Reading 10: Portfolios, Pyramids, Emotions, and Biases －LO impact, regarding

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 10: Portfolios, Pyramids, Emotions, and Biases
LOS d: Evaluate the impact of excessive optimism and overconfidence on investors' decisions regarding portfolio construction.

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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 a resampled frontier.

C) According to their employers advice.

D) Using 1/n diversification.

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Answer and Explanation

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.

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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 employers defined contribution plan.

B) The investor will put an equal dollar amount in each mutual fund on the menu of their employers defined contribution plan.

C) The investor will put most of their money in the more risky assets on the menu of their employers defined contribution plan.

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

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Answer and Explanation

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 employers 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.

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According to behavioral finance, which of the following best describes the components of investors portfolios?

A) Their portfolios will be over concentrated in their employers stock and risky securities.

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

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

D) Their portfolios will be over concentrated in their employers stock and domestic securities.

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Answer and Explanation

According to behavioral finance, individuals invest in securities they are familiar with. They are over concentrated in their employers stock and in domestic securities. Their portfolios will exhibit a home bias, with few international assets.

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Jack McCauley has been working as a successful electrical engineer for ten years. He is now considering a career move in which he would move to management because he thinks he would be successful at that as well. According to behavioral finance, which of the following would most likely characterize McCauleys evaluation of his skills as an investor? Jack will most likely use a:

A) bottoms-up approach.

B) holistic approach.

C) cognitive approach.

D) top-down approach.

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Answer and Explanation

McCauley assumes that because he is successful as an engineer, he would be successful in management. He is using a top-down approach to evaluate his skills and assumes that his success in one area will carry over into other activities he attempts.

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Which of the following best represents the behavioral finance discussion of overconfidence in individual investors?

A) Investors will often fail to recognize their own incompetence but can correct their poor decision making with the help of others.

B) Investors will often fail to recognize their own incompetence but can correct their poor decision making through adaptive processing.

C) Investors will often fail to recognize their own incompetence and they will also fail to correct their poor decision making process.

D) Overconfident investors who underperform will be exploited by more skilled investors and will exit the market.

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Answer and Explanation

According to behavioral finance, overconfident individual investors will fail to correct their poor decision making process. Their inability to make correct decisions also means that they lack the ability to recognize their own incompetence.

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According to behavioral finance, overconfident individual investors:

A) cannot detect their own underperformance and generalize when thinking about their abilities.

B) cannot detect their own underperformance and think in specific terms about their abilities.

C) gradually learn about their underperformance and turn their portfolios over to professionals.

D) gradually learn about their underperformance and adapt a cognitive approach.

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Answer and Explanation

According to behavioral finance, overconfident individual investors cannot detect their own underperformance and generalize when thinking about their abilities. They believe that because they have been successful in one area of their life then they should be successful in investing as well.

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