Reading 8: Frame Dependence: The Second Theme －LOS b emotional, illusion, investor, money

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 8: Frame Dependence: The Second Theme
LOS b: Evaluate the impacts that the emotional frames of self-control, regret minimization, and money illusion have on investor behavior.

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If a stock he sells rises in price, Tom Barth feels particularly bad and wishes he had held onto it. Which of the following is the most likely result of his behavior? Barth is most likely to:

A) use dividends and coupon income instead of the sale of stock to fund living expenses.

B) use the sale of stock instead of dividends and coupon income to fund living expenses.

C) invest in value stocks.

D) use modern portfolio theory to limit his losses.

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Answer and Explanation

Barth is most likely to use dividends and coupon income instead of the sale of stock to fund living expenses. He does so because he does not want to experience the potential regret from selling profitable investments. This would be necessary if he were to sell stock instead of using dividends and coupon income to fund living expenses. If Barth has a fear of regret, he will not have a well diversified portfolio because he will want to make comfortable investments. So he would not use modern portfolio theory which states that investors should hold well diversified portfolios.

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After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making?

A) Representativeness.

B) Fear of regret.

C) Overconfidence.

D) Anchoring.

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Answer and Explanation

Shrum refuses to follow a stock after she sells it because she does not want to experience the regret of seeing it rise. The behavioral characteristic used for the basis for her decision making is the fear of regret.

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If a stock she holds falls in price, Ann Marget feels particularly bad and wishes she had sold it. Which of the following is the most likely result of her behavior? Marget is most likely to:

A) have a poorly diversified portfolio.

B) invest in risky stocks.

C) depend on financial publications to guide her investment strategy.

D) invest in tech stocks.

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Answer and Explanation

Marget is likely to have a poorly diversified portfolio because her fear of regret will encourage her to stay in comfortable investments. This could lead to a lack of variety in her portfolio and a poorly diversified portfolio. She will avoid risky stocks and tech stocks because the risk of them could cause her to experience more regret. Her fear of regret would not necessarily cause her to depend on financial publications to guide her investment strategy.

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Tom Roberts loves to read about stocks. He subscribes to the Los Angeles Times, the New York Times, and Smart Money Magazine. He respects the various publications but places more emphasis on Smart Money magazine because it specializes in investment issues. What behavioral characteristic does Roberts have as the basis for his decision making?

A) Representativeness.

B) Frame dependence.

C) Overconfidence.

D) Anchoring.

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Answer and Explanation

Roberts uses frame dependence as the basis for his decision making. He places more weight on the financial publication just because it specializes in investments without evaluating the investment advice on its own merits.

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All of the following actions are consistent with feelings of regret EXCEPT:

A) creating an overly conservative portfolio.

B) holding on to losers too long.

C) hiring a full-service broker.

D) selling losers quickly.

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Answer and Explanation

Investors attempt to avoid regret by holding on to losers hoping the stocks will rebound. If the stock rebounds to its original purchase price, the stock can be sold with no regret. To avoid regret, the investor might select low risk stocks (overly conservative). The investor also might try to avoid regret by distancing themselves from their decisions by hiring a full-service broker.