2019 CFA level 3 qbank reading 7 the behavioral finance perspective answers

Study Session 4, Module 7.1, LOS 7.a Related Material SchweserNotes - Book 1 Question #2 of 18 What is the purpose of using Baye's formula in the investment decision making process?. Stu

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Question #1 of 18

Which of the following actions is most likely the result of applying Bayes' theorem of

conditional probability? A fundamental analyst revises a stock recommendation when:

A) the rm experiences a major re that destroys its production line.

B) the rm issues a revised earnings report.

C) she revises her in ation expectations.

Explanation

A fundamental analyst bases recommendations on rm or market fundamentals such as

expected earnings The re would signal an unexpected change in the rm's fundamentals as

would a revised earnings announcement Revising a recommendation based on the

probability of a given level of in ation is an example of applying a Bayesian framework to an

expectation That is, the rm's performance is based conditionally on the probability of a

given level of in ation

(Study Session 4, Module 7.1, LOS 7.a)

Related Material

SchweserNotes - Book 1

What is the purpose of using Baye's formula in the investment decision making process?

A) Incorporate new information into previous forecasts updating those forecasts

which aids in the investment decision making process

B) Assign probabilities to various outcomes helping the investor gain insight into the

range of those possible outcomes

C) Incorporate some quantitative aspects into the portfolio construction process.

Explanation

Baye's formula measures the probability of an event occurring given the probability of some

other event occurring It is used in the forecasting process, for example new information

about a stock would be incorporated into a revised forecast aiding in determining whether or

not to buy or sell the stock Using Baye's formula should result in more accurate forecasts

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When an investor considers wealth fungible:

A) he may create and hold a single portfolio to meet lifetime consumption.

B) he will create a layered portfolio with each layer consisting of di erent assets

designated to meet a speci c goal

C) he will put investments into separate mental accounts.

Explanation

Fungible means that wealth is interchangeable By assuming individuals create a single

portfolio to meet their lifetime obligations, for example, individuals must assume wealth is

fungible The same wealth can be used to meet any needs By thinking of wealth in terms of

separate mental accounts, the individual implicitly assumes it is not fungible; speci c wealth

is dedicated to speci c goals This is also the concept behind layered portfolios

(Study Session 4, Module 7.3, LOS 7.d)

According to prospect theory, investors are generally more concerned with:

A) fear of regret, which suggests that the prospect for outperforming a benchmark is

the primary concern for these investors

B) avoiding losses, which suggests that risk of loss may be the best measure of risk.

C) diminishing marginal utility, which suggests that expected return is more important

than risk to these investors

Explanation

Behavioral investors are generally more concerned with avoiding losses, which implies that

risk of loss may be the best measure of risk

(Study Session 4, Module 7.2, LOS 7.b)

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Which of the following statements best de nes satis ce?

A) The investor gathers adequate information to make the utility maximizing choice.

B) Making a decision in which you are satis ed.

C) Investors make a satisfactory choice based on the information gathered.

Explanation

Satis ce means the investor gathers what they consider to be an adequate amount of

information and apply heuristics to analyze the information into an acceptable decision

which is not necessarily the optimal decision from a traditional nance perspective The

traditional nance perspective would instead gather and meticulously analyze all relevant

information to make the utility maximizing choice

(Study Session 4, Module 7.2, LOS 7.c)

Which of the following statements most correctly describes the shift in focus when moving

from a traditional nance to a behavioral nance investment process, and what is the most

pronounced result of this shift?

A) The de nition of investor motives shifts to a focus on emotions, and the most

pronounced result is that the de nition of risk changes from dispersion-based

B) The de nition of investor motives shifts to a focus on emotions, and the most

pronounced result is the development of measures to quantify how emotions

C) The goal de nition shifts from statistical measures of risk and return to

lifestyle-based objectives, and the most pronounced result is that the de nition of risk

Explanation

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The primary shift is from the traditional performance concepts of expected return and

dispersion-based measures of risk, to de ning performance in terms of the realization of

lifestyle-based objectives The most pronounced result is that new measures of risk are

required, and the new risk measures are concerned with whether or not the stated objectives

are realized

Which of the following statements best describes bounded rationality?

A) Individuals make rational decisions within the con nes of knowing they don’t have

all the information or the ability to fully interpret it

B) Individuals act rationally within de ned limits.

C) Individuals recognize they do not have all the information necessary to make a

rational decision

Explanation

Bounded rationality means individuals act as rationally as possible realizing they do not have

all the available information or the cognitive ability to fully interpret the information

Martina Blackwood has not been doing well with her investments She consults Ben Haifen,

CFA, for some advice Which of Haifen's following statements indicates that Blackwood is using

heuristics?

A) Blackwood's most valuable lessons were learned through her own mistakes.

B) Blackwood doesn't like xed-income investments because she doesn't understand

them

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C) Blackwood tends to hold onto her losers too long.

Explanation

Blackwood developed her investment style through trial and error, learning from her own

mistakes called heuristics The other statements could be true of many types of investors

who are not bound by heuristic-driven bias

Basing trading decisions on available public information, Carla Maplewood, CFA, is consistently

able to identify and pro t on mispriced securities Based on her successful trading strategy, we

would most likely conclude that the market is at best:

A) weak-form e cient.

B) semi-strong form e cient.

C) strong-form e cient.

Explanation

In a semi-strong form e cient market, where prices incorporate all available public

information, investors should not be able to consistently generate excess returns by using

public information alone If the market is not semi-strong form e cient, it cannot be

strong-form e cient At best, the market could be considered weakly e cient

The tendency for individuals to identify outcomes as gains or losses in the editing phase of

decision making would most likely be an example of:

A) simpli cation.

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B) combination.

C) codi cation.

Explanation

Classifying outcomes as gains or losses is an example of codi cation, during which investors

code outcomes and place probabilities on their occurrence Investors combine outcomes with

identical values to gain clarity among choices Investors also simplify by rounding For

example, very similar probabilities might be made equal

The isolation e ect seen in the editing phase of prospect theory is thought to be the result of:

A) combination.

B) cancellation.

C) dominance.

Explanation

Prospect theory proposes that investors make decisions in two phases: editing and

evaluation In the editing phase, investors clarify choices using some combination of six

possible steps: codi cation, combination, segregation, cancellation, simpli cation, and

detection of dominance In the cancellation step, investors eliminate (ignore) possible

outcomes common to choices, so they might focus on low-probability, large outcomes By

focusing on the large, low-probability outcomes, they exhibit isolation (i.e., they isolate and

make decisions based on certain outcomes)

The inability of technical trading rules to consistently provide excess returns is most likely used

as proof that a market is at least:

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A) semi-strong form e cient.

B) weak-form e cient.

C) strong-form e cient.

Explanation

In a weakly e cient market, prices incorporate all past price and volume information, so

technical trading rules will fail to consistently produce excess returns Although by de nition

a market that is semi-strong form or strong-form e cient will also be weak-form e cient, we

cannot say that the inability to generate excess returns using technical data would in itself

indicate semi- or strong-form e ciency

Which of the following steps is least likely to be included in the process of developing

heuristic-driven bias?

A) Receiving bad advice.

B) Reliance on rules of thumb for investment decisions.

C) Making mistakes.

Explanation

The process of developing heuristic-driven bias starts with developing investment principals

through experience, followed by reliance on heuristics (rules of thumb) to make decisions At

this point, imperfect heuristics start to sway investment decisions, and investors make errors

Bad advice can contribute to all of these steps, but it is not a part of the development of

heuristic-driven bias

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An individual is presented with a number of choices, with only two outcomes each: one positive

and one negative If the individual's selection is a ected by whether only the positive or

negative outcome of each choice is stated, the individual is most likely subject to the behavioral

characteristic known as:

A) self-control bias.

B) framing.

C) mental accounting.

Explanation

Framing refers to the way information is presented or perceived and can a ect the way

individuals view choices Due to loss aversion, an investor's selections will be a ected by

whether the outcome is stated in terms of the possible loss or in terms of the possible gain

Self-control bias refers to the individual's inability to resist the expected utility of current

consumption Consuming now and not saving for the future can lead to suboptimal lifetime

consumption Mental accounting refers to the individual's tendency to place goals into

mental les with a portion of wealth dedicated to each goal In this way, it leads to layered

portfolios

Which of the following statements best exempli es the di erence between behavioral and

traditional nance? Traditional nance:

A) does not take into consideration the behavioral aspects of investing which if

considered would lead to better portfolio construction

B) assumes investors make rational decisions whereas behavioral nance attempts to

explain why investors act the way they do

C) views portfolio construction from an historical perspective whereas behavioral

nance incorporates modern up-to-date techniques in the portfolio construction

Explanation

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Traditional nance assumes investors exhibit risk aversion and make unbiased,

utility-maximizing rational decisions Behavioral nance assumes investors employ some

combination of traditional nance and psychological biases when making investment

decisions and attempts to explain why investors make the decisions they do

To satis ce means the investor:

A) takes steps to achieve intermediate goals that help them get closer to the desired

goal

B) achieves intermediate goals that lead to the utility maximizing choice.

C) gathers all the relevant information available to them and using heuristics they

make the optimally maximizing decision

Explanation

To satis ce is the process of gathering and utilizing information that helps the investor take

intermediate steps towards their goals They do not gather and analyze all the information

available to them but instead use heuristics, trial and error learned behavior, and the

information they have gathered to make a decision they are satis ed with which is most likely

not the optimally maximizing portfolio

Assume there are two investments to choose from: investment A has an expected return of

10% and a standard deviation of 15%, and investment B also has an expected return of 10% but

its standard deviation is 20% The risk neutral investor would:

A) not choose investment B because it has a higher level of risk with no additional

compensation

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B) choose either investment A or B since they are not concerned about the level of risk

but only with the level of return

C) choose investment A because it has a higher return for a given level of risk.

Explanation

Given two alternatives with the same expected return but di erent levels of risk (i.e.,

di erent standard deviations), the risk-neutral investor would be indi erent between the two

alternatives, the risk-averse investor will select the alternative with less risk, and a

risk-seeking investor would actually prefer (derive more utility from) the riskier alternative

Which of the following is least likely a heuristic learning process?

A) Research.

B) Trial and error.

C) Experimentation.

Explanation

Trial and error, and experimentation are heuristic learning processes Heuristic learners pick

up information simply, through their own e orts or from sources simple to access They

don't do research

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