2019 CFA level 3 qbank reading 9 behavioral finance and investment processes answers

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Question #1 of 54
Which of the following is NOT a reason for excessive trading taking place in discount brokerage
accounts as compared to company retirement plans?

A) Framing bias.
B) The availability of investment options in one account as compared to the other.
C) Individuals self-selecting into one account versus the other.

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Explanation

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Framing bias is seen in company retirement plans and can take two di erent forms: 1) when
given the choice among di erent funds to invest in the investor allocates their investments
evenly among the di erent funds which is also called 1/n naïve diversi cation and, 2) when a
company match is in the form of company stock the employee frames this as implicit advice
and subsequently allocates a higher proportion of their own contributions to the company's
stock. Excessive trading is seen in discount brokerage accounts as compared to company
retirement plans. Availability of more investment options in a discount brokerage account is
thought to lend itself to more excessive trading along with trading oriented individuals selfselecting into the discount brokerage account.

(Study Session 4, Module 9.2, LOS 9.c)
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Question #2 of 54

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Jean Stall, CFA, has just completed the yearly review for one of her clients Je Schaller. During
the review she went over the original questionnaire he lled out to make sure the current
portfolio has not drifted too far from the original asset allocation as determined by the
questionnaire. The questionnaire was well designed to quantitatively determine Schaller's level
of risk aversion. One of Schaller's statements in the questionnaire was that he was comfortable
investing in stocks but did not want to lose any money in the stock market. As a result Stall took
a portion of his non-retirement money and put it in an indexed annuity which is a long term
investment guaranteed not to lose any money but will participate in any market gains. Which of
the following is NOT an error that Stall committed?

A) There is no mention that behavioral traits were addressed in the questionnaire.
B) Stall met with Schaller on a yearly basis.
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C) Stall took Schaller’s comment too literally and may have placed him in a potentially
inappropriate product with the indexed annuity.
Explanation
Stall made several errors regarding the questionnaire and subsequent meeting:

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Question #3 of 54

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(Study Session 4, Module 9.2, LOS 9.b)

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1. The questionnaire should be re-administered during the yearly review to make sure
any changes in the client's circumstances are captured.

2. The questionnaire should be able to identify behavioral biases displayed by the client
which there is no mention of this occurring.
3. Stall interpreted Schaller's statement about not wanting to lose any money too literally
resulting in an inappropriate product, the annuity which is a long term retirement
product, being used for non-retirement savings. She should have inquired further into
his statement to see if he really meant not to lose any money in an investment or if he
is just overly risk averse.

Which of the following is most likely not one of the behavioral investor types identi ed by

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Pompian?

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A) The Independent individualist.

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B) The adventurer.

C) The passive preserver.

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Explanation

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The adventurer is from the Bailard, Biehl, and Kaiser (BB&K) ve-way model which classi es
investors along two dimensions according to how they approach life in general. The rst
dimension, con dence, identi es the level of con dence usually displayed when the
individual makes decisions. Con dence level can range from con dent to anxious. The
second dimension, method of action, measures the individual's approach to decision making.
Depending on whether the individual is methodical in making decisions or tends to be more
spontaneous, method of action can range from careful to impetuous. The ve behavioral
types identi ed by the BB&K ve-way model are the: adventurer, celebrity, individualist,
guardian, and straight arrow.

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The Pompian behavioral model identi es four behavioral investor types (BITs): passive
preserver, friendly follower, independent individualist, and active accumulator. The Passive
Preserver and the Active Accumulator tend to make emotional decisions whereas the Friendly
Follower and Independent Individualist tend to use a more thoughtful approach to decision
making.
(Study Session 4, Module 9.1, LOS 9.a)

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Question #4 of 54

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SchweserNotes - Book 1

De ning investor objectives in terms of mean and standard deviation:

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A) may make it easier to estimate the probability that the objectives will be realized.

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B) usually makes it less likely that the investor will deviate from the investment policy
because of current market conditions.

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C) may make selecting an asset allocation more di cult for the individual.

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Explanation

De ning investor objectives in terms of mean and standard deviation may make selecting an

asset allocation more di cult for the individual, since it can be hard to see how the choices
a ect the probability of success. In addition, this method of goal de nition often makes it can
make it di cult to estimate the probability that the objectives will be realized, and may make
it more likely that deviations from policy will occur.
(Study Session 4, Module 9.2, LOS 9.b)
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Question #5 of 54
Gina Arturo has an online brokerage account in which she frequently places trades. Which of
the following behavioral traits is she most likely exhibiting?

A) Home bias e ect.
B) Disposition e ect.
C) Overcon dence.
Explanation

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When retail investors trade their brokerage accounts excessively this is thought to be caused
by overcon dence based on a false sense of insight into the investment's future
performance. The typical result is lower overall returns due to trading costs as well as from
selling winners too soon and holding losers too long. Selling winners too soon and holding
onto losers too long is called the disposition e ect. There is no evidence in this question that
Arturo is exhibiting the disposition e ect. Many retail investors also typically display the
home bias e ect which is the behavioral trait of investors placing a high proportion of their
assets in the stocks of rms in their own country. This is closely related to familiarity where
investors invest in stocks they are familiar with such as domestic stocks or their own
company stock.
(Study Session 4, Module 9.2, LOS 9.d)
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SchweserNotes - Book 1

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Question #6 of 54

According to behavioral nance, which of the following best describes how investors will invest

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their retirement portfolio?

A) The investor will put most of their money in the less risky assets on the menu of
their employer’s de ned contribution plan unless the employer forces them to put
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B) The investor will put most of their money in the less risky assets on the menu of
their employer’s de ned contribution plan.
C) The investor will put an equal dollar amount in each mutual fund on the menu of
their employer’s de ned contribution plan.
Explanation

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According to behavioral nance, investors will diversify the portfolio for their de ned
contribution pension using 1/n diversi cation. In 1/n diversi cation, an employee puts an
equal amount in each fund on the employer's de ned contribution pension plan menu. For
example, if there are eight mutual funds available, the employee will put one-eighth of their
contribution in each fund. Note that in the U.S., an employer cannot force an employee to put
more than 10% of their retirement funds in company stock.

(Study Session 4, Module 9.2, LOS 9.d)
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Question #7 of 54

Limitations of classifying investors into behavioral types would include all of the following
EXCEPT:

A) individuals may simultaneously display both emotional biases and cognitive errors

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all the while seeming to act rationally, making it di cult to classify the individual
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B) as investors age, they will most likely go through behavioral changes, usually
resulting in decreased risk tolerance along with becoming more emotional about

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Explanation

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C) the resulting client portfolio is not the “rational” portfolio.

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The client portfolio constructed by the adviser not falling on the e cient frontier (the rational
portfolio) is not a limitation but the result of classifying an investor into a behavioral type. It
results in a portfolio that is better suited to the client given their behavioral biases.

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Limitations of classifying investors into the various behavioral investor types include:
Individuals may simultaneously display both emotional biases and cognitive errors all
the while seeming to act rationally, making it di cult to classify the individual
according to behavioral biases.
An individual might display traits of more than one behavioral investor type, making it
di cult to place the individual into a single category.
As investors age, they will most likely go through behavioral changes, usually resulting
in decreased risk tolerance along with becoming more emotional about their investing.
Even though two individuals may fall into the same behavioral investor type, the
individuals should not necessarily be treated the same due to their unique
circumstances and psychological traits.
Individuals tend to act irrationally at unpredictable times because they are subject to
their own speci c psychological traits and personal circumstances. In other words,

people don't all act irrationally (or rationally) at the same time.

(Study Session 4, Module 9.1, LOS 9.a)
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Question #8 of 54
Which of the following is least likely a way to reduce overcon dence in analyst forecasts?

A) The analyst is properly self-calibrated through feedback from colleagues and
superiors along with a structure that rewards accuracy and forecasts that are

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B) The analyst should seek a contrary opinion to their forecast based on evidence

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along with using a large enough sample size and Bayes’ formula.

C) Gather a large amount of data from which to develop a forecast.
Explanation

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Collecting a large amount of data can lead to overcon dence 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.

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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.

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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 con dence in unreliable models. Lastly, Bayes' formula
is a useful tool for reducing behavioral biases when incorporating new information.

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(Study Session 4, Module 9.3, LOS 9.e)
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Question #9 of 54
Typical individual investors tend not to understand the e ects of correlation on their portfolio.
Which of the following characteristics of a DC plan participant's portfolio best re ects the
attempt to derive bene ts from the e ects of correlation even though the participant does not
understand those e ects?
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A) Status quo bias.
B) Familiarity.
C) 1/n diversi cation heuristics.
Explanation
Feeling that they should spread out their risk, but not knowing how leads to the 1/n
diversi cation heuristic. Often times, participants will only have a rough understanding of the
e ects of correlation and diversi cation and will simply divide their assets equally over the
investment options in the plan in an attempt diversify their portfolio.
(Study Session 4, Module 9.2, LOS 9.d)
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Question #10 of 54

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An investor selling winning securities too soon and holding losing positions too long is an
example of:

A) representativeness.

Explanation

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C) overcon dence.

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B) the disposition e ect.

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This is the de nition of the disposition e ect.
(Study Session 4, Module 9.2, LOS 9.d)

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Question #11 of 54
Which of the following is least likely to be a common bias found in analyst research?

A) The analyst makes a decision based on incomplete information knowing the
outcome could be unfavorable.

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B) The analyst inappropriately tries to apply a probability to a random event.
C) The analyst nds evidence that con rms their forecast.
Explanation
Biases speci c to analysts performing research are usually related to the analysts collecting
too much information, which leads to the illusions of knowledge and control and to
representativeness, all of which contribute to overcon dence. Two other common biases
found in analysts' research are the con rmation bias and the gambler's fallacy.

The con rmation bias (related to con rming evidence) relates to the tendency to view new
information as con rmation of an original forecast.

(Study Session 4, Module 9.3, LOS 9.e)
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Question #12 of 54

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The gambler's fallacy, in investing terms, is thinking that there will be a reversal to the longterm mean more frequently than actually happens. A representative bias is one in which the
analyst inaccurately extrapolates past data into the future. An example of a representative
bias would be classifying a rm as a growth rm based solely on previous high growth
without considering other variables a ecting the rm's future.

Heather Jones graduated from a prestigious Ivy League college in May, recently passed Level I

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of the CFA exam, and just landed her rst professional job as a junior portfolio manager

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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.

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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 di erent 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 re ective of how nancial decisions are typically made in a
group setting?

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A) “Decisions made at this level are made by professionals with similar backgrounds,

the committee should be functioning in a more e cient and e ective manner with
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B) “Their individual behavioral biases have become exacerbated in the group setting!”
C) “These people are displaying irrational behavior which is typical of group settings!”
Explanation
In a group setting individual biases can be either diminished or ampli ed 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
identi ed.

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(Study Session 4, Module 9.3, LOS 9.f)

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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 di ers with others or a powerful member of

the group.

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Question #13 of 54

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

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nance view?

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

B) The excuses will prevent analysts from recognizing their own limitations.
C) Other investors depend on these forecasts, resulting in aggregate investment
losses.
Explanation

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According to behavioral nance, 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 nance.
(Study Session 4, Module 9.3, LOS 9.e)
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Question #14 of 54

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All of the following are behavioral investor types identi ed by Pompian EXCEPT the:

A) guardian.
B) active accumulator.

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C) friendly follower.
Explanation

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The guardian is from the Bailard, Biehl, and Kaiser (BB&K) ve-way model which classi es
investors along two dimensions according to how they approach life in general. The rst
dimension, con dence, identi es the level of con dence usually displayed when the
individual makes decisions. Con dence level can range from con dent to anxious. The
second dimension, method of action, measures the individual's approach to decision making.
Depending on whether the individual is methodical in making decisions or tends to be more
spontaneous, method of action can range from careful to impetuous. The ve behavioral
types identi ed by the BB&K ve-way model are the: adventurer, celebrity, individualist,
guardian, and straight arrow.

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The Pompian behavioral model identi es four behavioral investor types (BITs): passive
preserver, friendly follower, independent individualist, and active accumulator. The Passive
Preserver and the Active Accumulator tend to make emotional decisions whereas the Friendly
Follower and Independent Individualist tend to use a more thoughtful approach to decision
making.
(Study Session 4, Module 9.1, LOS 9.a)

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SchweserNotes - Book 1

Question #15 of 54
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Which of the following is least likely a way the success of the client / adviser relationship is
measured?

A) The adviser acts as the client expects.
B) Both client and adviser bene t from the relationship.
C) The adviser has been able to successfully grow their business year after year.
Explanation
The success of the typical client/adviser relationship can be measured in four areas with each
one being enhanced by incorporating behavioral nance traits:

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The adviser understands the long-term nancial goals of the client.
The adviser maintains a consistent approach with the client.
The adviser acts as the client expects.
Both client and adviser bene t from the relationship.

(Study Session 4, Module 9.2, LOS 9.b)

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Question #16 of 54

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1.
2.
3.
4.

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All of the following are potential bene ts of de ning portfolio objectives in terms of client

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objectives EXCEPT:

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A) it may improve the likelihood that the investor will adhere to investment policy.

B) it allows the investor to better connect the probability of goal attainment with

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investment policy.

C) the optimal portfolio can then be determined analytically.
Explanation
Choosing the optimal portfolio is still a matter of judgement—a tradeo between risk and
return, but the speci cation of risk is often much easier for the investor to understand. Both
remaining statements are correct.
(Study Session 4, Module 9.2, LOS 9.b)
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Question #17 of 54
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.
Explanation

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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-todividend ratios, with growth stocks having the opposite characteristics of high PE ratios, low
book-to-market values, and high price to dividend ratios.

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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). A bubble or crash is de ned 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.

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(Study Session 4, Module 9.3, LOS 9.g)

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Question #18 of 54
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) Anchoring.
B) Fear of regret.
C) Representativeness.
Explanation
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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.
(Study Session 4, Module 9.3, LOS 9.g)
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Question #19 of 54

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Analyst M routinely adjusts his previously vague forecasts to t new information that has just
been made available making his forecast look better than it actually was. Analyst Q judges the

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probability of her forecast being correct on how well the available data ts the outcome. Which
of the following behavioral biases are M and Q displaying? M is displaying:

A) hindsight bias and Q is displaying representativeness.

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B) illusion of knowledge and Q is displaying availability bias.

C) illusion of control bias and Q is displaying self-attribution bias.
Explanation

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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 ts the outcome.

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In representativeness, an analyst judges the probability of a forecast being correct on how
well the available data represent (i.e., t) the outcome. The analyst incorrectly combines two
probabilities: (1) the probability that the information ts a certain information category, and
(2) the probability that the category of information ts the conclusion.

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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 overcon dence.
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 " t" 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.
(Study Session 4, Module 9.3, LOS 9.e)
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SchweserNotes - Book 1

Question #20 of 54
Which of the following is least likely a limitation of classifying an investor into a behavioral type?

A) The client portfolio constructed by the adviser most likely will not fall on the
e cient frontier.
B) Individuals tend to act irrationally at unpredictable times because they are subject

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to their own speci c psychological traits and personal circumstances. In other

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C) Even though two individuals may fall into the same behavioral investor type, the
individuals should not necessarily be treated the same due to their unique
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Explanation

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The client portfolio constructed by the adviser not falling on the e cient frontier is not a
limitation but the result of classifying an investor into a behavioral type. It results in a
portfolio that is better suited to the client given their behavioral biases.
Limitations of classifying investors into the various behavioral investor types include:

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Individuals may simultaneously display both emotional biases and cognitive errors all
the while seeming to act rationally, making it di cult to classify the individual
according to behavioral biases.
An individual might display traits of more than one behavioral investor type, making it
di cult to place the individual into a single category.
As investors age, they will most likely go through behavioral changes, usually resulting
in decreased risk tolerance along with becoming more emotional about their investing.
Even though two individuals may fall into the same behavioral investor type, the
individuals should not necessarily be treated the same due to their unique
circumstances and psychological traits.
Individuals tend to act irrationally at unpredictable times because they are subject to
their own speci c psychological traits and personal circumstances. In other words,
people don't all act irrationally (or rationally) at the same time.

(Study Session 4, Module 9.1, LOS 9.a)
Related Material
SchweserNotes - Book 1

Question #21 of 54
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Which of the following best characterizes overcon dence in expert forecasters, according to
behavioral nance? Expert forecasters are overcon dent in their forecasting ability because:

A) of the positive reinforcement they receive from the media.
B) they have access to information others do not.
C) they feel their knowledge allows them to make more accurate forecasts.
Explanation

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According to behavioral nance, expert forecasters are overcon dent 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 overcon dence, according to behavioral nance.

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(Study Session 4, Module 9.3, LOS 9.e)
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Question #22 of 54

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According to behavioral nance, which of the following best represents how investors will

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diversify a portfolio for their de ned contribution pension?

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A) According to their employer’s advice.

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B) Using modern portfolio theory.
C) Using 1/n diversi cation.

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Explanation

Investors will diversify a portfolio for their de ned contribution pension using 1/n
diversi cation. If their employer o ers ten mutual funds, employees will tend to put onetenth of their contribution in each mutual fund.
(Study Session 4, Module 9.2, LOS 9.d)
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Question #23 of 54
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Which of the following statements most accurately describes social proof bias? Social proof bias
is when:

A) an individual follows the beliefs of a group.
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) the individuals in a group start thinking and acting as if they are a single individual.
Explanation

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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 con icting discussions
resulting in the group making decisions as if the group was a single individual.

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(Study Session 4, Module 9.3, LOS 9.f)
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Question #24 of 54

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Investor X works for company A and investor Y works for company B. Company A makes a

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matching contribution into their employees' retirement funds in cash whereas company B
matches with company stock. Which of the following are the most likely behavioral traits

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exhibited by both employees?

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A) Investor Y will purchase more company stock than investor X.
B) Investor X will purchase more company stock than investor Y with the nal

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proportions being approximately equal in their retirement plans.
C) Both investor X and Y will purchase company stock in approximately the same
proportions so the nal allocation of company stock is actually higher in investor Y’s

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Explanation
Research has shown that employees who can choose where the employer match is invested
allocate a smaller amount of their own funds to their employer's stock than when the
employer match is made with company stock. In other words the employee who is receiving a
retirement match in company stock is more likely to purchase more company stock with their
own funds than an employee who receives a retirement match in cash. This behavioral bias is
a type of framing because the employee may be interpreting the company's match in
company stock as implicit advice regarding the stock.
(Study Session 4, Module 9.2, LOS 9.d)
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Question #25 of 54
Bobby Steele, a software engineer at a local rm, 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

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investment style?

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A) Steele is likely to have high turnover in his portfolio and is likely to make unjusti ed
bets.

B) Steele is likely to have low turnover in his portfolio and is likely to make unjusti ed
bets.

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c

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

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m

Steele is an overcon dent 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 unjusti ed because he does not understand that he does not
possess all the information necessary to form unbiased projections.

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(Study Session 4, Module 9.3, LOS 9.e)
Related Material

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SchweserNotes - Book 1

Question #26 of 54
Which of the following statements about the disposition e ect is least accurate? The disposition
e ect is:

A) driven by fear of regret.
B) when an individual holds onto winning stocks and sells losing stocks.
C) seen in retail investment accounts.
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Explanation
The disposition e ect is seen in retail brokerage accounts where winners are sold too soon
and losing stocks are held too long. The disposition e ect is also thought to be driven by fear
of regret.
(Study Session 4, Module 9.2, LOS 9.c)
Related Material
SchweserNotes - Book 1

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Question #27 of 54

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Many de ned contribution plan participants tend to hold a large amount of assets in company
stock relative to other asset classes. Which of the following characteristics of a DC plan
participant's portfolio best re ects the reason behind this tendency?

A) Familiarity.

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c

B) Naive diversi cation.
C) Status quo bias.
Explanation

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m

DC participants tend to hold excess stock of the company they work for due to familiarity
which is the tendency for individuals to invest in where they are most comfortable or familiar

which could be the company they work for. Naive diversi cation is allocating an equal
amount of retirement savings to each investment option. Note that the status quo bias refers
to a lack of action on the part of the participant.
(Study Session 4, Module 9.2, LOS 9.d)

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Related Material

SchweserNotes - Book 1

Question #28 of 54
Which of the following behavioral biases are most commonly seen in employee retirement
plans?

A) Framing, loyalty e ect, and nancial incentives.

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B) Status quo bias and naïve diversi cation also referred to as 1/n naïve
diversi cation.
C) Familiarity, overcon dence, and naively extrapolating past returns.
Explanation
Two biases commonly seen in de ned contribution retirement plans are the status quo bias

and naïve diversi cation also known as 1/n naïve diversi cation. When the employee is
subject to status quo bias, he leaves his initial asset allocation as is without adjusting it for
changing circumstances, even as he ages and his wealth and risk tolerance change. Naïve
diversi cation, also referred to as 1/n naïve diversi cation, is allocating an equal proportion
of their retirement assets to each fund alternative. The other behavioral biases are
commonly seen when an investor purchases their own company's stock.

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(Study Session 4, Module 9.2, LOS 9.d)

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Related Material

Question #29 of 54

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SchweserNotes - Book 1

Which of the following best exempli es the structure of a committee that e ectively makes
decisions?

m

A) The committee members get along well and there is little animosity or in- ghting

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between the committee members.

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

C) The committee is comprised of individuals from di erent backgrounds and where

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the committee chair encourages people to voice their opinions even if it is contrary
h

i

Explanation
E ectively 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 di ers 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.
(Study Session 4, Module 9.3, LOS 9.f)
Related Material

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SchweserNotes - Book 1

Joseph Brophy and Pamela Carr work in the collections department of Swank's, an upscale
department store in downtown Cleveland. Swank's is a publicly traded company with more
than 400 locations nationwide, and is also rated by national publications as one of the best
places to work. Brophy and Carr like their jobs, and like the company for which they work. 
Swank's recently switched from a de ned-bene t plan to a de ned-contribution plan, and
employees with vested pension assets were given lump sums, with the option of investing that
money in the new plan. Both Brophy and Carr have worked for Swank's for more than 10 years,

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and as such receive sizable payments, which they intend to move into the new plan. 

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On the day enrollment forms arrive at the Cleveland o ce, Brophy and Carr have lunch
together to discuss the new pension plan. The investment packet contains a short newsletter
that provides historical performance data on the investment options. Here are the choices:

A large-cap value fund.

A small-cap value fund.
A small-cap growth fund.
A mid-cap blend fund.

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c

An S&P 500 Index fund.

m

An aggressive-growth stock fund.
A foreign-stock fund.

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A long-term bond fund.

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A short-term bond fund.

Swank's stock, available at a 5% discount to market price.

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Brophy and Carr know nothing about investing, but the recent past returns of the funds look
pretty high, and Swank's stock has done very well in recent years. Carr, who is 15 years younger

than Brophy, likes the returns on some of the stock funds and on Swank's stock. Brophy is ve
years away from retirement and feels he's too old to learn about nancial management. During
his discussion with Carr, he remembers an article he read in Forbes years ago. He can recall
nothing about the article except that the writer said diversi cation was a good idea. Carr
responds by warning that you have to make bets on a winner if you expect to earn good
returns. 
Brophy assumes that Swank's wouldn't recommend any funds unless they were good, and in an
e ort to diversify, puts 10% of his money into each option. 

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Carr wants to earn the biggest returns possible, so she invests 50% of her money in Swank's
stock and split the remaining cash between the small-cap growth fund and the aggressivegrowth fund. 
Twelve months after the start of the new pension plan, all Swank's employees have the
opportunity to change their investment elections. Brophy sees that his portfolio is up roughly in
line with the S&P 500 Index, so he leaves his elections intact. Carr notes that Swank's stock has
fallen 25%, and the portfolio was roughly at with year-earlier levels. Grumbling, she changes
her allocation so the portion currently in Swank's stock is divided between the available bond

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funds.

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Question #30 of 54

Which of the following least likely re ects Brophy's portfolio decisions?

A) Familiarity.

bo
ok
c

B) Availability bias.
C) 1/n diversi cation.
Explanation

m

Brophy's original allocation was a classic example of 1/n diversi cation, with 10% in each of
10 investments. Brophy's focus on recent results is an example of the availability bias.
Familiarity addresses such biases as favoring company stock. That's not an issue for Brophy.

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Related Material

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(Study Session 4, Module 9.2, LOS 9.d)

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SchweserNotes - Book 1

Question #31 of 54
Carr's initial investment choices show she avoided falling into which behavioral characteristic?

A) Representativeness.
B) Overcon dence.
C) Pyramiding.
Explanation

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Carr's investment choices clearly show overcon dence in her ability to predict which
investments will do well. Her choices are driven by an emotional desire to make bets and win
big thus she is extrapolating favorable past returns into the future referred to as
representativeness. However, Carr has one goal, and that's to maximize returns. She is most
certainly not creating a portfolio pyramid.
Related Material
SchweserNotes - Book 1

Question #32 of 54

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Brophy's initial investment choices show he has fallen prey to which of the following traps?

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A) Naive diversi cation.
B) Status quo bias.
C) Familiarity.

bo
ok
c

Explanation

Allocating an equal amount of retirement savings to each investment choice is called naive
diversi cation or 1/n naive diversi cation. Familiarity and status quo bias do not come into
play with Brophy's initial investment decision.

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SchweserNotes - Book 1

m

Related Material

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Question #33 of 54

Swank's wants to improve its de ned-contribution pension plan. Which of the following actions
will be least helpful to employees?

A) Increase the number of fund options.
B) Allow the employees to change their allocations more than once a year.
C) Provide detailed nancial and performance data on the company stock.
Explanation

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Companies cannot force employees to invest in their stock, but many strongly encourage
such investment. Even if the stock is a good investment, such an emphasis is not always a
good idea, as employees may see such information as a strong endorsement for investing in
company stock. Increased fund options and more frequent allocations give employees
additional exibility in their investments.
Related Material
SchweserNotes - Book 1

Question #34 of 54

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Brophy appears to be:

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A) frame dependent.
B) prone to regret.
C) loss averse.

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c

Explanation

Related Material

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SchweserNotes - Book 1

m

Brophy read an article on diversi cation in Forbes, then reinforced the ideas based on the
newsletter. His frame is diversi cation, and he does what he thinks is best in purchasing an
equal-dollar amount of all 10 choices. There is no evidence that Brophy is particularly loss
averse or prone to regret, just inexperienced.

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Question #35 of 54

Neither Brophy nor Carr made optimal investment decisions. In the wake of the portfolio
rebalancing, which of the following statements best re ect the situation of which employee?

Has bestallocated
portfolio
A)

B)

Exhibits
herding
behavior

Carr

Neither Carr
nor Brophy

Brophy

Neither Carr
nor Brophy

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C) Carr

Brophy

Explanation
After the rebalancing, Brophy most likely has more than 80% of his assets in equities, which is
almost certainly too much for a working man ve years from retirement. Carr, on the other
hand, has about 38% of her assets in bonds, which is probably closer to the optimum level
for a worker with at least 10 years of experience but who is still about 20 years from
retirement. Neither Carr nor Brophy appear to be in uenced by anyone else's investment
decisions, so neither is exhibiting herding mentality.
Related Material

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SchweserNotes - Book 1

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Question #36 of 54

All of the following are prescribed methods of measuring the success of the client / adviser

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ok
c

relationship EXCEPT the:

A) adviser maintains a consistent approach with the client.
B) adviser understands the long-term nancial goals of the client.
C) client is satis ed with the return they are getting from their portfolio.

m

Explanation

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The adviser understands the long-term nancial goals of the client.
The adviser maintains a consistent approach with the client.
The adviser acts as the client expects.
Both client and adviser bene t from the relationship.

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1.

2.
3.
4.

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The success of the typical client/adviser relationship can be measured in four areas with each
one being enhanced by incorporating behavioral nance traits:

(Study Session 4, Module 9.2, LOS 9.b)
Related Material
SchweserNotes - Book 1

Question #37 of 54
Which of the following are uses of classifying investors into various types? Classifying investors
into behavioral types:
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A) helps the advisor understand their client resulting in better overall investment
decisions being made that are closer to the e cient frontier.
B) gives the adviser the tools to be able to explain to the client why their portfolio
should resemble the “rational portfolio” based on traditional nance concepts.
C) allows the advisor to have a better understanding of how to approach their client
when educating them on traditional nance concepts.

Explanation

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c

(Study Session 4, Module 9.1, LOS 9.a)

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The goal of viewing the client/adviser relationship from a psychological perspective as
compared to a purely traditional nance perspective is for the adviser to better understand
their client and to make better investment decisions. By incorporating behavioral biases into
clients' IPSs, clients' portfolios will tend to be closer to but not on the e cient frontier (the
rational portfolio), and clients will be more trusting and satis ed and tend to stay on track
with their long-term strategic plans. Ultimately, since everyone is happy, the result is a better
overall working relationship between client and adviser. Clients who are at the extremes of
risk aversion tend to approach investing very emotionally and are not interested in
traditional nance concepts therefore educating them on these concepts is of little value to
them and does not work.

Related Material
SchweserNotes - Book 1

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Terry Shiver and Mary Trickett are portfolio managers for High End Investment Managers. High

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End provides investment advice to wealthy individuals. As part of their annual review of their

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client portfolios, they review the appropriateness of their client portfolios given their clients'
return objective, risk tolerance, time horizon, liquidity constraints, tax situation, regulatory

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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 ve 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 rm, I just don't have the time."
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