CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 02 behavioral finance answers

Loss aversion bias  Hold onto losing stocks in hopes of breaking even.. Status quo bias is when the investor leaves their asset allocation the same over time without regard to changing

BEHAVIORAL FINANCE ANSWERS

Question 1

Statement

State the most

likely behavioral bias being exhibited

Explain one consequence of the behavior from a

portfolio perspective

When he first started

investing, he thought

his MBA gave him

the expert knowledge

needed to be a

proficient investor

Overconfidence bias

 Trade too frequently leading to higher transactions costs and lower returns

 Under-diversified portfolios

 Under estimate risk and overestimate return

Historically, X-wire

has performed well

and this led Clark to

believe it would

continue to do so in

the future

Representativeness

bias

 Hold on to or buy recent winners

 Sell or avoid recent losers

 Excessive turnover

Candidate discussion: Investors base decisions

on the recent past rather than unbiased expectations of future performance, placing too much emphasis on new information received and too small of a data set

After buying the

X-wire stock it

continued to do well

for a short period of

time and then

decreased in price

below Clark’s

original purchase

price Clark is

reluctant to sell it in

hopes of at least

breaking even in the

near future

Loss aversion bias

 Hold onto losing stocks in hopes of breaking even

 Sell winners too soon to capture gains

 Trade too frequently leading to higher transactions costs and lower returns

 Incur too much risk holding onto assets that have lost value

Candidate discussion: Fear of regret or regret

is a hindsight bias where the investor feels an opportunity has passed them by thinking they should have bought or sold a particular

investment Myopic loss aversion is

overemphasizing short-term potential losses and underemphasizing long-term return, resulting in

a risk premium on stocks that is too high given long-term characteristics and under-weighting stocks

Sample Scoring Key:

1 point for each behavioral trait

2 points for any one consequence from a portfolio perspective

Question 2

Part A

1 Status quo bias is when the investor leaves their asset allocation the same over time without

regard to changing circumstances such as age, wealth, and risk tolerance

2 1/n nạve diversification is investing equally amount various investment options within a

defined contribution plan

Sample Scoring Key:

1 point each for correctly identifying the behavioral trait

1 point each for describing each trait

Part B

An advantage of pyramiding is (1) it’s easier for the investor to understand and (2) more likely they will maintain the asset allocation, leading to their goals

A disadvantage of pyramiding is the correlation of assets is ignored, leading to a

less-than-optimal asset allocation from a traditional finance perspective

Sample Scoring Key:

2 points each for one advantage and one disadvantage of pyramiding

Question 3

A

 Statement 1: Traditional finance is normative (or proscriptive) and explains how

investors should invest (Or: Behavioral finance is descriptive in explaining how

investors actually invest.)

 Statement 2: Behavioral finance assumes investors are limited in their cognitive ability (Or: Traditional finance assumes no limits to decision-making ability.)

 Statement 2: Behavioral finance does not assume investors are always risk seekers, only that, at some times or under some conditions, they could be

Sample Scoring Key:

Any two of the three items identified and restated can be used One point for each identification and each restatement

B

 Utility theory assumes that satisfaction (utility) depends on level of wealth, while loss aversion assumes it depends on perceived gain versus loss

 Utility theory assumes investors are always risk averse, while loss aversion assumes risk aversion for gains and risk seeking for loses

 Utility theory focuses on total portfolio value, while loss aversion focuses on each

position and increase or decrease in value (i.e., increasing or decreasing gain or loss)

Sample Scoring Key:

Any two of the three items can be used for 2 points each

C

 Markets can be inefficient and exhibit technical momentum effects, where a period of increasing stock price leads to further increases and, eventually, highly overvalued

(bubble) conditions

 Investors can exhibit herding, where all investors take the same action (buying), which increases stock prices and leads to overvalued markets

 Investors may fear regret if they do not buy whatever is increasing in price, engage in trend chasing and buy whatever is going up in price, or assume available positive

information on securities is representative of everything relative to their valuation; in the process, investors push prices to unreasonably overvalued levels

Sample Scoring Key:

One point for any one item discussed and two points for a discussion of how it leads to highly overvalued conditions Potentially, there are other acceptable answers to such an open-ended

question If you review the CFA text and use an item directly discussed in the CFA text as tied to a market bubble, it should be accepted However, it is not acceptable to pick an item

not directly discussed in this context and apply your own “inherent” logic of why you think it should be acceptable In other words, you must answer based directly on the most relevant taught material

D Each member brings their own individual biases, and in a poorly run group setting, the group setting itself creates new issues as individuals feel inhibited in speaking freely or talk too much The chairman can:

 Establish an environment where members feel safe to voice their views

 Encourage all members to speak up and voice dissenting opinions

 Establish and stick to a relevant agenda

 Require clear decisions be made and document those decisions

 Require members to treat each other with professional respect

Sample Scoring Key:

Two points for making it clear the group setting itself can be the problem as social proof, peer pressure, and herding behavior inhibit free discussion One point each for any two of the actions the chairman can take

Candidate discussion: Recruiting diverse and qualified members is also an appropriate

chairperson action but will receive no credit in this question Reread the case facts; it is not an issue for this committee