2019 CFA level 3 qbank reading 9 behavioral finance and investment processes answers

10/11/2018 Learning Management System Question #1 of 54 Which of the following is NOT a reason for excessive trading taking place in discount brokerage accounts as compared to company retirement plans? A) Framing bias B) The availability of investment options in one account as compared to the other C) Individuals self-selecting into one account versus the other .in Explanation bo ok c en tre Framing bias is seen in company retirement plans and can take two di erent forms: 1) when given the choice among di erent funds to invest in the investor allocates their investments evenly among the di erent funds which is also called 1/n naïve diversi cation and, 2) when a company match is in the form of company stock the employee frames this as implicit advice and subsequently allocates a higher proportion of their own contributions to the company's stock Excessive trading is seen in discount brokerage accounts as compared to company retirement plans Availability of more investment options in a discount brokerage account is thought to lend itself to more excessive trading along with trading oriented individuals selfselecting into the discount brokerage account (Study Session 4, Module 9.2, LOS 9.c) Related Material o m SchweserNotes - Book w w Question #2 of 54 w Jean Stall, CFA, has just completed the yearly review for one of her clients Je Schaller During the review she went over the original questionnaire he lled out to make sure the current portfolio has not drifted too far from the original asset allocation as determined by the questionnaire The questionnaire was well designed to quantitatively determine Schaller's level of risk aversion One of Schaller's statements in the questionnaire was that he was comfortable investing in stocks but did not want to lose any money in the stock market As a result Stall took a portion of his non-retirement money and put it in an indexed annuity which is a long term investment guaranteed not to lose any money but will participate in any market gains Which of the following is NOT an error that Stall committed? A) There is no mention that behavioral traits were addressed in the questionnaire B) Stall met with Schaller on a yearly basis https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 1/39 10/11/2018 Learning Management System C) Stall took Schaller’s comment too literally and may have placed him in a potentially inappropriate product with the indexed annuity Explanation Stall made several errors regarding the questionnaire and subsequent meeting: Related Material Question #3 of 54 bo ok c SchweserNotes - Book en tre (Study Session 4, Module 9.2, LOS 9.b) in The questionnaire should be re-administered during the yearly review to make sure any changes in the client's circumstances are captured The questionnaire should be able to identify behavioral biases displayed by the client which there is no mention of this occurring Stall interpreted Schaller's statement about not wanting to lose any money too literally resulting in an inappropriate product, the annuity which is a long term retirement product, being used for non-retirement savings She should have inquired further into his statement to see if he really meant not to lose any money in an investment or if he is just overly risk averse Which of the following is most likely not one of the behavioral investor types identi ed by m Pompian? o A) The Independent individualist w w B) The adventurer C) The passive preserver w Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 2/39 10/11/2018 Learning Management System The adventurer is from the Bailard, Biehl, and Kaiser (BB&K) ve-way model which classi es investors along two dimensions according to how they approach life in general The rst dimension, dence, identi es the level of dence usually displayed when the individual makes decisions Con dence level can range from dent to anxious The second dimension, method of action, measures the individual's approach to decision making Depending on whether the individual is methodical in making decisions or tends to be more spontaneous, method of action can range from careful to impetuous The ve behavioral types identi ed by the BB&K ve-way model are the: adventurer, celebrity, individualist, guardian, and straight arrow .in The Pompian behavioral model identi es four behavioral investor types (BITs): passive preserver, friendly follower, independent individualist, and active accumulator The Passive Preserver and the Active Accumulator tend to make emotional decisions whereas the Friendly Follower and Independent Individualist tend to use a more thoughtful approach to decision making (Study Session 4, Module 9.1, LOS 9.a) en tre Related Material Question #4 of 54 bo ok c SchweserNotes - Book De ning investor objectives in terms of mean and standard deviation: m A) may make it easier to estimate the probability that the objectives will be realized .o B) usually makes it less likely that the investor will deviate from the investment policy because of current market conditions w w C) may make selecting an asset allocation more di cult for the individual w Explanation De ning investor objectives in terms of mean and standard deviation may make selecting an asset allocation more di cult for the individual, since it can be hard to see how the choices a ect the probability of success In addition, this method of goal de nition often makes it can make it di cult to estimate the probability that the objectives will be realized, and may make it more likely that deviations from policy will occur (Study Session 4, Module 9.2, LOS 9.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 3/39 10/11/2018 Learning Management System Question #5 of 54 Gina Arturo has an online brokerage account in which she frequently places trades Which of the following behavioral traits is she most likely exhibiting? A) Home bias e ect B) Disposition e ect C) Overcon dence Explanation bo ok c en tre in When retail investors trade their brokerage accounts excessively this is thought to be caused by overcon dence based on a false sense of insight into the investment's future performance The typical result is lower overall returns due to trading costs as well as from selling winners too soon and holding losers too long Selling winners too soon and holding onto losers too long is called the disposition e ect There is no evidence in this question that Arturo is exhibiting the disposition e ect Many retail investors also typically display the home bias e ect which is the behavioral trait of investors placing a high proportion of their assets in the stocks of rms in their own country This is closely related to familiarity where investors invest in stocks they are familiar with such as domestic stocks or their own company stock (Study Session 4, Module 9.2, LOS 9.d) Related Material o m SchweserNotes - Book w w Question #6 of 54 According to behavioral nance, which of the following best describes how investors will invest w their retirement portfolio? A) The investor will put most of their money in the less risky assets on the menu of their employer’s de ned contribution plan unless the employer forces them to put h j i f h f d i h k B) The investor will put most of their money in the less risky assets on the menu of their employer’s de ned contribution plan C) The investor will put an equal dollar amount in each mutual fund on the menu of their employer’s de ned contribution plan Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 4/39 10/11/2018 Learning Management System According to behavioral nance, investors will diversify the portfolio for their de ned contribution pension using 1/n diversi cation In 1/n diversi cation, an employee puts an equal amount in each fund on the employer's de ned contribution pension plan menu For example, if there are eight mutual funds available, the employee will put one-eighth of their contribution in each fund Note that in the U.S., an employer cannot force an employee to put more than 10% of their retirement funds in company stock (Study Session 4, Module 9.2, LOS 9.d) Related Material in SchweserNotes - Book en tre Question #7 of 54 Limitations of classifying investors into behavioral types would include all of the following EXCEPT: A) individuals may simultaneously display both emotional biases and cognitive errors bo ok c all the while seeming to act rationally, making it di cult to classify the individual di b h i l bi B) as investors age, they will most likely go through behavioral changes, usually resulting in decreased risk tolerance along with becoming more emotional about o Explanation m h i i i C) the resulting client portfolio is not the “rational” portfolio w w The client portfolio constructed by the adviser not falling on the e cient frontier (the rational portfolio) is not a limitation but the result of classifying an investor into a behavioral type It results in a portfolio that is better suited to the client given their behavioral biases w Limitations of classifying investors into the various behavioral investor types include: Individuals may simultaneously display both emotional biases and cognitive errors all the while seeming to act rationally, making it di cult to classify the individual according to behavioral biases An individual might display traits of more than one behavioral investor type, making it di cult to place the individual into a single category As investors age, they will most likely go through behavioral changes, usually resulting in decreased risk tolerance along with becoming more emotional about their investing Even though two individuals may fall into the same behavioral investor type, the individuals should not necessarily be treated the same due to their unique circumstances and psychological traits Individuals tend to act irrationally at unpredictable times because they are subject to their own speci c psychological traits and personal circumstances In other words, people don't all act irrationally (or rationally) at the same time (Study Session 4, Module 9.1, LOS 9.a) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 5/39 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #8 of 54 Which of the following is least likely a way to reduce overcon dence in analyst forecasts? A) The analyst is properly self-calibrated through feedback from colleagues and superiors along with a structure that rewards accuracy and forecasts that are in bi d d il d B) The analyst should seek a contrary opinion to their forecast based on evidence en tre along with using a large enough sample size and Bayes’ formula C) Gather a large amount of data from which to develop a forecast Explanation bo ok c Collecting a large amount of data can lead to overcon dence in analysts' forecasts referred to as the illusion of knowledge when the analyst thinks they are smarter than they are This, in turn, makes them think their forecasts are more accurate than the evidence indicates m Self-calibration is the process of remembering their previous forecasts more accurately in relation to how close the forecast was to the actual outcome Getting prompt and immediate feedback through self evaluations, colleagues, and superiors, combined with a structure that rewards accuracy, should lead to better self-calibration Analysts' forecasts should be unambiguous and detailed, which will help reduce hindsight bias w w o Analysts should seek at least one counterargument, supported by evidence, for why their forecast may not be accurate They should also consider sample size Basing forecasts on small samples can lead to unfounded dence in unreliable models Lastly, Bayes' formula is a useful tool for reducing behavioral biases when incorporating new information w (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book Question #9 of 54 Typical individual investors tend not to understand the e ects of correlation on their portfolio Which of the following characteristics of a DC plan participant's portfolio best re ects the attempt to derive bene ts from the e ects of correlation even though the participant does not understand those e ects? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 6/39 10/11/2018 Learning Management System A) Status quo bias B) Familiarity C) 1/n diversi cation heuristics Explanation Feeling that they should spread out their risk, but not knowing how leads to the 1/n diversi cation heuristic Often times, participants will only have a rough understanding of the e ects of correlation and diversi cation and will simply divide their assets equally over the investment options in the plan in an attempt diversify their portfolio (Study Session 4, Module 9.2, LOS 9.d) Related Material en tre in SchweserNotes - Book Question #10 of 54 bo ok c An investor selling winning securities too soon and holding losing positions too long is an example of: A) representativeness Explanation o C) overcon dence m B) the disposition e ect w w This is the de nition of the disposition e ect (Study Session 4, Module 9.2, LOS 9.d) w Related Material SchweserNotes - Book Question #11 of 54 Which of the following is least likely to be a common bias found in analyst research? A) The analyst makes a decision based on incomplete information knowing the outcome could be unfavorable https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 7/39 10/11/2018 Learning Management System B) The analyst inappropriately tries to apply a probability to a random event C) The analyst nds evidence that rms their forecast Explanation Biases speci c to analysts performing research are usually related to the analysts collecting too much information, which leads to the illusions of knowledge and control and to representativeness, all of which contribute to overcon dence Two other common biases found in analysts' research are the rmation bias and the gambler's fallacy The rmation bias (related to rming evidence) relates to the tendency to view new information as rmation of an original forecast (Study Session 4, Module 9.3, LOS 9.e) Related Material m Question #12 of 54 bo ok c SchweserNotes - Book en tre in The gambler's fallacy, in investing terms, is thinking that there will be a reversal to the longterm mean more frequently than actually happens A representative bias is one in which the analyst inaccurately extrapolates past data into the future An example of a representative bias would be classifying a rm as a growth rm based solely on previous high growth without considering other variables a ecting the rm's future Heather Jones graduated from a prestigious Ivy League college in May, recently passed Level I o of the CFA exam, and just landed her rst professional job as a junior portfolio manager w w working with CFA charterholders for the Fortress mutual fund company She works in a group setting comprised of a lead portfolio manager and one or more co- or junior portfolio managers who together make the investment management decisions for a single mutual fund w Jones has observed the following behavior during the committee meetings where the portfolio managers discuss which investments should be a part of the portfolio: analyst A always sides with and follows the lead of analyst B, analyst C tends to have a di erent opinion from the group view but fears being ostracized therefore he rarely voices his opinion, manager D is very aggressive and shoots down the opinions of others if they contradict his own and also likes to argue with people Jones is starting to wonder whether or not she made the right decision by taking the job and has had several thoughts about the behavior at the meetings Which of the following of her thoughts is least re ective of how nancial decisions are typically made in a group setting? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 8/39 10/11/2018 Learning Management System A) “Decisions made at this level are made by professionals with similar backgrounds, the committee should be functioning in a more e cient and e ective manner with li l di d h b B) “Their individual behavioral biases have become exacerbated in the group setting!” C) “These people are displaying irrational behavior which is typical of group settings!” Explanation In a group setting individual biases can be either diminished or ampli ed with additional biases being created Research has shown that the investment decision making process in a group setting is notoriously poor Committees not learn from past experience because feedback from decisions is generally inaccurate and slow, so systematic biases are not identi ed bo ok c (Study Session 4, Module 9.3, LOS 9.f) en tre in The typical makeup of a committee coupled with group dynamics leads to the problems normally seen with committees typically comprised of people with similar backgrounds thus they approach problems in the same manner leading the group to start thinking as a single individual, individuals can sometimes follow the beliefs of a group, and some individuals may feel uncomfortable expressing their opinion if it di ers with others or a powerful member of the group Related Material m SchweserNotes - Book o Question #13 of 54 w w According to behavioral nance, analysts often make excuses for their inaccurate predictions Which of the following best represents the problem with this occurrence, from a behavioral w nance view? A) The excuses allow poor forecasters to stay in their positions when they should be replaced B) The excuses will prevent analysts from recognizing their own limitations C) Other investors depend on these forecasts, resulting in aggregate investment losses Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 9/39 10/11/2018 Learning Management System According to behavioral nance, analysts often make excuses for their inaccurate predictions The excuses will prevent them from recognizing their own limitations and allow them to continue to make inaccurate forecasts Although there is an element of truth in the other responses, they are not the central problem in this case, according to behavioral nance (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book in Question #14 of 54 en tre All of the following are behavioral investor types identi ed by Pompian EXCEPT the: A) guardian B) active accumulator bo ok c C) friendly follower Explanation w w o m The guardian is from the Bailard, Biehl, and Kaiser (BB&K) ve-way model which classi es investors along two dimensions according to how they approach life in general The rst dimension, dence, identi es the level of dence usually displayed when the individual makes decisions Con dence level can range from dent to anxious The second dimension, method of action, measures the individual's approach to decision making Depending on whether the individual is methodical in making decisions or tends to be more spontaneous, method of action can range from careful to impetuous The ve behavioral types identi ed by the BB&K ve-way model are the: adventurer, celebrity, individualist, guardian, and straight arrow w The Pompian behavioral model identi es four behavioral investor types (BITs): passive preserver, friendly follower, independent individualist, and active accumulator The Passive Preserver and the Active Accumulator tend to make emotional decisions whereas the Friendly Follower and Independent Individualist tend to use a more thoughtful approach to decision making (Study Session 4, Module 9.1, LOS 9.a) Related Material SchweserNotes - Book Question #15 of 54 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 10/39 10/11/2018 Learning Management System A) helps the advisor understand their client resulting in better overall investment decisions being made that are closer to the e cient frontier B) gives the adviser the tools to be able to explain to the client why their portfolio should resemble the “rational portfolio” based on traditional nance concepts C) allows the advisor to have a better understanding of how to approach their client when educating them on traditional nance concepts Explanation bo ok c (Study Session 4, Module 9.1, LOS 9.a) en tre in The goal of viewing the client/adviser relationship from a psychological perspective as compared to a purely traditional nance perspective is for the adviser to better understand their client and to make better investment decisions By incorporating behavioral biases into clients' IPSs, clients' portfolios will tend to be closer to but not on the e cient frontier (the rational portfolio), and clients will be more trusting and satis ed and tend to stay on track with their long-term strategic plans Ultimately, since everyone is happy, the result is a better overall working relationship between client and adviser Clients who are at the extremes of risk aversion tend to approach investing very emotionally and are not interested in traditional nance concepts therefore educating them on these concepts is of little value to them and does not work Related Material SchweserNotes - Book m Terry Shiver and Mary Trickett are portfolio managers for High End Investment Managers High o End provides investment advice to wealthy individuals As part of their annual review of their w w client portfolios, they review the appropriateness of their client portfolios given their clients' return objective, risk tolerance, time horizon, liquidity constraints, tax situation, regulatory w situation, and unique circumstances Their boss, Jill Castillo, is concerned that Shiver and Trickett allow the clients' behavioral biases to enter into the asset allocation decision She has asked them to review their notes from meetings with clients and examine the clients' statement for potential biases The information below is excerpts from their notes, along with the client's name Tom Heggins: "In the past ve years, I have consistently outperformed the market averages in my stock portfolio It really does not take a genius to beat a market average, but I am proud to say that I have beaten the market averages by at least percent each year and have not once lost money I would continue managing my portfolio myself because I know I could keep beating the averages, but with a new baby on the way and a promotion to Senior Vice President at my technology rm, I just don't have the time." https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 25/39 10/11/2018 Learning Management System Joanne McHale: "The last three quarters were bad for my portfolio I have lost about a third of my portfolio's value, primarily because I invested heavily in two aggressive growth mutual funds whose managers had o quarters I need to get back that one-third of my portfolio's value because I am only fteen years away from retirement and I don't have a de ned-bene t pension plan Because of this, I am directing Mary Trickett to invest my savings in technology mutual funds Their potential return is much higher and I believe I can make back that loss with an investment in them." Jack Sims: "I enjoy bird watching and hiking outdoors I am an avid environmental advocate and will only invest in rms that share my concern for the environment My latest investment was in Washington Materials Washington was recently featured in an environmental magazine for in their outstanding dedication to environmental protection The CEO of Washington was also featured on the cover of Fortune magazine He has turned the rm around in the three years en tre he has been there The rm was near bankruptcy, but now Washington is the leader in its niche Question #38 of 54 bo ok c market, which is waterproof fabric for outdoor clothing and equipment." Which of the following best describes Tom Heggins's behavioral characteristic in investment decisions? m A) Tom uses frame dependence .o B) Tom is overcon dent w w C) Tom uses anchoring Explanation w Tom is overcon dent Tom believes that on the basis of his ve-year record, he can continue to outperform a benchmark His record could be due to luck and he may be not reporting his shortcomings as an investor (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book Question #39 of 54 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 26/39 10/11/2018 Learning Management System Which of the following best describes the potential problem with Heggins's investment strategy in regards to certainty overcon dence? A) He will underestimate the risk of his portfolio and set too narrow of dence intervals B) He will underestimate the risk of his portfolio and overestimate the probability of success C) He will overestimate the risk of his portfolio and overestimate the impact of an event on stocks Explanation (Study Session 4, Module 9.3, LOS 9.e) Related Material m Question #40 of 54 bo ok c SchweserNotes - Book en tre in As an investor exhibiting certainty overcon dence, Heggins will tend to underestimate risk and will also tend to overestimate the probability of success Prediction overcon dence is when too narrow of dence intervals are assigned to possible outcomes .o Which of the following most likely explains Tom Heggins's behavior in investment decisions? A) Tom uses the ceteris-paribus heuristic to assess his skills w w B) Tom is su ering from an illusion of knowledge in assessing his skills w C) Tom uses anchoring to assess his skills Explanation Tom is su ering from an illusion of knowledge leading to overcon dence Overcon dent individuals will presume that because they are successful in one area of their life, they can be successful in other areas as well (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book Question #41 of 54 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 27/39 10/11/2018 Learning Management System Which of the following best describes Joanne McHale's behavioral characteristic in investment decisions? A) Joanne is loss averse B) Joanne uses the ceteris-paribus heuristic C) Joanne’s regret too heavily in uences her investment decisions Explanation Joanne is loss averse Because she dislikes losses so much, she is willing to take more risk to make up the losses in her portfolio She is investing her savings in technology mutual funds that will have much higher risk .in (Study Session 4, Module 9.3, LOS 9.e) Related Material bo ok c Question #42 of 54 en tre SchweserNotes - Book Which of the following least accurately describes Jack Sims's behavioral characteristic in investment decisions? m A) Jack is using the representativeness bias .o B) Jack would be classi ed as an Active Accumulator personality type w w C) Jack is using the availability bias Explanation w The Active Accumulator behavioral investor type displays characteristics of Illusion of Control Jack would most likely be classi ed as an Independent Individualist which can have characteristics of: conservatism, availability, rmation, and representative biases Jack is exhibiting availability bias by putting undue emphasis on the information that is readily available and resonates with him in this case the environmental and investing magazines He also displays traits of representativeness bias in that the favorable results of the recent past (sample size neglect) will persist into the future with the relatively new CEO (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 28/39 10/11/2018 Learning Management System Question #43 of 54 Which of the following would Heggins, McHale, and Sims be least likely to use when making investment decisions? A) Fundamental analysis B) Feelings C) Emotions Explanation in These investors would be least likely to use fundamental analysis of nancial statements Behavioral investors who are overly risk averse or have a high tolerance for risk tend to make investment decisions based on feelings and emotions and not on scienti c analysis en tre (Study Session 4, Module 9.3, LOS 9.e) Related Material Question #44 of 54 bo ok c SchweserNotes - Book Jack Melby places his investments into di erent "mental accounts" with each investment being m tied to accomplishing a di erent goal All the investments together comprise a pyramid where o the most conservative investments are on the bottom layer to meet his most immediate and important goals Riskier investments are represented higher up in the pyramid and used to w w meet less immediate goals This behavioral trait is: A) called “mental accounting” and is not thought to be an acceptable way for investors w to allocate their assets B) perceived as being ine cient and the investment adviser should try to persuade the investor to allocate their assets to resemble an allocation based on traditional h C) not the most e cient from a traditional nance perspective but acceptable because the portfolio tends to be fairly well diversi ed and if constructed properly from a b h i Explanation l i ill h l h li k ih h i l https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 29/39 10/11/2018 Learning Management System Investors exhibit behavioral biases when they construct portfolios in layers, comprising a pyramid with each layer having a speci c purpose in achieving a di erent goal This is also referred to as mental accounting because the assets in each layer of the pyramid are viewed separately from each other with no regard to how they are correlated In the pyramid structure, the most pressing goals are placed on the bottom layer and are met using low-risk, conservative investments Each successive layer going toward the top of the pyramid is comprised of riskier assets to accomplish less immediate or less important goals In the pyramid approach, investors see each layer as having a separate level of risk Advisers with clients who view their portfolios in layered pyramids can help them understand which mental accounts they have and the risk the client is assigning to each account This is in contrast to traditional nance theory, which constructs a portfolio based on viewing the assets as working together as one unit, taking into consideration the correlation between those assets In this scenario, the portfolio is viewed as having a single measure of risk .in (Study Session 4, Module 9.2, LOS 9.d) Related Material bo ok c w w w o m Question #45 of 54 en tre SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 30/39 10/11/2018 Learning Management System Steve Perlewitz, a retirement plan specialist for Mercantile Asset Advisors (MAA), is discussing the behavioral characteristics of individual investors in de ned contribution retirement plans in an e ort to educate MAA's sales team as they sell MAA's services In his presentation, Perlewitz makes the following comments: An investor whose decisions are impacted by mental Comment 1: accounting are likely to hold on to losing investments too long, and sell winning investments too soon The 1/n diversi cation methodology used by many DC plan participants is an example of naïve diversi cation en tre Comment 3: in Since mental accounting tends to guide investors toward more conservative asset classes, the portfolio of an investor Comment 2: impacted by mental accounting will tend to be more conservative than that of an investor who is not, assuming similar return objectives bo ok c If a de ned contribution plan investor has an appropriate Comment 4: allocation in their retirement plan, the same allocation should also apply to their other investment accounts After listening to Perlewitz's presentation, sales team leader Vicki Bruning would be CORRECT to agree with: m A) Comment only B) Comments 1, 2, and only w w Explanation o C) Comments and only w Perlewitz is only correct with respect to Comment With 1/n diversi cation, where a DC plan participant divides his investment dollars equally across available investment options, diversi cation is by chance only and is not part of a total portfolio perspective Such a diversi cation methodology is re ective of naïve diversi cation The other comments are incorrect An investor whose decisions are impacted by mental accounting will look at investments as separate, focusing on the risk of investments in isolation This means that the investor dismisses the e ects of correlation, thus leading to more risky portfolios than an investor who does consider correlation Note that the disposition e ect refers to holding on to losing investments too long and selling winners too soon Finally, diversi cation from an e cient perspective may allocate investments in tax-deferred accounts (like a retirement plan) di erently than investments in taxable accounts, while still focusing on the investor's allocation as a whole (Study Session 4, Module 9.2, LOS 9.d) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 31/39 10/11/2018 Learning Management System Question #46 of 54 When an investor extrapolates past data from a small sample size into a forecast this is most likely indicative of: A) the recency bias B) hindsight bias C) fear of regret .in Explanation bo ok c en tre Herding is when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available to them Two behavioral biases associated with herding are the availability bias (a.k.a the recency bias or recency e ect) and fear of regret In the availability bias, recent information is given more importance because it is most vividly remembered It is also referred to as the availability bias because it is based on data that are readily available, including small data samples or data that not provide a complete picture In the context of herding, the recent data or trend is extrapolated by investors into a forecast m Regret is the feeling that an opportunity has passed by and is a hindsight bias The investor looks back thinking they should have bought or sold a particular investment (note that in the availability bias, the investor most easily recalls the recent positive performance) Regret can lead investors to buy investments they wish they had purchased, which in turn fuels a trendchasing e ect Chasing trends can lead to excessive trading, which in turn creates shortterm trends w w Related Material o (Study Session 4, Module 9.3, LOS 9.g) w SchweserNotes - Book Question #47 of 54 Which of the following statements best re ects the relationship between company management presenting reports in a favorable light and analysts' forecasts? A) The way company management presents reports in uences analysts but they possess the skills to be able to mitigate the in uence by company management B) The way company management presents reports generally in uences analysts because they are also susceptible to behavioral biases https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 32/39 10/11/2018 Learning Management System C) Analysts can be unduly in uenced by the way management presents and frames company reports thus analysts should be aware of the various biases management b Explanation ibl The way a company's management presents (frames) information can in uence how analysts interpret it and include it in their forecasts There are three cognitive biases frequently seen when management reports company results: (1) framing, (2) anchoring and adjustment, and (3) availability Framing refers to a person's inclination to interpret the same information di erently depending on how it is presented In the case of company information, analysts should be aware that a typical management report presents accomplishments rst en tre in Anchoring and adjustment refers to being "anchored" to a previous data point The way the information is framed (presenting the company's accomplishments rst), combined with anchoring (being overly in uenced by the rst information received), can lead to overemphasis of positive outcomes in forecasts Availability refers to the ease with which information is attained or recalled The enthusiasm with which managers report operating results and accomplishments makes the information very easily recalled and, thus, more prominent in an analyst's mind bo ok c Analysts should also look for self-attribution bias in which management has overemphasized the positive as well as the extent to which their personal actions in uenced the operating results leading to excessive optimism (overcon dence) .o m To help avoid the undue in uence in management reports, analysts should focus on quantitative data that is veri able and comparable rather than on subjective information provided by management The analyst should also be certain the information is framed properly and recognize appropriate base rates (starting points for the data) so the data is properly calibrated w w (Study Session 4, Module 9.3, LOS 9.e) Related Material w SchweserNotes - Book Question #48 of 54 When an investor stays with the default investor option and default contribution rate in a company retirement plan this is an example of: A) conditional naïve diversi cation B) status quo bias C) familiarity https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 33/39 10/11/2018 Learning Management System Explanation This is an example of status quo bias when an investor sticks with the default investment option and default contribution rate in a company retirement plan Conditional naïve diversi cation is when an investor allocates equally among a select number of investment choices in their company retirement plan Familiarity is seen in investors choosing to invest in their company's stock because they are familiar with it (Study Session 4, Module 9.2, LOS 9.c) Related Material in SchweserNotes - Book en tre Question #49 of 54 Mike McLaughlin is an economist who makes quarterly forecasts for the state of the economy and interest rates Last quarter, the economy did not grow as fast as McLaughlin predicted McLaughlin explains that his forecast was inaccurate by stating "This change in the economy bo ok c was due to a real estate market that slowed faster than many forecasters, including myself, expected If it weren't for the real estate market, my projection for GDP would have been accurate." Which of the following is the best interpretation of McLaughlin's statement, from a behavioral nance view? McLaughlin is using: m A) hindsight bias as a defense for his inaccurate forecasts and this will prevent him o from accurately evaluating his own abilities B) a self attribution defense for his inaccurate forecasts and this will prevent him from w w accurately evaluating his own abilities C) an “if-only” defense for his inaccurate forecasts and his recognition of it will sharpen w his abilities Explanation McLaughlin is using a self-attribution bias which is an ego defense mechanism where analysts take credit for their successes and blame others or external factors for their failures According to behavioral nance, analysts will use excuses to justify their inaccurate forecasts These excuses will prevent them from accurately evaluating their own abilities As a result, they will persist in making the same mistakes Hindsight bias is when the analyst selectively recalls details of the forecast and reshapes it in such a way that it ts the outcome (Study Session 4, Module 9.3, LOS 9.e) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 34/39 10/11/2018 Learning Management System Question #50 of 54 According to behavioral nance, which of the following best describes the components of individual investors' portfolios? A) Their portfolios will be over concentrated in their employer’s stock and domestic securities B) Their portfolios will be over concentrated in risky securities C) Their portfolios will be over concentrated in their employer’s stock and risky in securities en tre Explanation According to behavioral nance, individuals invest in securities they are familiar with They are over concentrated in their employer's stock and in domestic securities Their portfolios will exhibit a home bias, with few international assets bo ok c (Study Session 4, Module 9.2, LOS 9.d) Related Material m SchweserNotes - Book o Question #51 of 54 w w Kelly Lieb and Don Carsner are discussing their investments in the Shrader Tire 401(k) de ned contribution plan Lieb and Carsner make the following statements in their conversation: Carsner: "I allocate most of my money to Shrader Tire Company stock as well I don't know anything about the other investment options, and I want to be loyal to the company." w Lieb: "Most of the money I have invested in our 401(k) plan is in Shrader Tire stock Management would not give it to us as a company match if it were not a good investment Which of the following factors behind holding company stock best re ects Lieb's comment and Carsner's comment respectively? Lieb's Comment Carsner's Comment https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 35/39 10/11/2018 Learning Management System A) Familiarity Bias Familiarity Bias B) Framing Framing C) Familiarity Bias Framing Explanation bo ok c (Study Session 4, Module 9.2, LOS 9.d) en tre in Even without direct encouragement by the plan sponsor, employees tend to invest more in their company's stock that would be warranted from a diversi cation standpoint Lieb's and Carsner's comments are re ective of the two primary factors that contribute to DC plan participants holding company stock: framing and familiarity bias Lieb's comment re ects framing which refers to the misconception that by matching the employee's contribution with company stock the sponsor is implicitly endorsing it as a good investment Carsner's comment is re ective of familiarity bias, which refers to investors selecting stocks with which they are comfortable with or have a proximity to If company stock is o ered as an investment option in a de ned contribution plan, participants may feel a sense of control or allegiance to the rm and hold more company stock than is sensible, which is an e ect of familiarity Related Material m SchweserNotes - Book o Question #52 of 54 w w Leonard Busch is a employee of Matrix Technologies, and a participant in the Matrix Technologies de ned contribution plan The assets in the plan are the only investments he w owns Busch's investment allocation is shown below Allocation Investment Option 20% Yukon Large Cap Growth Fund 40% Matrix Technologies Company Stock 15% Yukon Intermediate Bond Fund 10% Yukon Money Market Fund 15% Yukon International Stock Fund Which of the following factors is most likely to drive Busch's investment allocation? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 36/39 10/11/2018 Learning Management System A) Status quo bias B) 1/n diversi cation heuristics C) Familiarity Explanation Related Material Question #53 of 54 bo ok c SchweserNotes - Book en tre (Study Session 4, Module 9.2, LOS 9.d) in Looking at Busch's allocation, he obviously has a disproportionate amount of Matrix Technologies company stock DC participants tend to hold excess stock of the company they work for due to familiarity and a perceived endorsement by management Familiarity refers to investors selecting stocks with which they are comfortable with or have a proximity to If company stock is o ered as an investment option in a de ned contribution plan, participants may feel a sense of control or allegiance to the rm and hold more company stock than is sensible, which is an e ect of familiarity Note that Busch's assets are not equally divided among investment options, which means the 1/n diversi cation heuristic would not seem to apply Status quo bias is clearly not the best answer given the weight in company stock Which of the following would least likely be viewed as rational behavior during a market m bubble? o A) The investor knows she is in a bubble but she doesn’t know where the peak is w w B) A real estate portfolio manager has no suitable alternative investments to switch to C) Investors believe the price of a stock will continue to go up therefore they buy w more Explanation Financial bubbles and subsequent crashes are periods of unusual positive or negative returns caused by panic buying and selling, neither of which is based on economic fundamentals The buying (selling) is driven by investors believing the price of the asset will continue to go up (down) In bubbles, investors sometimes exhibit rational behavior—they know they are in a bubble but don't know where the peak of the bubble is Or, there are no suitable alternative investments to get into, making it di cult to get out of the current investment For investment managers, there could be performance or career incentives encouraging them to stay invested in the in ated asset class (Study Session 4, Module 9.3, LOS 9.g) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 37/39 10/11/2018 Learning Management System Related Material SchweserNotes - Book Question #54 of 54 Brian Piezer is a participant in the NSS Enterprises 401(k) plan and started contributing to the plan in 1998 Piezer's portfolio allocation when he started the plan in 1998 was as follows: Investment Option Reliant Large Cap Growth Fund 20% Reliant Small Cap Value Fund 20% Reliant Intermediate Bond Fund 20% Reliant Money Market Fund 20% Reliant International Stock Fund bo ok c en tre 20% in Allocation In March of 2000, the equity markets started to decline, eventually hitting a low point in October 2002 Piezer's investment allocation in 2002 is below: Allocation Investment Option Reliant Large Cap Growth Fund 10% Reliant Small Cap Value Fund 30% o Reliant Money Market Fund w 10% Reliant Intermediate Bond Fund w w 36% m 8% Reliant International Stock Fund Which of the following characteristics of a DC plan participant's portfolio is most re ective of Piezer's in 1998 and 2002 respectively? Portfolio in 1998 A) Framing B) Framing Portfolio in 2002 1/n diversi cation e ect Status quo bias https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 38/39 10/11/2018 Learning Management System C) 1/n Status quo diversi cation bias e ect Explanation in Piezer's portfolio in 1998 is re ective of 1/n diversi cation – the allocation is divided equally among the funds Often times, participants will only have a basic understanding of diversi cation and will simply divide their assets equally over the investment options in the plan in order to e ectively diversify their portfolio The portfolio in 2002 is re ective of the status quo bias, which refers to a participant's tendency to make an original allocation and not change it With the bear market from 2000 – 2002, it appears that Piezer's allocation to equities went down dramatically as equities decreased in value, thus increasing his weighting in the money market and bond fund There does not appear to be any attempts to rebalance or change his allocation (Study Session 4, Module 9.2, LOS 9.d) en tre Related Material w w w o m bo ok c SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83415812/print 39/39 ... Session 4, Module 9 .3, LOS 9. e) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab 495 925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 15812/print 13/ 39 10/11/2018... Session 4, Module 9 .3, LOS 9. f) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab 495 925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 15812/print 19 / 39 10/11/2018... (Study Session 4, Module 9 .3, LOS 9. g) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab 495 925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 15812/print 37 / 39 10/11/2018 Learning