ABFP Chapter 1

The passive investment heuristic minimizes emotional drivers to decision making. It is

A). >>>>>>>>not the preferred option of most investors who are intent on beating the market. B). the preferred option of most investors and is exemplified by the 2/N rule. C). irrational given a world of bounded rationality and tends to result in suboptimal returns. D). both irrational and inefficient, yet achieves superior returns based on symmetric information. Passive investment strategies minimize emotional drivers to decision making, which often motivate and determine an individual's investment decisions, and can generate errors in decision making. Additionally, passive investing is not the preferred option of most investors who are intent on beating the market. LO 1.4

Behavioral finance theory suggests that decision making is influenced by

A). >>>>>>Emotions B). Psychology C). Values D). Fear Explanation Unlike traditional finance theory that suggests people are rational economic agents, behavioral finance suggests that decision-making is greatly influenced by emotions. For example, investors feel more optimistic on sunny days and therefore are more likely to speculate when buying stocks. LO 1.1

Traditional finance theory suggests that decision makers

A). >>>>>>evaluate all possible outcomes. B). ignore uncertain outcomes. C). ignore suboptimal outcomes. D). evaluate all optimal outcomes. Explanation Traditional finance theory suggests that people are fractional economic agents, while behavioral finance suggests that decision making is greatly influenced by emotions. LO 1.1

Many defined contribution (DC) plan participants tend to hold onto large amounts of company stock relative to other asset classes, even when company stock loses significant value. Which of the following decision-making heuristics best explains this tendency?

A). Ambiguity aversion B). Animal spirits C). Herding D). >>>>>>Disposition effect The disposition effect results in individuals selling stocks too quickly that have appreciated in price, but holding on to stocks that have depreciated in price for too long. This is consistent with acknowledging gains but not losses. LO 1.3

Skylar is a passionate environmentalist and is involved in several groups that promote natural resource conservation. She will only invest in companies that share her interest in conserving our ecosystems. Her most recent investment was in Green Housing Systems (GHS), a green company that won the Environmental Home Champion award, which recognizes leaders in ecofriendly housing design and construction. Which of the following best describes Skylar's behavior?

A). Anchoring B). Confirmation bias C). Availability D). >>>>>>Representativeness Explanation Skylar's behavior illustrates the "if-then" heuristic known as representativeness. She believes that, because of GHS's environmental policy and its CEO's ability to increase assets, the firm's stock is a good investment. Skylar ignores the fact that the stock might be overvalued. Confirmation bias is the tendency to search out evidence consistent with one's prior beliefs and to ignore conflicting data. Availability heuristic occurs when individuals estimate future probabilities by how easily they recall a past event. Familiarity is finding comfort in what a person knows. LO 1.3

Which of these heuristics is described as behavior that is motivated by emotive factors as opposed to calculating or hard care economic rationality?

A). Herding B). Beauty contest C). Loss aversion D). >>>>>Animal spirits Animal spirits, also called irrational exuberance, is behavior that is motivated by emotive factors, as opposed to calculating or hard care economic rationality. The concept of a beauty contest refers to rational individuals estimating what future prices might be by anticipating what other people believe future prices will be. Herding occurs when decision makers follow the leader, and are unsure of how asset prices will move. Loss aversion weighs losses about twice as much as gains. LO 1.4

Which of these heuristics is described when decision makers follow the leader and are unsure of how asset prices will move?

A). Loss aversion B). Animal spirits C). >>>>>>>Herding D). Beauty contest Explanation Herding occurs when decision makers follow the leader, and are unsure of how asset prices will move. Loss aversion weighs losses about twice as much as gains. The concept of a beauty contest refers to rational individuals estimating what future prices might be by anticipating what other people believe future prices will be. Animal spirits, also called irrational exuberance, is behavior that is motivated by emotive factors, as opposed to calculating or hard care economic rationality. LO 1.3

Prospect theory posits that I. Loss aversion is synonymous with risk aversion II. People overweight certain outcomes versus probable ones

A). Neither I nor II B). >>>>>>>II only C). Both I and II D). I only Explanation Loss aversion is quite different from risk aversion. When Kahneman and Tversky were developing prospect theory, they found that people tend to overweight outcomes that they can ascertain with certainty, and they tend to underweight outcomes to which they must assign probabilities. LO 1.2

In prospect theory, a prospect includes which of the following elements?

A). Neither probabilities nor wealth outcomes B). >>>>>>>Both probabilities and wealth outcomes C). Wealth outcomes D). Probabilities Explanation A prospect is a lottery or series of wealth outcomes, each of which is associated with a probability. LO 1.2

Which statement best describes representativeness?

A). People often consider their investment abilities to be much better than they actually are. B). People tend to follow the actions of a larger group, whether rational or not in a particular case. C). >>>>>>People believe the past will persist and will classify new information based on past experience or classification. D). People often make irrational decisions based on information that should have no influence on the decision at hand. People believe the past will persist and will classify new information based on past experience or classification. The prospect theory of behavioral finance states that people tend to fear losses much more than they value gains. Making irrational decisions based on information that should have no influence on the decision at hand is anchoring. Following the actions of a larger group, whether rational or not, is herding. Considering one's abilities to be much better than they actually are, is overconfidence. LO 1.3

You just participated in a bet on drawing a blue ball from a bag filled with 50 blue and 50 red balls. Now, you are invited to participate in a bet on drawing a blue ball from a bag of 100 balls (red and blue mix unknown). If you don't participate in the bet, one reason could be

A). base rate neglect. B). >>>>>>>ambiguity aversion. C). endowment effect. D). loss aversion. The unknown (lack of information) would have to be factored into the bet. More people would choose to forgo the second bet because of ambiguity aversion (opposite of familiarity/home bias). People become a lot more cautious when dealing with things they do not know. You can observe that in practice—recommending actions connected with common/public knowledge (such as a large company stock) is much easier than recommending unknown stocks, no matter how well the reasoning behind it may be. LO 1.3

All of the following are reasons why investors make poor decisions except

A). biases. B). emotions. C). cognitive errors. D). >>>>>>>access to all relevant information. Explanation Cognitive errors, biases, and emotions can cause poor decisions. Cognitive errors cause people to base decisions on incorrect reasoning. Biases cause people to give undue weight to an idea. Emotions, as defined by a mental state with observable features, also influence our decision making positively or negatively. Access to all relevant information is one of the fundamental assumptions of traditional finance theory. LO 1.1

Prospect theory posits that people

A). evaluate their final position of wealth. B). >>>>>>maximize value. C). maximize expected utility. D). are risk averse. Explanation Prospect theory posits that people maximize their value. Traditional finance posits that people maximize their expected utility, evaluate their final position of wealth, and are risk averse. LO 1.2

Grant is presented with two equal investment opportunities. The first is stated in terms of potential gains, and the second is stated in terms of potential losses. Without having any additional information, Grant selects the first investment. His decision reflects

A). herding behavior. B). >>>>>>>loss aversion. C). gambler's fallacy. D). risk aversion. Explanation Grant's decision reflects the loss aversion, which asserts that people make decisions based on perceived gains rather than perceived losses. Herding behavior occurs when a person follows the actions of a larger group, whether rational or not. Gambler's fallacy is the belief that a winning or losing streak is limited. Risk aversion is exhibited when an individual prefers the expected value of a prospect to the prospect itself (as predicted by traditional economic theory). Grant is displaying a type of framing bias that falls under prospect theory. LO 1.2

Traditional finance theory assumes that investors will make decisions and predictions that are

A). irrational and unbiased. B). rational and biased. C). >>>>>>>>rational and unbiased. D). irrational and biased. Explanation Traditional finance assumes that individuals are rational economic agents who are self-interested and who attempt to optimize based on resource constraints. LO 1.2

Classical decision theory (Traditional Finance) takes the

A). maximizing approach. B). >>>>>>>>>normative approach. C). positive approach. D). satisficing approach. Explanation Classical decision theory takes a normative view of decision making in that it attempts to identify the best or most optimal decision. LO 1.1

Each of these describes a person's approach to risk except

A). risk neutral. B). risk averse. C). risk seeking. D). >>>>>>risk complacent. Explanation Risk aversion, risk seeking, and risk neutral are typical risk attitudes. Risk aversion describes a person who prefers a guaranteed outcome over a gamble. Risk seeking describes a person who prefers a gamble over a guaranteed outcome. Risk neutral describes a person who is indifferent between a guaranteed outcome and a gamble. LO 1.2

Modern portfolio theory is based on

A). satisficing theory. B). loss aversion. C). >>>>>>>expected utility theory. D). prospect theory. Explanation Modern portfolio theory is based on the tenants of classical finance theory and that investors are risk averse regarding their wealth, with which expected utility theory contributes greatly. Classical finance views in terms of risk aversion, not loss aversion. LO 1.1

Behavioral finance suggests that people make poor decisions because of

A). their intelligence. B). considering the outcomes. C). >>>>>>>cognitive errors. D). risk aversion. Explanation Behavioral finance suggests that people make poor decisions because of cognitive errors, emotions, and biases. Traditional finance focuses on risk aversion and considering the outcomes; not the end state, as behavioral finance does. LO 1.1

When considering traditional finance and utility,

A). utility functions indicate that utility decreases with wealth. B). utility functions assign higher numbers to preferred outcomes. C). utility functions are not unique and can be compared across people. D). >>>>>>> utility functions convert alternatives into measurable rankings. Explanation A utility function converts alternatives into measurable rankings of preferences. Utility functions assign higher numbers to preferred outcomes and can be used to rank combinations of risky alternatives. LO 1.1