prashantsahni

Kent Andling is 55 years old and recently sold his high tech manufacturing company, which was started in his father’s basement 35 years ago. Andling’s two children are grown and have been featured in recent entrepreneur magazine articles as up and coming entrepreneurs. How would Andling be classified given this brief profile?

A) Not enough information to tell.

B) Low-to-moderate risk tolerant.

C) Moderate-to-high risk tolerant.

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Although Andling is approaching the latter stage of life, his participation as an entrepreneur of a high-tech manufacturing firm indicates knowledge of risk-taking activities. Apparently, he has brought up his children to understand risk-taking activities, too. These factors indicate a moderate-to-high risk tolerant profile.

prashantsahni

Dan Newsmith is 35 and was recently promoted to regional sales manager of a national trading company. Newsmith has no credit card debt, he does not have an automobile loan, and his home is mortgage free. Newsmith’s salary and bonus more than adequately cover living expenses. Given this brief profile, classify Newsmith’s ability to tolerate risk when investing excess funds.

A) Low-to-moderate risk tolerance.

B) Moderate-to-high risk tolerance.

C) Not enough information to tell.

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Newsmith’s stage of life (young age) and low requirement for current liquidity (no debts, living expenses covered) indicate a situational profile to tolerate moderate-to-high risk.

prashantsahni

In creating an investment policy statement, a portfolio manager needs to be aware that an investor’s psychological profile may impact:

A) neither the investor’s risk tolerance nor their return objective.

B) the investor’s risk tolerance and return objective.

C) the investor’s risk tolerance only.

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Psychological profiling is important for understanding individual investor behavior because defense mechanisms of the brain often cause investors to violate standard finance assumptions (MPT), resulting in irrational decisions. These psychological tendencies can impact client preferences, goals and constraints. When constructing an investment policy statement, these psychological preferences can have a direct impact on a client’s willingness to take risk as well as their desired return.

prashantsahni

Amy Tillman and Josh Northrup are portfolio managers for Parquet Asset Management. Tillman and Northrup are discussing the process their firm uses to identify an individual investor’s objectives and constraints, and ultimately construct an investment policy statement. Tillman makes the following statements to Northrup during the course of their conversation:

Statement 1:	Since investors tend to exhibit irrational, psychological characteristics, the investor should be educated so that these characteristics are put aside and rational expectations can be the sole determinant of the investor’s risk and return objectives.
Statement 2:	Investors that exhibit the characteristic of asset segregation may tend to take on more risk than necessary in their portfolios.

With regard to Tillman’s statements:

Statement 1

Statement 2

A) Correct Incorrect

B) Correct Correct

C) Incorrect Correct

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Psychological/behavioral patterns can have a significant influence on an investor’s decision making process. Statement 1 is incorrect – the role of a portfolio manager is not to eliminate the effect of these psychological patterns on decision making, but to know and understand the investor’s situation, and use these psychological characteristics when discussing risk and return objectives with the client. The client may need education, but the psychological characteristics a client has should be a key consideration when setting risk and return objectives. Statement 2 is correct. Asset segregation refers to focusing on individual assets instead of evaluating the asset’s impact on the portfolio. Asset segregation tends to lead to the investor taking on more risk than is necessary in their portfolio – the investor may dismiss a particular asset because “it is too risky” however, in a portfolio context, the asset would actually reduce the risk of the portfolio as a whole.

prashantsahni

When investors choose riskier investments over less risky choices in the domain of losses, they exhibit which of the following characteristics?

A) Risk aversion.

B) Asset segregation.

C) Loss aversion.

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When investors chose larger uncertain losses over smaller losses that are certain, they exhibit loss averse behavior.

kim226

Focusing on asset-by-asset characteristics is an example of asset:

A) assimilation.

B) integration.

C) segregation.

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Asset segregation occurs when investors focus on asset-by-asset characteristics rather than how assets fit into an overall portfolio.

kim226

Behavioral finance indicates investors do NOT exhibit which of the following?

A) Biased expectations.

B) Asset integration.

C) Asset segregation.

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Behavioral investors exhibit biased expectations and asset segregation, as well as loss aversion. Rational investors exhibit asset integrations.

kim226

The concept of behavioral finance has begun to be employed in investment management. Which of the following statements is CORRECT regarding behavioral finance and its potential affect on a client’s risk objectives? Behavioral finance implies that investors are:

A) loss averse, rather than risk averse, and this may have an impact upon the investors' willingness to take risk.

B) risk averse, rather than loss averse, and this may have an impact upon the investors' willingness to take risk.

C) loss averse, rather than risk averse, and this may have an impact upon the investors' ability to take risk.

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Behavioral finance suggests that investors may view risk of loss differently from risk of gain (i.e., that they are more risk seeking in the domain of losses). This is known as being loss averse. The investor’s psychological profile can affect their willingness to take risk. However, the ability to take risk is a more objective measure of what is appropriate given the client’s situation.

kim226

Which of the following sets of assumptions is most relevant to the behavioral finance investment framework? Investors are:

A) loss averse, investors exhibit biased expectations, investors construct portfolios via asset segregation.

B) risk averse, investors demonstrate rational expectations with respect to investment choices, investors construct portfolios consistent with asset integration.

C) risk averse, investors exhibit biased expectations, investors construct portfolios via asset segregation.

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Behavioral finance assumes that:

• investors are loss averse, which means they prefer uncertain losses to certain losses.
• investors exhibit biased expectations, due to overconfidence in their ability to forecast the future.
• investors construct portfolios via asset segregation, meaning that they tend to focus on an asset’s individual investment features versus its impact on the overall portfolio position.

kim226

Which of the following statements about behavioral finance is CORRECT?

A) Investors are more concerned with portfolio construction versus individual assets' characteristics.

B) Behavioral finance assumes investors exhibit character traits different than those stipulated by traditional finance.

C) Investors realize their lack of experience in forecasting.

The three major characteristics exhibited by traditional finance are risk aversion, rational expectations, and portfolio diversification. Behavioral finance assumes investors exhibit three other major characteristics which are loss aversion, biased expectations, and they construct portfolios via asset segregation. Most individual investors overestimate their ability to forecast the future.