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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.

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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.

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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.

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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.

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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.

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Which of the following best exemplifies the structure of a committee that effectively makes decisions?

A) The committee members get along well and there is little animosity or in-fighting between the committee members.

B) The committee members are encouraged to speak out so different opinions are heard.

C) The committee is comprised of individuals from different backgrounds and where the committee chair encourages people to voice their opinions even if it is contrary to the group’s view.

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Effectively functioning groups would have the following features:

• Be comprised of individuals with diverse backgrounds.
• Have members who are not afraid to express their opinions even if it differs from others.
• Have a committee chair that encourages members to speak out even if the member’s views are contrary to the group’s views.
• A mutual respect for all members of the group.

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Which of the following would least likely be viewed as rational behavior during a market bubble?

A) Investors believe the price of a stock will continue to go up therefore they buy more.

B) The investor knows she is in a bubble but she doesn’t know where the peak is.

C) A real estate portfolio manager has no suitable alternative investments to switch to.

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Financial bubbles and subsequent crashes are periods of unusual positive or negative returns caused by panic buying and selling, neither of which is based on economic fundamentals. The buying (selling) is driven by investors believing the price of the asset will continue to go up (down).
In bubbles, investors sometimes exhibit rational behavior—they know they are in a bubble but don’t know where the peak of the bubble is. Or, there are no suitable alternative investments to get into, making it difficult to get out of the current investment. For investment managers, there could be performance or career incentives encouraging them to stay invested in the inflated asset class.

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When an investor extrapolates past data from a small sample size into a forecast this is most likely indicative of:

A) fear of regret.

B) the recency bias.

C) hindsight bias.

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Herding is when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available to them. Two behavioral biases associated with herding are the availability bias (a.k.a. the recency bias or recency effect) and fear of regret. In the availability bias, recent information is given more importance because it is most vividly remembered. It is also referred to as the availability bias because it is based on data that are readily available, including small data samples or data that do not provide a complete picture. In the context of herding, the recent data or trend is extrapolated by investors into a forecast.
Regret is the feeling that an opportunity has passed by and is a hindsight bias. The investor looks back thinking they should have bought or sold a particular investment (note that in the availability bias, the investor most easily recalls the recent positive performance). Regret can lead investors to buy investments they wish they had purchased, which in turn fuels a trend-chasing effect. Chasing trends can lead to excessive trading, which in turn creates short-term trends.

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Which of the following would least likely be considered a market anomaly?

A) Underperformance of stocks with relatively high PE ratios or low book-to-market values.

B) The stock market continues to climb as investors are trading according to economic expectations.

C) Bubbles and crashes.

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Typically, in a bubble, the initial behavior is thought to be rational as investors trade according to economic changes or expectations. Later, investors start to doubt the fundamental value of the underlying asset, at which point the behavior becomes irrational.
Two anomalies discussed by Fama and French are associated with value and growth stocks. Value stocks have low price-to-earnings ratios, high book-to-market values, and low price-to-dividend ratios, with growth stocks having the opposite characteristics of high PE ratios, low book-to-market values, and high price to dividend ratios.
Financial bubbles and subsequent crashes are periods of unusual positive or negative returns caused by panic buying and selling, neither of which is based on economic fundamentals. The buying (selling) is driven by investors believing the price of the asset will continue to go up (down). A bubble or crash is defined as an extended period of prices that are two standard deviations from the mean. A crash can also be characterized as a fall in asset prices of 30% or more over a period of several months, whereas bubbles usually take much longer to form.