CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz item set answers, study session 3, reading 6

Question ID: 16911 Correct Answer: B Walter is subject to the confirmation bias since he has established screening criteria, and is ignoring information that is refuting the validity o

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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 6: The Behavioral Biases of Individuals

1 Question ID: 16911

Correct Answer: B

Walter is subject to the confirmation bias since he has established screening criteria, and is ignoring information that is refuting the validity of the criteria This is evident from the fact that Walter is ignoring the investment recommendation made by Bright just because the investment does not meet the screening criteria (and more so, challenges the validity of his criteria)

In his comment, Walter has stated that it would not be wise to update beliefs about the company’s future performance by processing the new information The effort involved in such updating is termed

as cognitive cost Not updating beliefs just to avoid cognitive costs can lead to the conservatism bias (maintaining a prior belief)

Walter is not subject to the representative bias because he has not updated his beliefs upon learning of the expected lower future growth rate Investors subject to the representative bias update their beliefs

by using simple classifications rather than dealing with the pressure of interpreting complex data

Correct Answer: C

The confirmation bias and the illusion of control bias can lead to inadequately diversified portfolios and excessive exposure to risk

Correct Answer: A

The representativeness bias and the illusion of control bias can lead to excessive trading and inferior performance results

Statement 1 is correct Individuals subject to the conservatism bias tend to overweight the base rates, and those subject to the representativeness bias tend to underweight the base rates

Statement 2 is correct A useful step in correcting for the confirmation bias is to get corroborating support for an investment decision

Buying into a fund after a rapid price appreciation indicates a focus on short-term results and is due to the representativeness bias

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Turner is subject to representativeness bias She is making all her new investments based on the apparent similarities of the stocks with the stock of Agri-Group (a successful investment) without doing research to validate the new investment’s merits She thinks that the stock’s characteristics are

representative of successful companies’ stocks

Regret aversion can lead investors to hold on to investments too long Even though the stock’s price has reached the target Brown set for it, he is still reluctant to sell because he fears that the position will increase in value even more and then he will regret having sold it

Correct Answer: A

Given the low turnover and low frequency of trading, the client seems to be subject to status-quo bias The low frequency of trading seems unintentional (like in a state of inertia), since when Turner brought the issue to the client’s attention, he asked her to sell off all investments that had gained immediately This also demonstrates his loss aversion—he wants to sell profitable investments as soon as possible to realize the gains (a concept also known as the disposition effect)

Turner is referring to self-attribution bias and herding behavior Individuals who are overconfident are generally also the victims of self-attribution bias; a bias which boosts their self-esteem and

relieves them of personal responsibility for failures Regret-aversion bias can be responsible for initiating herding behavior: the tendency to go with the crowd in order to avoid the future regret of making an unconventional, poor decision

Client A is subject to availability bias and Client B is subject to loss aversion bias Since availability bias is a cognitive bias, and loss aversion is an emotional bias, given a high level of wealth and low standard of living risk, Client B’s bias should be adapted to, and Client A’s bias should be moderated and adapted to

Brown is subject to regret aversion bias This bias has led to the preference of White Inc.’s stock, even though the risk and return expectations of both stocks are equal By investing in a stock that is backed by well-known institutional investors, Brown is trying to avoid the burden of responsibility of making a poor decision This in turn will reduce the pain of regret he would feel (it seems safe to be with the crowd)

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