hinsafdar

Defining investor objectives in terms of mean and standard deviation:

A) can make it difficult to estimate the probability that the objectives will be realized.

B) will increase the complexity of the process for the investment advisor.

C) may make it easier for the investor to make a connection between the investment policy and the investor’s own goals.

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Defining investor objectives in terms of mean and standard deviation can make it difficult to estimate the probability that the objectives will be realized. Therefore, this also often makes it more difficult for the investor to see the connection between policy and their own goals, and may make it more likely that deviations from policy will occur. It also simplifies the process for the investment advisor.

hinsafdar

Jack Melby places his investments into different “mental accounts” with each investment being tied to accomplishing a different goal. All the investments together comprise a pyramid where 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 meet less immediate goals. This behavioral trait is:

A) perceived as being inefficient and the investment adviser should try to persuade the investor to allocate their assets to resemble an allocation based on traditional finance theory.

B) not the most efficient from a traditional finance perspective but acceptable because the portfolio tends to be fairly well diversified and if constructed properly from a behavioral finance perspective will help the client stay on track with their long term investing goals.

C) called “mental accounting” and is not thought to be an acceptable way for investors to allocate their assets.

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Investors exhibit behavioral biases when they construct portfolios in layers, comprising a pyramid with each layer having a specific purpose in achieving a different 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 finance 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.

hinsafdar

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) Overconfidence.

B) Disposition effect.

C) Home bias effect.

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When retail investors trade their brokerage accounts excessively this is thought to be caused by overconfidence 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 effect. There is no evidence in this question that Arturo is exhibiting the disposition effect. Many retail investors also typically display the home bias effect which is the behavioral trait of investors placing a high proportion of their assets in the stocks of firms 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.

hinsafdar

Investor X works for company A and investor Y works for company B. Company A makes a matching contribution into their employees’ retirement funds in cash whereas company B matches with company stock. Which of the following are the most likely behavioral traits exhibited by both employees?

A) Both investor X and Y will purchase company stock in approximately the same proportions so the final allocation of company stock is actually higher in investor Y’s plan.

B) Investor Y will purchase more company stock than investor X.

C) Investor X will purchase more company stock than investor Y with the final proportions being approximately equal in their retirement plans.

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Research has shown that employees who can choose where the employer match is invested allocate a smaller amount of their own funds to their employer’s stock than when the employer match is made with company stock. In other words the employee who is receiving a retirement match in company stock is more likely to purchase more company stock with their own funds than an employee who receives a retirement match in cash. This behavioral bias is a type of framing because the employee may be interpreting the company’s match in company stock as implicit advice regarding the stock.

hinsafdar

Which of the following behavioral biases are most commonly seen in employee retirement plans?

A) Familiarity, overconfidence, and naively extrapolating past returns.

B) Status quo bias and naïve diversification also referred to as 1/n naïve diversification.

C) Framing, loyalty effect, and financial incentives.

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Two biases commonly seen in defined contribution retirement plans are the status quo bias and naïve diversification also known as 1/n naïve diversification. When the employee is subject to status quo bias, he leaves his initial asset allocation as is without adjusting it for changing circumstances, even as he ages and his wealth and risk tolerance change. Naïve diversification, also referred to as 1/n naïve diversification, is allocating an equal proportion of their retirement assets to each fund alternative. The other behavioral biases are commonly seen when an investor purchases their own company’s stock.

hinsafdar

According to behavioral finance, which of the following best describes how investors will invest their retirement portfolio?

A) The investor will put most of their money in the less risky assets on the menu of their employer’s defined contribution plan.

B) The investor will put most of their money in the less risky assets on the menu of their employer’s defined contribution plan unless the employer forces them to put the majority of the funds in the company’s stock.

C) The investor will put an equal dollar amount in each mutual fund on the menu of their employer’s defined contribution plan.

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According to behavioral finance, investors will diversify the portfolio for their defined contribution pension using 1/n diversification. In 1/n diversification, an employee puts an equal amount in each fund on the employer’s defined 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.

hinsafdar

According to behavioral finance, which of the following best represents how investors will diversify a portfolio for their defined contribution pension?

A) Using modern portfolio theory.

B) Using 1/n diversification.

C) According to their employer’s advice.

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Investors will diversify a portfolio for their defined contribution pension using 1/n diversification. If their employer offers ten mutual funds, employees will tend to put one-tenth of their contribution in each mutual fund.

hinsafdar

According to behavioral finance, 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 risky securities.

B) Their portfolios will be over concentrated in risky securities.

C) Their portfolios will be over concentrated in their employer’s stock and domestic securities.

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According to behavioral finance, 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.

hinsafdar

Joseph Brophy and Pamela Carr work in the collections department of Swank's, an upscale department store in downtown Cleveland. Swank's is a publicly traded company with more than 400 locations nationwide, and is also rated by national publications as one of the best places to work. Brophy and Carr like their jobs, and like the company for which they work.
Swank's recently switched from a defined-benefit plan to a defined-contribution plan, and employees with vested pension assets were given lump sums, with the option of investing that money in the new plan. Both Brophy and Carr have worked for Swank's for more than 10 years, and as such receive sizable payments, which they intend to move into the new plan.
On the day enrollment forms arrive at the Cleveland office, Brophy and Carr have lunch together to discuss the new pension plan. The investment packet contains a short newsletter that provides historical performance data on the investment options. Here are the choices:

• An S&P 500 Index fund.
• A large-cap value fund.
• A small-cap value fund.
• A small-cap growth fund.
• A mid-cap blend fund.
• An aggressive-growth stock fund.
• A foreign-stock fund.
• A long-term bond fund.
• A short-term bond fund.
• Swank's stock, available at a 5% discount to market price.

Brophy and Carr know nothing about investing, but the past returns of the funds look pretty high, and Swank's stock has done very well in recent years. Carr, who is 15 years younger than Brophy, likes the returns on some of the stock funds and on Swank's stock. Brophy is five years away from retirement and feels he's too old to learn about financial management. During his discussion with Carr, he remembers an article he read in Forbes years ago. He can recall nothing about the article except that the writer said diversification was a good idea. Carr responds by warning that you have to make bets on a winner if you expect to earn good returns.
Brophy assumes that Swank's wouldn't recommend any funds unless they were good, and in an effort to diversify, puts 10% of his money into each option.
Carr wants to earn the biggest returns possible, so she invests 50% of her money in Swank's stock and split the remaining cash between the small-cap growth fund and the aggressive-growth fund.
Twelve months after the start of the new pension plan, all Swank's employees have the opportunity to change their investment elections. Brophy sees that his portfolio is up roughly in line with the S&P 500 Index, so he leaves his elections intact. Carr notes that Swank's stock has fallen 25%, and the portfolio was roughly flat with year-earlier levels. Grumbling, she changes her allocation so the portion currently in Swank's stock is divided between the available bond funds.
Which of the following least likely reflects Brophy's portfolio decisions?

A) Availability bias.

B) 1/n diversification.

C) Familiarity.

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Brophy's original allocation was a classic example of 1/n diversification, with 10% in each of 10 investments. Brophy's focus on recent results is an example of the availability bias. Familiarity addresses such biases as favoring company stock. That's not an issue for Brophy. (Study Session 3, LOS 9.c)

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Carr's initial investment choices show she avoided falling into which behavioral characteristic?

A) Representativeness.

B) Pyramiding.

C) Overconfidence.

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Carr's investment choices clearly show overconfidence in her ability to predict which investments will do well. Her choices are driven by an emotional desire to make bets and win big thus she is extrapolating favorable past returns into the future referred to as representativeness. However, Carr has one goal, and that's to maximize returns. She is most certainly not creating a portfolio pyramid. (Study Session 3, LOS 8.d)

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Brophy's initial investment choices show he has fallen prey to which of the following traps?

A) Naive diversification.

B) Status quo bias.

C) Familiarity.

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Allocating an equal amount of retirement savings to each investment choice is called naive diversification or 1/n naive diversification. Familiarity and status quo bias do not come into play with Brophy's initial investment decision. (Study Session 3, LOS 9.c)

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Swank's wants to improve its defined-contribution pension plan. Which of the following actions will be least helpful to employees?

A) Allow the employees to change their allocations more than once a year.

B) Provide detailed financial and performance data on the company stock.

C) Increase the number of fund options.

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Companies cannot force employees to invest in their stock, but many strongly encourage such investment. Even if the stock is a good investment, such an emphasis is not always a good idea, as employees may see such information as a strong endorsement for investing in company stock. Increased fund options and more frequent allocations give employees additional flexibility in their investments. (Study Session 3, LOS 9.c)

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Brophy appears to be:

A) frame dependent.

B) loss averse.

C) prone to regret.

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Brophy read an article on diversification in Forbes, then reinforced the ideas based on the newsletter. His frame is diversification, and he does what he thinks is best in purchasing an equal-dollar amount of all 10 choices. There is no evidence that Brophy is particularly loss averse or prone to regret, just inexperienced. (Study Session 3, LOS 8.b)

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Neither Brophy nor Carr made optimal investment decisions. In the wake of the portfolio rebalancing, which of the following statements best reflect the situation of which employee?

Has best-allocated portfolio

Exhibits herding behavior

A) Carr Neither Carr nor Brophy

B) Brophy Neither Carr nor Brophy

C) Carr Brophy

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After the rebalancing, Brophy most likely has more than 80% of his assets in equities, which is almost certainly too much for a working man five years from retirement. Carr, on the other hand, has about 38% of her assets in bonds, which is probably closer to the optimum level for a worker with at least 10 years of experience but who is still about 20 years from retirement. Neither Carr nor Brophy appear to be influenced by anyone else's investment decisions, so neither is exhibiting herding mentality. (Study Session 3, LOS 9.f)

hinsafdar

Steve Perlewitz, a retirement plan specialist for Mercantile Asset Advisors (MAA), is discussing the behavioral characteristics of individual investors in defined contribution retirement plans in an effort to educate MAA’s sales team as they sell MAA’s services. In his presentation, Perlewitz makes the following comments:

Comment 1:	An investor whose decisions are impacted by mental accounting are likely to hold on to losing investments too long, and sell winning investments too soon.
Comment 2:	Since mental accounting tends to guide investors toward more conservative asset classes, the portfolio of an investor impacted by mental accounting will tend to be more conservative than that of an investor who is not, assuming similar return objectives.
Comment 3:	The 1/n diversification methodology used by many DC plan participants is an example of naïve diversification.
Comment 4:	If a defined contribution plan investor has an appropriate 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:

A) Comment 3 only.

B) Comments 1, 2, and 4 only.

C) Comments 2 and 3 only.

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Perlewitz is only correct with respect to Comment 3. With 1/n diversification, where a DC plan participant divides his investment dollars equally across available investment options, diversification is by chance only and is not part of a total portfolio perspective. Such a diversification methodology is reflective of naïve diversification. 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 effects of correlation, thus leading to more risky portfolios than an investor who does consider correlation. Note that the disposition effect refers to holding on to losing investments too long and selling winners too soon. Finally, diversification from an efficient perspective may allocate investments in tax-deferred accounts (like a retirement plan) differently than investments in taxable accounts, while still focusing on the investor’s allocation as a whole.