CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz item set answers, study session 3, reading 5

Question ID: 67409 Correct Answer: A Client A constructs a portfolio consistent with the traditional finance portfolio construction process.. He uses a risk tolerance level and a stat

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CFA Level III Item-set - Solution

Study Session 3 June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 5: The Behavioral Finance Perspective

1 Question ID: 67409

Correct Answer: A

Client A constructs a portfolio consistent with the traditional finance portfolio

construction process He uses a risk tolerance level and a stated expected return to choose an optimal portfolio (based on mean-variance analysis) He wants to maximize his portfolio’s return given his risk objective This approach to portfolio construction implicitly assumes that investors (or their advisors) have perfect information and

behave rationally

Correct Answer: B

Client B uses the concepts of expected return, standard deviation, and correlation to construct his/her portfolio Hence, his/her portfolio construction decisions are

consistent with the traditional finance mean-variance efficient decisions

Correct Answer: C

Client C is framing his/her expenditure decisions taking into account the source of wealth He has classified his net worth into current income and current assets, and likes

to spend first from current income, and then from current assets This type of mental accounting is a partial response to the issue of self-control

Client D is subject to the self-control bias The client tries to deposit all extra income and 20% of his/her annual salary to the pension account, which is considered as a

current asset for which he/she has a low marginal propensity to consume This is in response to the lack of self-control: by classifying assets as such, the client is trying to save for meeting long-term goals instead of focusing on short-term satisfaction Such an approach is consistent with the behavioral life-cycle theory

Client E’s subjective beliefs about the discount rates do not match those of traditional finance (as measured by his/her portfolio manager) Hence, the client’s beliefs include a risk sentiment; a sentiment that causes asset prices to deviate from values determined using traditional finance approaches (efficient prices)

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Client F wants to maximize expected wealth on his portfolio subject to a safety

constraint A BPT investor usually states his ability to tolerate failure to achieve at least the aspirational level of wealth (by stating a probability level)

Bounded rationality assumes that individuals identify satisfactory sub-goals and limited objectives and make decisions by applying heuristics that meet these sub-goals The adaptive market hypothesis applies an evolutionary perspective to the framework and states that as experience increases, individuals learn and the heuristics they apply to a situation evolve The AMH considers both bounded rationality and evolutionary principles

Investor A does not construct portfolios consistent with the BPT This is because he/she considers the covariance among the investment layers In BPT, no consideration is given to

covariance of the investment layers since the risk and return of the portfolio as a whole is not

considered Investors B and C make comments consistent with the BPT

Statement 2 is incorrect The AMH also assumes that individuals act in their own

self-interest

Statement 3 is incorrect The BPT does not assume that people are loss-averse and not risk-averse It does, however, state that investors reluctant to realize losses (loss-averse) would hold higher amounts of cash It also states that some investors would have concave utility functions (risk-averse investors)

The portfolio meets the safety objective (0% probability of falling below $4.5 million), but it does not meet Hart’s aspirational goals (4% return with 70% probability) The portfolio returns only 3.9% with a 65% probability Hence, to meet the aspirational goals, the safety level objective must be lowered (that is, more risk should be taken with the portfolio)

By trying to determine if stock prices move too much to be justified by subsequent changes

in dividends, Cameron is trying to identify a fundamental anomaly (an anomaly that emerges when one considers a stock’s performance based on a fundamental assessment of the stock’s value) By studying capital market seasonality, Cameron is trying to identify calendar

anomalies

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The decision theory assumes that a decision maker is fully informed, is able to make

quantitative calculations with accuracy, and is perfectly rational The BPT and AMH

consider bounded rationality and the concept of satisficing

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