 10/11/2018 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415755/print 14/14 ... https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 0 38 5 18/ quiz/ 83 4 15755/print 10/14 10/11/20 18 Learning Management System A) A cognitive error is the result of the inability to analyze all the information or from a lack of. .. https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 0 38 5 18/ quiz/ 83 4 15755/print 2/14 10/11/20 18 Learning Management System Question #5 of 21 Which of the following cognitive errors would... Module 8. 1, LOS 8. d) Related Material SchweserNotes - Book Question #15 of 21 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 0 38 5 18/ quiz/ 83 4 15755/print