S3

Question 0

Emotional biases caused by

Answer 0

Impulse
Intuition

Or result from reasoning influenced by feelings

Question 1

Sources of cognitive biases

Answer 1

Errors :

Statistical
Information processing
Memory

Or result from reasoning based on faulty thinking.

Question 2

Adjectives describing traditional vs behavioral finance

Answer 2

Traditional finance - prescriptive

Behavioral finance - descriptive

Question 3

Utility theory

Answer 3

People maximize PV of Utility considering PV of budgetary contraints.

Question 4

4 axioms of utility

Answer 4

Completeness - people choose A or B or are indiferent
Tranzitivity - if A is better than B and B is better then C then A is better then C
Continuity - inlimited amount of optins to combine A with B to get a constant (indiferent) level of utility
Independence - if A is better than B then A+xC is better than B+xC

Question 5

Bayes formula

Answer 5

P(A/B) = P(B/A) * P(A) / P(B)

Probability A happening given B already happenend =…

Question 6

Utility wealth function for risk NEUTRAL individual is

Answer 6

A straight line with positive slope.

Question 7

Utility ealth function for risk AVERSE individuals is

Answer 7

Concave curve.

Question 8

Utility wealth function of risk SEEKING individuals is

Answer 8

Convex curve.

Question 9

Bounded rationality assumes…

Answer 9

assumes knowledge capacity LIMITS and 
removes the ASSUMPTIONS of 
...perfect information, 
...fully rational decision making, and 
...consistent utility maximization.

Question 10

Satisficing is when individuals

Answer 10

Find acceptable/satisfactory solution as opposed to optimal.

Question 11

7 steps of Editing/framing part of decision process

Answer 11

... Codification
... Combination
... Segregation
... Cancelation
... Simplification
... Dominance detection

Question 12

Behavioral approach to asset pricing

Answer 12

Discount rate used in asset valuation should include a SEMNTIMENT premium (which accou ts for dispersion of analyst estimates)

Question 13

Behavioral portfolio theory - portfolio are constructed…

Answer 13

in layers to satisfy goals rather than to be mean variance efficient.

Question 14

Benavioral life cycle hypothesis - Suggests people classify their…

Answer 14

… assets into nonfungible mentals accounts when planning savings/consumption and as a result achieve a non optimal balance between short term gratification and LT goal achievement.

Question 15

Cognitive errors - 2 categories

Answer 15

Belief perseverance biases

Information processing biases

Question 16

5 Cognitive errors… Belief perseverance biases

Answer 16

CRICH

Are related to cognitive dissonance - mental discomfort when new infomration contradicts with oreviously held beliefs

CONSERVATISM. Slow or unwilling to react to new information
Mitigation: Look carefully at the new information itself to determine its value.

CONFIRMATION. Focus just on positive information about an investment . Leads to overconfidence and overweighiting.
Mitigation: seek contradiction and analyze it carefully.

REPRESENTATIVENESS. Place too much emphasis on perceived category of new information. Likely to change strategies based on a small sample of information.
Mitigation: Consciously take steps to avoid base rate neglect and sample size neglect.

ILLUSION OF CONTROL over investment outcomes. Can lead to excessive trading or concentrated portfolios.
Mitigation: Seek opinions of others. Keep records of trades to see if successful at controlling investment outcomes.

HINDSIGHT. Overestimate accuracy of their forecasts and take too much risk.
Mitigation: Keep detailed record of all forecasts, including the data analyzed reasoning behind the forecast.

Question 17

4 Cognitive errors… Informations processing.

Answer 17

FAMA

ANCHORING AND ADJUSTMENT.. Stay close to their original forecasts or interpretations.
Mitigation: Give new information thorough consideration to determine its impact on the original forecast or opinion.

MENTAL ACCOUNTING: Portfolios in layered pyramids of assets. ignore correlations. May consider income and capital gains separately.
Mitigation: Look at all investments as a single portfolio.

FRAMING: individuals focus on one piece of information and lose sight of the overall situation or how the information.
Mitigation: Investors should focus on expected returns and risk, rather than on gains or losses.

AVAILABILITY: Four causes are retrievability, categorization, narrow range of experience, and resonance.
Impact: Select investments based on how easily their memories are retrieved and categorized. Narrow range of experience can lead to concentrated portfolios.
Mitigation: Develop an IPS and construct a suitable portfolio through diligent research.

Question 18

Conservatism
vs anchoring
vs status quo

Answer 18

Conservatism. Belief perserverance. Avoiding new info.

Anchoring. Information processing problem.

Status quo. Holding constant portfolio.

Question 19

6 Emotional biases

Answer 19

LOSSER

Loss AVERSION Bias - Myopic loss aversion combines the effects of time horizon and framing.
Impact: Focus on current gains and losses. Continue to hold losers in hopes of breaking even. Sell winners to capture the gains.
Mitigation- Perform a thorough fundamental analysis. Overcome mental anguish of recognizing losses.

OVERCONFIDENCE Bias Impact: Hold under-diversified portfolios; underestimate the downside while overestimating the upside potential. Trade excessively.
Mitigation: Keep detailed records of trades, including the motivation for each trade. Analyze successes and losses relative to the strategy used.

SELF-CONTROL Bias Impact: Lack discipline to balance short-term gratification with long-term goals. Tend to try to make up the shortfall by assuming too much risk.
Mitigation: Maintain complete, clearly defined investment goals and strategies. Budgets help deter the propensity to over-consume.

STATUS QUO Bias Impact: Risk characteristics profitable assets.
Mitigation: Education about risk and return and proper asset. Difficult to mitigate.

ENDOWMENT Bias Impact: Value of owned assets of the portfolio change. Investor loses out on potentially higher than same assets if not owned. Stick with assets because of familiarity and comfort or were inherited.
Mitigation: Determine whether the asset allocation is appropriate.

REGRET AVERSION Bias Impact: Stay in low-risk investments. Portfolio with limited upside potential. Stay in familiar investments or “follow the herd.” Mitigation: Education is primary mitigation tool.

Question 20

Goals-based investing - recognizes/builds

Answer 20

recognizes that individuals are subject to loss aversion and mental accounting. Builds a portfolio in layers, each consisting of assets used to meet individual goals.

Question 21

Behaviorally Modified Asset Allocation - how to deal with biases

Answer 21

Emotional biases can be accomodated, especially for higher wealth relative to lifestyle need.

Congnitive biases must be mitigated/educated, especially for lower wealth vs lifestyle needs more often accommodated through deviations from the rational asset portfolio allocation.

Question 22

BBK 5 FACTOR MODEL

Adventurer…

Answer 22

Confident + Impetuous

Question 23

Bbk 5 factor model

Celebrity…

Answer 23

Impetuous and anxious

Question 24

Bbk 5 factor model | Individualist

Answer 24

Confident and careful

Question 25

Bbk 5 factor model | Guardian

Answer 25

Anxious and careful

Question 26

Bbk 5 factor model | Staight arror

Answer 26

Neither anxiuous nor confident | Neither careful nor impetuous

Question 27

Bbk five factor model

Answer 27

``` Adventurer Guardian Celebrity Individualist Straight arrow - avg investor ```

Question 28

Pompian model 4 types | Passive preserver

Answer 28

Emotional + conservative Biases emotional - Passive Preserver: Endowment, loss aversion, status quo, regret aversion. Biases cognitive - Passive Preserver: Mental accounting, anchoring and adjustment.

Question 29

Pompian 4 type | Friendly Follower

Answer 29

Conservative + conitive Biases emotional: Regret aversion. Biases cognitive: Availability, hindsight, framing.

Question 30

Pompian 4 types | Independent / individualist

Answer 30

Cognitive + aggresive Emotional biases - Overconfidence, self-attribution. Cognitive biases - Conservatism, availability, confirmation, rep resentariveness.

Question 31

Pompian 4 types | Active accumulator

Answer 31

Aggresive + emotional Emotional biases - Overconfidence, self-control. Cognitive biases - Illusion of control.

Question 32

Succes of investor advisor relationship

Answer 32

The adviser UNDERSTANDS the long-term financial GOALS ofthe client. The adviser maintains a CONSISTENT APPROACH with the client. The adviser ACTS as the client EXPECTS. BOTH client and adviser BENEFIT from the relationship.

Question 33

Gamblers phalacy

Answer 33

is thinking that there will be a reversal to the long-term mean more frequently than actually happens

Question 34

Social proof bias is

Answer 34

is when a person follows the beliefs of a group

Question 35

halo effect is

Answer 35

perception of positive qualities in one thing or part GIVES RISE to the perception of SIMILAR qualities in related things or in the whole. Being positive about one thing or the whole, based on positive perceptions about related things or parts.

Question 36

Incorporating behavioral biases into the client's IPS - benefits

Answer 36

Portfolios that are CLOSER to the EFFICIENT frontier. More SATISFIED clients. Clients who are better able to SATY ON TRACK with their long-term strategic plans. BETTER working RELATIONSHIPS between the client and adviser.

Question 37

Analyst can minimize overconfidence by

Answer 37

Get FEEDBACK through self evaluations, colleagues, and superiors, combined with a structure that rewards accuracy, leading to better self-calibration. Develop FORECASTS that are unambiguous and DETAILED, which help to reduce hindsight bias. Provide one CONTRARGUMENT supported by evidence for why their forecast may not be accurate. Consider SAMPLE SIZE and model complexity. Use BAYES' formula.

Question 38

Company mgmt biases

Answer 38

Framing. Anchoring and adjustment. Availability.

Question 39

Disposition effect

Answer 39

Selling winners, holding losers

Question 40

Risk tolerance questionares are more efficient with

Answer 40

Cognitive-biased individuals

Question 41

Self attribution

Answer 41

Blaming others for one's own wrong forecast.

Question 42

Limitations of classifying investors into behavioral types include the following:

Answer 42

.Individuals can display BOTH EMOTIONAL and COGNITIVE errors at the same time. .The same individual may DISPLAY TRAITS OF 2+ behavioral investor type. .As investors AGE, they become more risk averse and emotional toward investing. .Individuals of same behavioral type SHOULD.T necessarily be TREATED the same. .Unpredictably, individuals tend to ACT IRRATATIONALLY AT DIFFERENT TIMES

Question 43

4 BENEFITS for client/adviser relationship from INCORPORATING BEHAVIORAL FINANCE into the relationship:

Answer 43

1 . Behavioral finance helps the adviser UNDERSTAND the reasons for the client's goals. 2. Behavioral finance ADDS STRUCTURE AND PROFESSIONALISM to the relationship. 3. The adviser is BETTER EQUIPED TO MEET the client's expectations. 4. A CLOSER BOND between them results in happier clients and an enhanced practice for the adviser

Question 44

Biases of defined contribution plan beneficiaries

Answer 44

Status quo bias: Investors make no changes to their initial asset allocation. Nai"ve diversification (lin nai've diversification): Employees allocate an equal proportion of their retirements funds to each mutual fund in the plan.

Question 45

Why holding stocks issued by employer

Answer 45

FFF L Ex Familiarity: They underestimate its risk; they become overconfident in their estimate of the company's performance. Nai"ve extrapolation: The company's recent good performance is extrapolated into expected future performance. Framing: If the employer's contribution is in company stock, employees tend to keep it rather than sell it and reallocate. Loyalty: Employees hold company stock in an effort to help the company (e.g., to prevent a takeover by another firm). Financial incentive: Tax incentives or the ability to purchase the stock at a discount lead to holding too much company stock.

Question 46

Using behavioral finace in portfolio construction to handle status quo and high turnover issues...

Answer 46

TARGET FUNDS to overcome STATUS QUO bias. LAYERED PORTFOLIOS to ACCOMODATE PERCEPTIONS of risk and importance of goals to build portfolios the client will STAY WITH.

Question 47

Analysts should be aware of the following when a management report is presented:

Answer 47

Results and accomplishments are usually presented first, giving more importance to that information. Self-attribution bias in the reports. Excessive optimism. Recalculated earnings.

Question 47

biases leading to overconfidence

Answer 47

SHI AIR ``` The illusion of knowledge bias. The self-attribution bias. Representativeness. The availability bias. The illusion of control bias. Hindsight bias. ```

Question 48

Actions the analyst can take to prevent undue influence in management reports:

Answer 48

Focus on verifiable quantitative data. Be certain the information is framed properly. Recognize appropriate base rates so the data is properly calibrated.

Question 49

Analyst biases in research

Answer 49

Usually related to collecting too much information. Leads to illusions of knowledge and control as well as representativeness. Overconfidence. interpreting management reports Inaccurately extrapolate past data into the future. Can suffer from confirmation bias and gambler's fallacy. • • • •

Question 50

Committe biases and solutions

Answer 50

BIASES Committees are typically comprised of people with similar backgrounds; they tend to approach problems in the same manner. Individuals may feel uncomfortable expressing their opinions. SOLUTIONS To overcome these problems, - construct committees with individuals who have diverse backgrounds, are not afraid to express their opinions, and - have respect for the other members of the group.

Question 51

Financial bubbles and crashes

Answer 51

Periods of unusual positive or negative returns caused by panic buying or selling. They can be defined as a period of prices two standard deviations from their historical mean. A crash can also be characterized as a fall in asset prices of 30% or more over a period of several months; bubbles usually take much longer to form. Behavioral biases exhibited during bubbles are overconfidence, confirmation bias, self-attribution bias, hindsight bias, regret aversion, and the disposition effect.

Question 52

Momentum effect

Answer 52

Patterns in returns that are caused by investors following the lead of others; they tend to trade in the same direction, which is referred to as herding.

Question 53

Bbk 5 vs pompian 4

Answer 53

Bbk - careful/impulsive, anxious/confident | Pompian - cognitive/emotional, conservative/aggressive

Question 54

Target fund

Answer 54

A target-date fund – also known as a lifecycle, dynamic-risk or age-based fund – a portfolio whose asset allocation mix becomes more conservative as the target date (usually retirement) approaches