2019 CFA level 3 qbank reading 8 the behavioral biases of individuals answers

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Question #1 of 21
Which of the following would be considered emotional biases?

A) Status quo and endowment biases.
B) Con rmation, control, and availability biases.
C) Anchoring and adjustment bias.
Explanation

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Status quo and endowment biases are emotional biases whereas the other biases fall under
the category of cognitive errors.

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(Study Session 4, Module 8.1, LOS 8.b)
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Question #2 of 21

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Which of the following statements best describes the availability bias? An investor:

A) associates new information with an easily recalled past event.

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B) bases a decision on how the information is presented.

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C) only notices information that agrees with their perceptions or beliefs.
Explanation

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In the availability bias individuals estimate future probabilities by how easily they recall a
past event. An easily recalled event is more quickly associated with ( t to) new information.
The problem is worsened by the fact that individuals' memories can be incomplete or biased.
The con rmation bias is when individuals tend to notice only information that agrees with
their perceptions or beliefs. They look for con rming evidence while discounting or even
ignoring evidence that contradicts their beliefs or their perceptions. In the framing bias
individuals view information di erently depending on the way it is presented and received.
(Study Session 4, Module 8.1, LOS 8.c)
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Question #3 of 21
Which of the following most closely de nes base rate neglect?

A) Found in conservatism bias where the investor places too little weight on new
information.
B) A type of representativeness bias in which the probability of the categorization is
not adequately considered.
C) When the investor considers the long run average of data and how new information
relates to the past data.

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Explanation

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When the investor exhibits base rate neglect, he does not (neglects to) consider the
probability that the information does not t the category into which it has been placed and

places too little weight on the base rate. Conservatism can also be explained in terms of
Bayesian statistics where the investor forms probabilities or base rates. With the receipt of
new information, the rational investor updates those probabilities to re ect the new
information. When the analyst is subject to conservatism, however, he places too much
weight on the base rates (prior probabilities) and too little on the new information.
(Study Session 4, Module 8.1, LOS 8.d)
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Question #4 of 21

Which of the following would be considered biases due to cognitive errors?

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A) Loss aversion, self-control, and regret-aversion biases.
B) Representativeness, mental accounting, and overcon dence biases.
C) Conservatism, hindsight, and framing biases.
Explanation
Loss aversion, self-control, regret-aversion, and overcon dence are all emotional biases. The
other biases would fall under the category of cognitive errors.
(Study Session 4, Module 8.1, LOS 8.b)

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Question #5 of 21
Which of the following cognitive errors would be due to belief persistence?

A) Control, con rmation, and conservation biases.
B) Conservatism, representativeness, and hindsight biases.
C) Mental accounting, framing, and availability biases.
Explanation

(Study Session 4, Module 8.1, LOS 8.b)
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Question #6 of 21

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Mental accounting, framing, and availability biases are information processing biases
whereas conservatism, representativeness, and hindsight biases are belief persistence
biases. The conservation bias is made up.

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What kind of behavioral bias is an investor most likely displaying when they tend to hold on to

forecast?

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A) Hindsight bias.

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their earlier beliefs and fail to fully incorporate new information about a stock into their

B) Conservatism bias.

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C) Anchoring and adjustment bias.
Explanation

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In the conservatism bias individuals unconsciously place more emphasis on the information
they used to form their original forecast than on new information. They have di cultly
pulling away from an original forecast as they subconsciously place less value on new
information. In anchoring and adjustment individuals are anchored to a value, such as an
expected price or other forecast, as if it has a gravitational pull. Unlike the conservatism bias
that has similar e ects but is based on how investors relate "new" information to "old"
information, anchoring is based on a target number; once individuals have these targets in
their minds, they seem to be unduly a ected by them. Hindsight bias is when individuals
perceive outcomes as reasonable and expected. It's like saying, "This is what happened, and
this is why it happened." Their explanation is biased by the fact that the outcome actually did
occur; their explanation is not a prediction, so it's di cult to argue with.
(Study Session 4, Module 8.1, LOS 8.c)
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Question #7 of 21

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Which of the following cognitive errors would be due to information processing?

A) Status quo, endowment, and regret-aversion biases.
B) Anchoring and adjustment bias.

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C) Loss aversion, overcon dence, and self-control biases.

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Explanation

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Anchoring and adjustment is a cognitive information processing bias whereas all the other
biases listed are emotional biases.
(Study Session 4, Module 8.1, LOS 8.b)

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Question #8 of 21
Which of the following statements would most likely be classi ed as a cognitive error? The
investor:

A) has a tendency to place information into categories.
B) tends to take more risk rather than sell a stock at a loss.
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C) acts defensively when asked why he made a poor investment decision.
Explanation
This describes the cognitive error of "representativeness bias" where investors classify
information into the most appropriate subjective category based on "if-then" heuristics. The
other two answer choices describe "loss aversion" and "regret aversion."
(Study Session 4, Module 8.1, LOS 8.a)
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Question #9 of 21

An investor is averse to experiencing losses. Which of the following behaviors will result from
the loss aversion? It will lead to:

B) risk-seeking behavior.
C) the buying of loser stocks.
Explanation

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A) risk-aversion behavior.

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If an investor is loss averse, they may become risk-seeking in order to make up their losses
quickly. They would do so by investing in more risky assets that have a chance of high returns
that would cover the losses.

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(Study Session 4, Module 8.2, LOS 8.d)
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Question #10 of 21
Which of the following best describes myopic loss aversion and a way to address its a ect?

A) The investor focuses too much on long term strategic asset allocation without
considering tactical asset allocation. The remedy is to periodically review and adjust
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B) The investor becomes too focused on short term pro ts without keeping the long
term strategic asset allocation in mind. The remedy is to create an IPS that
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C) Investors tend to focus too much on the short term and view investments
separately instead of in a portfolio context. A remedy is to perform fundamental
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Explanation

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(Study Session 4, Module 8.2, LOS 8.d)

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Myopic loss aversion combines the e ects of time horizon and framing. First, investors tend
to focus on the short run; thus, they are more likely to estimate risk using recent
performance. Next, investors tend to segment (frame) di erent investments and look at their
risk characteristics separately. Thus, they tend to view stocks and bonds, for instance, from a
standalone perspective rather than combined in a portfolio. Rather than base buy/sell
decisions on fundamentals (unbiased expectations), investors focus on current gains and
losses. They might continue to hold a loser, for example, in hopes of at least breaking even
rather than have to accept the loss. They also tend to sell winners to capture the gain and
avoid the potential of loss (reduce perceived risk). Selling winners, without considering what
the fundamentals indicate, tends to increase portfolio turnover at the same time that it limits
the growth of the portfolio. To avoid loss aversion the investor should perform a thorough
fundamental analysis in an attempt to base investment decisions on expectations rather than
past performance.

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Question #11 of 21

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

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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) Framing.
B) Representativeness.
C) Anchoring.
Explanation
Roberts uses framing as the basis for his decision making. He places more weight on the
nancial publication just because it specializes in investments without evaluating the
investment advice on its own merits.
(Study Session 4, Module 8.1, LOS 8.b)
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Question #12 of 21
Bu alo Manufacturing has just announced earnings that are 3% higher than analysts' forecasts.
Panda Technologies has just announced earnings that are 4% less than analysts' forecasts.
According to the representative heuristic description of investor behavior, what is the most

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likely future performance of each stock as they revert to their intrinsic values?

A) Bu alo Manufacturing stock will underperform in the future while Panda

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Technologies stock will outperform in the future.

B) Both Bu alo Manufacturing stock and Panda Technologies stock will outperform in
the future.

C) Bu alo Manufacturing stock will outperform in the future while Panda Technologies

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stock will underperform in the future.
Explanation

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Bu alo Manufacturing stock will underperform in the future because investors will think that
the good earnings announcement "represents" good future performance for the stock and
bid the price too high. The Bu alo Manufacturing stock will become overpriced and its future
performance will be weak as a result. Similarly, investors will think that the bad Panda
Technologies earnings announcement "represents" poor future performance for the stock
and force the price too low. As a result, Panda Technologies stock will become underpriced
and its future performance will be strong.
(Study Session 4, Module 8.1, LOS 8.b)

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Question #13 of 21
Jill Davis tells her broker that she does not want to sell her stocks that are below the price she

paid for them. She believes that if she just holds on to them a little longer they will recover, at
which time she will sell them. What behavioral characteristic does Davis have as the basis for
her decision making?

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A) Conservatism.
B) Representativeness.
C) Loss aversion.
Explanation
Davis uses loss aversion as the basis for her decision making. She holds on to stocks that are
down from the purchase price in the hopes that they will recover. She is reluctant to accept a
loss.
(Study Session 4, Module 8.2, LOS 8.d)
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Question #14 of 21

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Some proponents of behavioral nance believe that investors structure their portfolios as
pyramids. Which of the following best represents the resulting structure of their portfolios?

A) Several pyramids of di erent sizes will be formed, each representing a di erent
funding requirement.

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B) The bottom layer of an investor’s pyramid will be invested in stock with higher

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layers invested in bonds and cash.

C) The bottom layer of an investor’s pyramid will be invested in bonds and cash with

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higher layers invested in stock.
Explanation

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Investors will structure their portfolios as pyramids, with the bottom layer invested in less

risky assets to fund necessities. Once necessities are funded, higher levels of the pyramid are
dedicated towards riskier investments.
(Study Session 4, Module 8.1, LOS 8.d)
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Question #15 of 21
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Which of the following is the best course of action an investor can take to reduce the
overcon dence bias?

A) Seek the opinions of others to nd contrary viewpoints allowing for further scrutiny
of predictions.
B) Increase the con dence interval of forecasts since overcon dence tends to lead to
con dence intervals that are too narrow.
C) Keep detailed records of trades developing a track record of performance relative
to strategy determining when strategy led to success as compared to luck.
Explanation

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In the overcon dence bias investors tend to hold under-diversi ed portfolios because they
underestimate the downside while overestimating the upside. They may also trade
excessively, leading to high costs and underperformance. Because they are prone to
remembering only their better investments, investors should keep detailed records of trades,
including the motivation for each trade. By doing so, the investor develops a track record of
investment performance relative to strategy. Both successes and losses should be analyzed
relative to the strategy used to generate them to determine when strategy produced the
results and when luck (market forces) produced the results. Overcon dence does lead to too
narrow of a con dence interval for predicted forecasts but simply increasing the con dence
interval is not as e ective at reducing overcon dence as keeping detailed records of trades
and reviewing those records. Seeking the opinions of others to nd contrary viewpoints
allowing for further scrutiny of predictions is something the CFA curriculum suggests analysts
do to reduce overcon dence in their forecasts.

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(Study Session 4, Module 8.1, LOS 8.d)

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Question #16 of 21
Assuming a stock will perform well in the future because the company just released a good
earnings report usually results in:

A) the stock becoming overpriced and underperforming.
B) the stock becoming a “winner” and outperforming.
C) no change in value since in an e cient market the intrinsic value of the stock is
already re ected in its price.
Explanation
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Representativeness can lead investors to make incorrect projections based upon stereotypes.
Since investors' perceptions are based upon current or historical information rather than
unbiased expectations, stocks can be temporarily mispriced. An example is assuming a stock
will perform well in the future because the rm just unexpectedly announced good earnings
over the last period. Assuming the good announcement implies good future performance (a
winner), investors buy the stock and push its price up. Likewise, a bad earnings
announcement (a loser) may be met with selling pressure, which drives the price down. The
result is that overpriced "winners" will tend to underperform and underpriced "losers" will
tend to outperform, as their prices return to their intrinsic values.

(Study Session 4, Module 8.1, LOS 8.b)
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Question #17 of 21

Tommy Shaver is saving for his retirement. Shaver invests as behavioral nance would predict.

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According to behavioral nance, which of the following best represents how Shaver will fund
this objective?

A) Shaver will use a pyramid approach and fund it with safe investments at the bottom
of the pyramid.

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B) Shaver will use a pyramid approach and fund it with safe investments at the top of

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the pyramid.

C) Shaver will use a modern portfolio approach and diversify across global stocks,

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bonds, and alternative assets.
Explanation

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If Shaver invests as behavioral nance would predict, he will use a pyramid approach and
fund it with safe investments at the bottom of the pyramid.
(Study Session 4, Module 8.1, LOS 8.d)
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Question #18 of 21
Which of the following statements best describes cognitive errors and emotional bias?
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A) A cognitive error is the result of the inability to analyze all the information or from a
lack of information whereas an emotional bias is caused by individuals' feelings,

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B) A cognitive error is an error in faulty reasoning whereas an emotional bias is based
on feelings.
C) A cognitive error is the result of having inadequate information whereas an
emotional bias is having a decision be unduly in uenced by feelings.
Explanation

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Question #19 of 21

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(Study Session 4, Module 8.1, LOS 8.a)

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Cognitive errors are the result of mechanical or physical limitations; they result from the
inability to analyze all available information or from basing decisions on incomplete
information. Emotional biases are caused by individuals' psychological predispositions and
can a ect how individuals see information and make decisions. Think of an emotional bias as
decisions based on individuals' feelings, impulses or intuition rather than the mechanical or
physical process used to analyze and interpret it. Emotional biases are not deliberate but can
result in spontaneous reactions. Although all the answer choices are technically correct the
correct answer choice has the best overall explanation.

Which of the following does NOT re ect the most likely asset allocation as a result of

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incorporating behavioral biases into the portfolio construction process?

A) Create a portfolio that accommodates the investor’s behavioral risk and return

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preferences.

B) Create a portfolio in which all of the investor’s assets are viewed together taking the
correlation between those assets into consideration assigning a single measure of
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C) Arrange the assets that relate to the investor’s speci c goals in layers resembling a
pyramid with the most conservative assets in the bottom layer and the most risky
Explanation

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The correct answer choice re ects portfolio construction based on traditional nance theory
which assumes investors make rational decisions and are not in uenced by behavioral
biases.

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In attempting to either mitigate or accommodate behavior biases goals-based investing
recognizes that individuals are subject to loss aversion and mental accounting. Applying
goals-based investing, the investor builds a portfolio in layers, one layer at a time. Each layer
of the portfolio consists of assets used to meet individual goals or subsets of goals. Looking
at the portfolio as if it were a pyramid, the bottom layer of the pyramid is constructed rst
and is comprised of assets designated to meet the investor's most important goals. Once this
foundation layer is constructed, the investor moves to the next layer. Each successive layer as
you move up the pyramid consists of increasingly risky assets used to meet less and less
import goals. Structuring the portfolio in this manner provides the investor with the ability to
see risk more clearly. Although from an e cient frontier perspective the portfolio probably
won't end up e cient, it will tend to be fairly well diversi ed.

(Study Session 4, Module 8.2, LOS 8.d)

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Behaviorally modifying a portfolio simply means constructing it according to the investor's
behavioral risk and return preferences. The strategy portfolio is probably not e cient from a
modern portfolio theory perspective, but the investor is comfortable with it and will, thus, be
more likely to adhere to the strategy. The construction of the modi ed portfolio considers
the investor's emotional and cognitive behavioral biases and current wealth.

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SchweserNotes - Book 1

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Question #20 of 21

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Dan Chechele is getting nervous that the market has experienced several consecutive days of
losses and is getting uncomfortable having experienced many market downturns throughout
his lifetime. Based on his past experience he is subconsciously putting the recent market

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activity into the category of a market trend. Which of the following biases is Chechele
exhibiting?

A) Loss aversion bias.
B) Representativeness bias.
C) Con rmation bias.
Explanation

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In the representativeness bias individuals classify information into subjective categories
using heuristics; they place new information into the most appropriate category based on
personal experiences. Think of representativeness as an if-then or stereotype heuristic.
Investors feel that "if" information looks a certain way, "then" it ts into a certain category.
The if-then heuristic is based on past experiences and on relationships the investor has
witnessed, such as a past market trend. In that case, recent upward or downward
movements in the market are classi ed as market trends with implications for performance
of the market and individual stocks. The con rmation bias is when individuals tend to notice
only information that agrees with their perceptions or beliefs. They look for con rming

evidence while discounting or even ignoring evidence that contradicts their beliefs or their
perceptions. The loss aversion bias is when individuals focus on potential gains and losses
relative to risk rather than returns relative to risk. They place more "value" on losses; the
reduction in utility caused by a loss is greater than the increase in utility provided by a gain of
the same magnitude. Thus, when considering a risky investment, investors exhibit loss
aversion rather than risk aversion, as assumed in portfolio theory.

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(Study Session 4, Module 8.1, LOS 8.c)
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Question #21 of 21

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Which of the following statements resembles the behavioral trait of conservatism bias most

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accurately?

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A) Rather than sell at a small gain, the investor waits for the stock to reach his

forecasted target price.

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B) The investor tends to avoid or ignore information that is contrary to his beliefs.
C) The investor places an incorrect value on information because it readily ts into a

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category with which he has recent experience.
Explanation

Conservatism is not updating an initial view that was rationally determined. It is very closely
tied to con rmation which seeks out only con rming information and ignores information
that contradicts the initial view. So ignoring information contrary to initial beliefs can be
labeled conservatism. Trying to reach a set price target is reference dependence. Focusing on
recent experience has elements of both representativeness (a cognitive error) and availability
(an emotional bias).
(Study Session 4, Module 8.1, LOS 8.a)
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