CWS Behavioral Finance 1 — Questions and Answers
Question 1: Which behavioral bias causes investors to hold losing investments too long while selling winning investments too quickly?
- Anchoring bias
- Disposition effect (Correct answer)
- Herding behavior
- Overconfidence bias
Correct answer: Disposition effect
The disposition effect describes the tendency of investors to sell assets that have increased in value while keeping assets that have declined in value, often leading to suboptimal tax and portfolio outcomes.
Question 2: A wealth strategist notices a client believes their investment portfolio will outperform the market simply because they selected the stocks themselves. This best illustrates:
- Loss aversion
- Mental accounting
- Overconfidence bias (Correct answer)
- Recency bias
Correct answer: Overconfidence bias
Overconfidence bias occurs when investors overestimate their own ability to select investments or predict market movements, often leading to excessive trading and underdiversification.
Question 3: Mental accounting, as described by Richard Thaler, refers to:
- Tracking all expenses in a dedicated financial software
- The tendency to assign different values to money based on its source or intended use (Correct answer)
- Calculating net worth across all accounts simultaneously
- Separating investment accounts from spending accounts for tax purposes
Correct answer: The tendency to assign different values to money based on its source or intended use
Mental accounting is the cognitive tendency to treat money differently depending on where it came from or how it is earmarked, such as treating a tax refund as 'free money' to be spent rather than saved.
Question 4: Which concept, central to prospect theory, explains why investors feel the pain of a $10,000 loss more intensely than the pleasure of a $10,000 gain?
- Risk tolerance asymmetry
- Loss aversion (Correct answer)
- Regret avoidance
- Status quo bias
Correct answer: Loss aversion
Loss aversion, a core principle of Kahneman and Tversky's prospect theory, holds that losses are felt approximately twice as powerfully as equivalent gains, causing risk-averse behavior in the domain of gains and risk-seeking behavior in the domain of losses.
Question 5: A client refuses to change their investment allocation because it is the same allocation they have had for years, despite changing market conditions. This behavior is most consistent with:
- Anchoring bias
- Herding behavior
- Status quo bias (Correct answer)
- Framing effect
Correct answer: Status quo bias
Status quo bias is the preference for the current state of affairs, causing clients to resist changes even when a rebalancing or reallocation would be in their financial interest.
Question 6: When a client makes investment decisions based heavily on recent market performance, assuming it will continue, this is known as:
- Recency bias (Correct answer)
- Representativeness heuristic
- Anchoring bias
- Confirmation bias
Correct answer: Recency bias
Recency bias leads investors to give disproportionate weight to recent events and trends when forecasting future performance, often causing them to buy at market peaks and sell at market troughs.
Question 7: Which of the following best describes 'anchoring' in the context of behavioral finance?
- Tying investment returns to a fixed benchmark
- Over-relying on the first piece of information encountered when making decisions (Correct answer)
- Maintaining a conservative allocation to anchor portfolio volatility
- Using historical averages as the baseline for all projections
Correct answer: Over-relying on the first piece of information encountered when making decisions
Anchoring occurs when an investor fixates on an initial piece of information—such as a stock's purchase price or a prior high—and insufficiently adjusts subsequent judgments away from that reference point.
CWS Behavioral Finance 1
Which behavioral bias causes investors to hold losing investments too long while selling winning investments too quickly?