Behavioral Finance - Reading 8: Frame Dependence: The Seco

Michael, managing, making, assets, partner

Q1. Dr. Michael Minter keeps most of his money in index funds. Concerned that he is not making wise use of his assets, he consults Dorothy Klemm, managing partner of Klemm, Wise & Lowry Investments.

In his initial consultation with Klemm, Minter explains that in the past he actively managed his portfolio, buying individual stocks based on his own research and material he read in Forbes and The Wall Street Journal.

"I focused on stocks with solid histories of sales and profit growth because those companies were likely to continue growing."
"A number of stories by the financial columnist in my local newspaper sounded interesting, but the writers at The Journal and Forbes know more about investing."
"A lot of the stocks I selected underperformed the market over long periods of time. I made money, but I never managed to sell when they were ahead of the market."
"Now I have about 40% of my portfolio in bond-index funds and the rest in stock-index funds.

Klemm asks Minter about his investment goals, and the doctor replies that he has managed to build up sufficient capital to invest in a friend's computer business in about three years, and keeps that money in bonds to protect the principal. The rest of Minter's money is earmarked for building a retirement nest egg.

When questioned about his fund holdings, Minter explains that his negative experience with stock selection drove him to stress diversification. He owns a variety of stock index funds, including small-cap, mid-cap, large-cap, and broad-market funds as well as foreign funds and sector index funds. His bond funds include indexes for long-term corporates, intermediate-term corporates, long-term Treasuries, intermediate-term Treasuries, short-term Treasuries, municipals, high-yield bonds, and foreign bonds.

After her meeting with Minter, Klemm writes the doctor a letter in which she makes the following statements:

"You may be able to increase your returns without adding too much risk by reducing the number of bond funds you hold."
"Your overconfidence cost you money in the past. Regrets about that past overconfidence are costing you money now."
"I think you should reduce your exposure to equities. Your current portfolio is too risky."
"Your investment strategy was sound, but you probably just picked the wrong stocks. I use a similar strategy, and I can help you boost returns by selecting individual stocks for you."

Klemm goes on to warn Minter about trying to manage his own investments. She has been bullish on the market for several years because she thinks stocks are undervalued. Recent news about the labor markets and consumer confidence has been negative, but she still sees many good values in the market.

From her discussion with Dr. Minter, Klemm will least likely conclude that Minter is:

A) a beta grazer.

B) a victim of representativeness.

C) loss averse.

Q2. Klemm's reaction to negative economic news represents which of the following defense mechanisms?

A) The "single predictor" defense.

B) The "ceteris-paribus" defense.

C) The "it didn't happen yet" defense.

Q3. Based only on the information presented above, which of Klemm's suggestions makes the least sense?

A) "Your investment strategy was sound, but you probably just picked the wrong stocks. I use a similar strategy, and I can help you boost returns by selecting individual stocks for you."

B) "You may be able to increase your returns without adding too much risk by reducing the number of bond funds you hold."

C) "I think you should reduce your exposure to equities. Your current portfolio is too risky."

Q4. Klemm's forecast is least likely to reflect:

A) selective recall.

B) anchoring.

C) risk-seeking behavior.

Q5. Minter's current investment strategy is an example of:

A) overconfidence.

B) a response to a bad forecast.

C) pyramiding.