hinsafdar

Typical individual investors tend not to understand the effects of correlation on their portfolio. Which of the following characteristics of a DC plan participant’s portfolio best reflects the attempt to derive benefits from the effects of correlation even though the participant does not understand those effects?

A) 1/n diversification heuristics.

B) Familiarity.

C) Status quo bias.

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Feeling that they should spread out their risk, but not knowing how leads to the 1/n diversification heuristic. Often times, participants will only have a rough understanding of the effects of correlation and diversification and will simply divide their assets equally over the investment options in the plan in an attempt diversify their portfolio.

hinsafdar

Leonard Busch is a employee of Matrix Technologies, and a participant in the Matrix Technologies defined contribution plan. The assets in the plan are the only investments he 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?

A) Status quo bias.

B) Familiarity.

C) 1/n diversification heuristics.

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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 offered as an investment option in a defined contribution plan, participants may feel a sense of control or allegiance to the firm and hold more company stock than is sensible, which is an effect of familiarity. Note that Busch’s assets are not equally divided among investment options, which means the 1/n diversification heuristic would not seem to apply. Status quo bias is clearly not the best answer given the weight in company stock.

hinsafdar

Many defined contribution plan participants tend to hold a large amount of assets in company stock relative to other asset classes. Which of the following characteristics of a DC plan participant’s portfolio best reflects the reason behind this tendency?

A) Familiarity.

B) Status quo bias.

C) Naive diversification.

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DC participants tend to hold excess stock of the company they work for due to familiarity which is the tendency for individuals to invest in where they are most comfortable or familiar which could be the company they work for. Naive diversification is allocating an equal amount of retirement savings to each investment option. Note that the status quo bias refers to a lack of action on the part of the participant.

hinsafdar

Kelly Lieb and Don Carsner are discussing their investments in the Shrader Tire 401(k) defined contribution plan. Lieb and Carsner make the following statements in their conversation:

Lieb:	"Most of the money I have invested in our 410(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.
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."

Which of the following factors behind holding company stock best reflects Lieb’s comment and Carsner’s comment respectively?

Lieb's Comment

Carsner's Comment

A) Familiarity bias Familiarity bias

B) Framing Familiarity bias

C) Framing Framing

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Even without direct encouragement by the plan sponsor, employees tend to invest more in their company’s stock that would be warranted from a diversification standpoint. Lieb’s and Carsner’s comments are reflective of the two primary factors that contribute to DC plan participants holding company stock: framing and familiarity bias. Lieb’s comment reflects 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 reflective of familiarity bias, which refers to investors selecting stocks with which they are comfortable with or have a proximity to. If company stock is offered as an investment option in a defined contribution plan, participants may feel a sense of control or allegiance to the firm and hold more company stock than is sensible, which is an effect of familiarity.

hinsafdar

An investor selling winning securities too soon and holding losing positions too long is an example of:

A) the disposition effect.

B) representativeness.

C) overconfidence.

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This is the definition of the disposition effect.

hinsafdar

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.

B) The analyst finds evidence that confirms their forecast.

C) The analyst inappropriately tries to apply a probability to a random event.

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Biases specific 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 overconfidence. Two other common biases found in analysts’ research are the confirmation bias and the gambler’s fallacy.
The confirmation bias (related to confirming evidence) relates to the tendency to view new information as confirmation of an original forecast.
The gambler’s fallacy, in investing terms, is thinking that there will be a reversal to the long-term 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 firm as a growth firm based solely on previous high growth without considering other variables affecting the firm’s future.

prashantsahni

Which of the following statements best reflects the relationship between company management presenting reports in a favorable light and analysts’ forecasts?

A) The way company management presents reports generally influences analysts because they are also susceptible to behavioral biases.

B) Analysts can be unduly influenced by the way management presents and frames company reports thus analysts should be aware of the various biases management can be susceptible to.

C) The way company management presents reports influences analysts but they possess the skills to be able to mitigate the influence by company management.

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The way a company’s management presents (frames) information can influence 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 differently depending on how it is presented. In the case of company information, analysts should be aware that a typical management report presents accomplishments first.
Anchoring and adjustment refers to being “anchored” to a previous data point. The way the information is framed (presenting the company’s accomplishments first), combined with anchoring (being overly influenced by the first 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.
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 influenced the operating results leading to excessive optimism (overconfidence).
To help avoid the undue influence in management reports, analysts should focus on quantitative data that is verifiable 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.

prashantsahni

Which of the following is least likely a way to reduce overconfidence in analyst forecasts?

A) The analyst should seek a contrary opinion to their forecast based on evidence along with using a large enough sample size and Bayes’ formula.

B) The analyst is properly self-calibrated through feedback from colleagues and superiors along with a structure that rewards accuracy and forecasts that are unambiguous and detailed.

C) Gather a large amount of data from which to develop a forecast.

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Collecting a large amount of data can lead to overconfidence 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.
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.
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 confidence in unreliable models. Lastly, Bayes’ formula is a useful tool for reducing behavioral biases when incorporating new information.

prashantsahni

Analyst M routinely adjusts his previously vague forecasts to fit new information that has just been made available making his forecast look better than it actually was. Analyst Q judges the probability of her forecast being correct on how well the available data fits the outcome. Which of the following behavioral biases are M and Q displaying? M is displaying:

A) illusion of knowledge and Q is displaying availability bias.

B) hindsight bias and Q is displaying representativeness.

C) illusion of knowledge and Q is displaying availability bias.

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Hindsight bias is when the analyst selectively recalls details of the forecast or reshapes it in such a way that it fits the outcome.
In representativeness, an analyst judges the probability of a forecast being correct on how well the available data represent (i.e., fit) the outcome. The analyst incorrectly combines two probabilities: (1) the probability that the information fits a certain information category, and (2) the probability that the category of information fits the conclusion.
Illusion of knowledge is 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. The illusion of knowledge is fueled when analysts collect a large amount of data.
The illusion of control bias can lead analysts to feel they have all available data and have reduced or eliminated all risk in the forecasting model; hence, the link to overconfidence.
The availability bias is when the analyst gives undue weight to more recent, readily recalled data. Being able to quickly recall information makes the analyst more likely to “fit” it with new information and conclusions.
In self-attribution bias analysts take credit for their successes and blame others or external factors for failures. Self-attribution bias is an ego defense mechanism, because analysts use it to avoid the cognitive dissonance associated with having to admit making a mistake.

prashantsahni

Terry Shiver and Mary Trickett are portfolio managers for High End Investment Managers. High End provides investment advice to wealthy individuals. As part of their annual review of their client portfolios, they review the appropriateness of their client portfolios given their clients’ return objective, risk tolerance, time horizon, liquidity constraints, tax situation, regulatory 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 five 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 2 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 firm, I just don’t have the time.”
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 off quarters. I need to get back that one-third of my portfolio’s value because I am only fifteen years away from retirement and I don’t have a defined-benefit 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 firms that share my concern for the environment. My latest investment was in Washington Materials. Washington was recently featured in an environmental magazine for their outstanding dedication to environmental protection. The CEO of Washington was also featured on the cover of Fortune magazine. He has turned the firm around in the three years he has been there. The firm was near bankruptcy, but now Washington is the leader in its niche market, which is waterproof fabric for outdoor clothing and equipment.” Which of the following best describes Tom Heggins’s behavioral characteristic in investment decisions?

A) Tom uses frame dependence.

B) Tom is overconfident.

C) Tom uses anchoring.

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Tom is overconfident. Tom believes that on the basis of his five-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 3, LOS 9.d)

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Which of the following best describes the potential problem with Heggins’s investment strategy in regards to certainty overconfidence?

A) He will underestimate the risk of his portfolio and overestimate the probability of success.

B) He will underestimate the risk of his portfolio and set too narrow of confidence intervals.

C) He will overestimate the risk of his portfolio and overestimate the impact of an event on stocks.

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As an investor exhibiting certainty overconfidence, Heggins will tend to underestimate risk and will also tend to overestimate the probability of success. Prediction overconfidence is when too narrow of confidence intervals are assigned to possible outcomes. (Study Session 3, LOS 8.b)

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Which of the following most likely explains Tom Heggins’s behavior in investment decisions?

A) Tom uses anchoring to assess his skills.

B) Tom is suffering from an illusion of knowledge in assessing his skills.

C) Tom uses the ceteris-paribus heuristic to assess his skills.

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Tom is suffering from an illusion of knowledge leading to overconfidence. Overconfident 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 3, LOS 9.d)

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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 influences her investment decisions.

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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. (Study Session 3, LOS 8.d)

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Which of the following best describes Jack Sims’s behavioral characteristic in investment decisions?

A) Jack is overconfident.

B) Jack uses frame dependence.

C) Jack uses representativeness.

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Jack uses an if-then heuristic called representativeness to make investment decisions. He believes that just because a firm’s environmental policy and CEO are good, then the firm’s stock will be a good investment. He ignores the fact that the stock might be overvalued. (Study Session 3, LOS 8.b, c)

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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.

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These investors would be least likely to use fundamental analysis of financial 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 scientific analysis. (Study Session 3, LOS 9.a)