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.

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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.

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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)

prashantsahni

Bobby Steele, a software engineer at a local firm, has been investing for the past two years and has been very successful. He shuns professional investment advice and in fact provides advice to his neighbors and friends. He states that his investment philosophy consistently outperforms the experts. Which of the following best describes the implications of Steele’s investment style?

A) Steele is likely to have low turnover in his portfolio and is likely to make unjustified bets.

B) Steele is likely to have low turnover in his portfolio and is likely to base stock valuation on fundamental analysis.

C) Steele is likely to have high turnover in his portfolio and is likely to make unjustified bets.

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Steele is an overconfident investor. As a result, he will have high turnover in his portfolio because he will believe that he can accurately forecast the future performance of stocks. He will also make bets that are unjustified because he does not understand that he does not possess all the information necessary to form unbiased projections.

prashantsahni

Which of the following best characterizes overconfidence in expert forecasters, according to behavioral finance? Expert forecasters are overconfident in their forecasting ability because:

A) they have access to information others do not.

B) of the positive reinforcement they receive from the media.

C) they feel their knowledge allows them to make more accurate forecasts.

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According to behavioral finance, expert forecasters are overconfident in their forecasting ability because they feel their knowledge allows them to make more accurate forecasts. Because they believe their forecasts are based on skill, they blame some external factor when the forecasts turn out incorrect. Although the other responses may have some real world validity, they are not given as a reason for overconfidence, according to behavioral finance.

prashantsahni

According to behavioral finance, analysts often make excuses for their inaccurate predictions. Which of the following best represents the problem with this occurrence, from a behavioral finance view?

A) The excuses will prevent analysts from recognizing their own limitations.

B) The excuses allow poor forecasters to stay in their positions when they should be replaced.

C) Other investors depend on these forecasts, resulting in aggregate investment losses.

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According to behavioral finance, analysts often make excuses for their inaccurate predictions. The excuses will prevent them from recognizing their own limitations and allow them to continue to make inaccurate forecasts. Although there is an element of truth in the other responses, they are not the central problem in this case, according to behavioral finance.

prashantsahni

Mike McLaughlin is an economist who makes quarterly forecasts for the state of the economy and interest rates. Last quarter, the economy did not grow as fast as McLaughlin predicted. McLaughlin explains that his forecast was inaccurate by stating “This change in the economy was due to a real estate market that slowed faster than many forecasters, including myself, expected. If it weren’t for the real estate market, my projection for GDP would have been accurate.” Which of the following is the best interpretation of McLaughlin’s statement, from a behavioral finance view? McLaughlin is using:

A) an “if-only” defense for his inaccurate forecasts and his recognition of it will sharpen his abilities.

B) a self attribution defense for his inaccurate forecasts and this will prevent him from accurately evaluating his own abilities.

C) hindsight bias as a defense for his inaccurate forecasts and this will prevent him from accurately evaluating his own abilities.

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McLaughlin is using a self-attribution bias which is an ego defense mechanism where analysts take credit for their successes and blame others or external factors for their failures. According to behavioral finance, analysts will use excuses to justify their inaccurate forecasts. These excuses will prevent them from accurately evaluating their own abilities. As a result, they will persist in making the same mistakes. Hindsight bias is when the analyst selectively recalls details of the forecast and reshapes it in such a way that it fits the outcome.

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Heather Jones graduated from a prestigious Ivy League college in May, recently passed Level I of the CFA exam, and just landed her first professional job as a junior portfolio manager working with CFA charterholders for the Fortress mutual fund company. She works in a group setting comprised of a lead portfolio manager and one or more co- or junior portfolio managers who together make the investment management decisions for a single mutual fund. Jones has observed the following behavior during the committee meetings where the portfolio managers discuss which investments should be a part of the portfolio: analyst A always sides with and follows the lead of analyst B, analyst C tends to have a different opinion from the group view but fears being ostracized therefore he rarely voices his opinion, manager D is very aggressive and shoots down the opinions of others if they contradict his own and also likes to argue with people. Jones is starting to wonder whether or not she made the right decision by taking the job and has had several thoughts about the behavior at the meetings. Which of the following of her thoughts is least reflective of how financial decisions are typically made in a group setting?

A) “These people are displaying irrational behavior which is typical of group settings!”

B) “Decisions made at this level are made by professionals with similar backgrounds, the committee should be functioning in a more efficient and effective manner with little discord among the members!”

C) “Their individual behavioral biases have become exacerbated in the group setting!”

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In a group setting individual biases can be either diminished or amplified with additional biases being created. Research has shown that the investment decision making process in a group setting is notoriously poor. Committees do not learn from past experience because feedback from decisions is generally inaccurate and slow, so systematic biases are not identified.
The typical makeup of a committee coupled with group dynamics leads to the problems normally seen with committees typically comprised of people with similar backgrounds thus they approach problems in the same manner leading the group to start thinking as a single individual, individuals can sometimes follow the beliefs of a group, and some individuals may feel uncomfortable expressing their opinion if it differs with others or a powerful member of the group.

prashantsahni

Which of the following statements most accurately describes social proof bias? Social proof bias is when:

A) the individuals in a group start thinking and acting as if they are a single individual.

B) an individual in a group setting is perceived by the group as being socially adept and thus a functional member of the group.

C) an individual follows the beliefs of a group.

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Social proof bias is when individuals tend to follow the beliefs of a group. Group think is when the group setting is very amiable thus leading to little or no conflicting discussions resulting in the group making decisions as if the group was a single individual.