Deck 26: Behavioural Finance: Implications for Financial Management

Question 1

Noise traders creates limits to arbitrage.

Answer 1

True

Question 2

Steve purchased a stock last year for $34 a share. The stock increased in value to $36 a share before declining to its current value of $30. Steve has decided to sell the stock, but only if he can receive $34 a share or better. Steve is suffering most from which one of the following behavioral conditions?

A) Representativeness heuristic.
B) House money.
C) False fallacy.
D) Randomness.
E) Arbitrage reaction.

Answer 2

C

Question 3

Risks related to an individual firm creates limits to arbitrage.

Answer 3

True

Question 4

Which one of the following best illustrates an error which you, as a manager, might make due to overconfidence?

A) Overestimating the best outcome expected from a project while underestimating the possibility of a less favorable outcome.
B) Assuming that a new project will be profitable since similar projects in the past were successful.
C) Assuming that your expectations of the future outcome from a project are more accurate than the expectations of others within your organization.
D) Listening to the advice of subordinates with whom you agree while ignoring the advice of subordinates with whom you tend to disagree.
E) Downplaying the cost of future failure of an existing project since the project has already paid for itself.

Question 5

You don't particularly like to shop so only go to the mall once a month. To help make the trek more enjoyable, you always have lunch at the restaurant located inside the mall. Since you are such a creature of habit, you always order the same meal. You've noticed that the price of that meal has increased every time you have been there over the past six months. Thus, you expect the meal to increase in price next month. This is an example of which one of the following?

A) Recency bias.
B) Anchoring and adjustment.
C) Frame dependence.
D) Aversion to ambiguity.
E) Clustering illusion.

Question 6

If a market is truly efficient, then all investments in that market are zero net present value opportunities.

Question 7

You are employed as a commission-based sales clerk for a cosmetics retail store. You know that on average; exactly 50 percent of the customers that enter your store will make at least one purchase. Thus far this morning, you have waited on eight customers without making a single sale. You are convinced that the next customer you wait on will buy something. This belief is known as:

A) Aversion to ambiguity.
B) The law of small numbers.
C) Anchoring and adjusting.
D) Gambler's fallacy.
E) False consensus.

Question 8

Implementation costs creates limits to arbitrage.

Question 9

When weighing a decision, Kate places greater emphasis on opinions that match her own than she does on opinions offered by others that disagree with her personal point of view. Kate illustrates which one of the following?

A) Frame dependence
B) Overconfidence
C) Gambler's fallacy
D) Confirmation bias
E) Over-optimism

Question 10

Most investors would tend to agree that technology stocks were highly overvalued in the late 1990's. This time period is best described as a technology:

A) Crash
B) Circle
C) Bubble
D) Limit
E) Arbitrage

Question 11

AB Industries is an all-equity firm that has $10 per share in cash and a book value per share of $12. At which one of the following market prices would you know with absolute certainty that the stock was mispriced?

A) $9
B) $10
C) $11
D) $12
E) $13

Question 12

The tendency for a decision maker to search for confirmation that a recent decision he or she made was a good decision represents which one of the following characteristics?

A) Over-confidence.
B) Over-optimism.
C) Affect heuristic.
D) Confirmation bias.
E) Representativeness heuristic.

Question 13

Stewart is a fellow finance student at your school who is addicted to day trading and thus buys and sells stocks between classes and over his lunch break. He never has time to really analyze a security so just trades the stock symbols that other investors appear to be trading. Stewart is which one of the following?

A) Noise trader.
B) Arbitrageur.
C) Crasher.
D) Regret averter.
E) Myopic loss averter.

Question 14

A sudden and severe decline in market prices is best described as a market:

A) Crash
B) Revolver
C) Bubble
D) Limit
E) Mispricing

Question 15

Actively managing a fund appears to be the key to outperforming the market.

Question 16

In an efficient market, it is believed by some individuals that the actions of traders who constantly buy and sell on any perceived market mispricings will in effect cause market prices to correctly reflect asset values. A person who believes that the actions of these traders will not result in correctly valued prices is most apt to believe in which one of the following?

A) Gambler's fallacy.
B) Limits to arbitrage.
C) Availability bias.
D) False consensus.
E) Clustering illusion.

Question 17

Professional fund managers that have tenures in excess of ten years, tend to consistently outperform the market on a long-term basis.

Question 18

Which one of the following refers to the fact that an individual may reply differently if a question is asked in a different manner?

A) Loss aversion.
B) Gambler's fallacy.
C) Frame dependence.
D) Overconfidence.
E) Format reference.

Question 19

Many professional fund managers are paid well but fail to outperform as expected.

Question 20

Rational traders create limits to arbitrage.

Question 21

Peter has successfully managed the finances of Jackson Corporation in a manner that has yielded abnormally high returns. Due to this success, Peter has decided to publish a newsletter for financial executives so that he can share his superior financial wisdom with others. There is a very real probability that Peter has which one of the following characteristics?

A) Gambler's fallacy.
B) Frame dependence.
C) Overconfidence.
D) Representativeness heuristic.
E) Sentiment-based risk attitudes.

Question 22

Roger's Meat Market is a chain of retail stores that limits its sales to fresh-cut meats. The stores have been very profitable in northern cities. However, when two stores were opened in the south, both lost money and had to be closed. Roger, the owner, has now concluded that no southern-based store should be opened as it would not be profitable. Which one of the following applies to Roger?

A) Confirmation bias.
B) Endowment effect.
C) Money illusion.
D) Affect heuristic.
E) Representativeness heuristic.

Question 23

Bill feels that he possesses a good dose of "street smarts". Thus, he makes his business decisions based on how a project feels to him rather than taking the time to financially analyze a project. This type of behavior is referred to as:

A) Overconfidence.
B) Endowment effect.
C) Money illusion.
D) Affect heuristic.
E) Sentiment-based risk.

Question 24

Anytime Ted analyzes a proposed project, he always assigns a much higher probability of success to the project than is warranted by the information he has gathered. Ted suffers from which one of the following?

A) Frame dependence.
B) Overconfidence.
C) Gambler's fallacy.
D) Confirmation bias.
E) Over-optimism.

Question 25

Ramon opened a combination laundry and dry cleaning establishment three years ago. Due to his excellent service and reasonable prices, his business has grown and is doing quite well financially. He has considered expanding this business by opening another location but keeps putting off that decision for fear that the second location will not be a success. Ramon is currently displaying which one of the following behavior characteristics?

A) Self-attribution bias.
B) Overconfidence.
C) Regret aversion.
D) House money effect.
E) Frame dependence.

Question 26

The ISDEX is an index of:

A) Internet-related stocks.
B) Overall S&P market.
C) Industrial Sector.
D) Industry Setters.
E) Initial Start-ups.

Question 27

Kaiser Marketing recently conducted a survey on behalf of Health Products. The primary purpose of the survey was to illustrate to Health Products that it was relying on results of previous studies that, according to Kaiser, were unreliable due to the wording of the survey questions. To prove this point, Kaiser conducted a two-prong survey. In the first prong, the survey questions were worded such that the answers tended to sound positive. In the second prong, the survey questions were re-worded such that the answers tended to convey a negative feeling. Both sets of survey questions should have resulted in similar results as the information solicited was essentially identical. However, the survey results varied significantly. This survey best illustrates which one of the following?

A) Mental accounting.
B) Overconfidence.
C) Self-attribution bias.
D) Confirmation bias.
E) Frame dependence.

Question 28

You started an online business three weeks ago. Thus far, you have averaged 10 sales a day, which is one sale for every five hits. You are now considering giving up your day job and becoming a full-time online retailer. You have calculated the amount of income you can earn based on 10 sales a day and know that level of income would support you in a comfortable fashion. The belief that you will have 10 sales per day on average if this becomes your full-time occupation is based on which one of the following?

A) Mental accounting.
B) Anchoring and adjustment.
C) Law of small numbers.
D) Bubble and crash theory.
E) Confirmation bias.

Question 29

You recently overheard your boss telling someone that if he'd actually crunched some numbers and done some analysis instead of just going with his instincts that he never would have opened the new store in Centre City. Which one of the following caused your boss to make a bad decision?

A) Regret aversion.
B) Endowment effect.
C) Money illusion.
D) Affect heuristic.
E) Representativeness heuristic.

Question 30

Old Country Productions requires skilled furniture finishers to put the final touches on all of the furniture it produces. The firm hired two individuals last year who had been students in Mr. Tedwell's wood shop class in high school. Both of these employees have demonstrated exceptional skills and have already been promoted to senior finishing positions. The firm currently has an opening for one additional finisher. Tom, the head of the finishing section, has stipulated that he only wants to interview candidates who have completed Mr. Tedwell's course. Tom's behavior is typical of someone who has which one of the following characteristic behaviours?

A) Endowment effect.
B) Framing effect.
C) Representativeness heuristic.
D) Narrow framing.
E) Affect heuristic.

Question 31

Phyllis is planning for her retirement in fifteen years. She knows that she can currently live reasonably well on $38,000 a year given that she is debt-free. Based on her family history she expects to die ten years after she retires. Thus, she computes her retirement need as $38,000 a year for 10 years. Which one of the following behaviors applies to Phyllis?

A) Regret aversion.
B) Money illusion.
C) Self-attribution bias.
D) Endowment effect.
E) Myopic loss aversion.

Question 32

Marzella Corp. is analyzing a project that involves expanding the firm into a new product line. The project includes the construction of a new manufacturing facility and the creation of a new distribution system. The project's financial projections will tend to have which one of the following characteristics if the person compiling those projections suffers from over-optimism?

A) Overestimated construction costs.
B) Overestimated expenses.
C) Overestimated net present values.
D) Underestimated profits.
E) Underestimated sales estimates.

Question 33

You are a hard-charging manager who doesn't really like to sit at a desk for too long. You prefer to gather information quickly, make a decision, and move on to the next item on your agenda. Which one of the following applies to you?

A) Availability bias.
B) Arbitrage limits.
C) Law of small numbers.
D) Representativeness heuristic.
E) Regret aversion.

Question 34

Kate is attempting to sell her house for $260,000. Fred lives across the street in an identical house. Fred recently stated to his wife that Kate's house is probably worth only $250,000 but that once she sells her house, he would like to put their house on the market at $285,000 and then move into a condominium. Which one of the following behaviors applies to Fred?

A) Myopic loss aversion.
B) House money effect.
C) Money illusion.
D) Self-attribution bias.
E) Endowment effect.

Question 35

Amy has been investing in stocks so she can accumulate sufficient money to purchase her own home. These savings are currently valued at $82,500. As recently as last month, her savings were worth in excess of $110,000. Today, Amy found the perfect house. She knows she can withdraw her savings to pay on this house and borrow the remaining balance from her father at zero percent interest. However, Amy is refusing now to buy any house until her savings increase in value back to their $110,000 previous valuation. Amy is displaying which one of the following behaviors?

A) Representativeness heuristic.
B) Loss aversion.
C) House money effect.
D) Under-confidence.
E) Confirmation bias.

Question 36

Recently, a neighbor you have known for years won a lottery and received a $250,000 prize. This neighbor decided to invest all of his winnings in a new business venture that he knew only had a five percent chance of success. Previous to this, the neighbor had always been ultra conservative with his money and had refused to invest in this business venture as recently as last week. Which one of the following behaviors most applies to your neighbor's decision to invest in this business venture now?

A) Over-optimism.
B) Affect heuristic.
C) Loss aversion.
D) House money.
E) False fallacy.

Question 37

You are the manager of a retail store. You believe the economy is in a recession and that sales for the month will be unusually slow. Since you have complete discretion over the pricing at your location, you decide to have a store-wide sale and offer 10 percent off all merchandise for a 3-day period. You don't expect your superiors to criticize this decision as you believe they, along with the majority of the other store managers, feel the same way about the economy as you do. Which one of the following applies to you?

A) Recency bias.
B) Law of small numbers.
C) Gambler's fallacy.
D) False consensus.
E) Money illusion.

Question 38

Over the past six months, you have watched as your parent's retirement savings have declined in value by 45 percent due to a severe financial market downturn. As a result, you have decided that you will never invest in stocks for your own retirement but will instead keep all of your money in an insured bank account. Which behavior characteristic have you developed as a result of the market downturn?

A) Myopic loss aversion.
B) False fallacy.
C) Self-attribution bias.
D) Mental accounting.
E) Regret aversion.

Question 39

Amy is the chief financial officer of a retail toy store. Recently, she decided that the firm should expand its operations and open two additional stores. Within a very brief period, it was obvious that Amy had made a very bad decision in opening those stores, given that the economy is in the middle of a severe recession. In reflecting back on her decision, Amy realizes that she made a bad decision due to a reasoning error. Which one of the following areas of study best applies to this situation?

A) Corporate ethics.
B) Financial statement analysis.
C) Managerial finance.
D) Debt management.
E) Behavioral finance.

Question 40

General rules used as the basis for decision making are referred to as:

A) A loss aversion technique.
B) Heuristics.
C) Self-attribution.
D) Narrow framing.
E) Confirmation bias.

Question 41

What is the best definition of affect heuristic?

A) The tendency to focus on avoiding short-term losses, even at the expense of long-term gains.
B) The tendency to avoid making a decision because you fear that the decision would have been less than optimal.
C) The tendency to consider something that you own to be worth more than it would be if you did not own it.
D) Confusion between real buying power and nominal buying power.
E) The reliance on instinct instead of analysis in making decisions.

Question 42

Which one of the following is an investment risk that investors face in addition to firm-based risk and market-based risk?

A) Management-related risk.
B) Inflation risk.
C) Supply chain risk.
D) Interest rate risk.
E) Sentiment-based risk.

Question 43

Provide an example of a managerial decision that illustrates each one of the following behaviors:
Behavior: Overconfidence - Example:
Behavior: Affect heuristic - Example:
Behavior: Loss aversion - Example:

Question 44

Historical returns support which one of the following statements?

A) Financial markets are highly inefficient as suggested by behavioral finance.
B) Professional money managers tend to outperform the Vanguard 500 index fund about 55 percent of the time on average.
C) The longer the time span, the more apt a professional money manager is to outperform an index fund, such as the S&P 500.
D) Historical data supports the statement that arbitrage is unlimited and results in a totally efficient market.
E) The financial markets appear to be efficient because, on average, they outperform professional money managers.

Question 45

Frame dependence is best defined as:

A) The area of finance dealing with the implications of reasoning errors on financial decisions.
B) The belief that your abilities are better than they really are.
C) Taking an overly optimistic view of potential outcomes
D) Searching for (and giving more weight to) information and opinion that confirms what you believe rather than information and opinion to the contrary.
E) The tendency of individuals to make different (and potentially inconsistent) decisions depending on how a question or problem is framed.

Question 46

Explain the difference between over-confidence versus over-optimism.

Question 47

What is the best definition of regret aversion?

A) The tendency to focus on avoiding short-term losses, even at the expense of long-term gains.
B) The tendency to avoid making a decision because you fear that the decision would have been less than optimal.
C) The tendency to consider something that you own to be worth more than it would be if you did not own it.
D) Confusion between real buying power and nominal buying power.
E) The reliance on instinct instead of analysis in making decisions.

Question 48

Mike is a stock broker and financial planner. Phil is one of Mike's clients. Phil prefers to meet with Mike just once a year to review his investment portfolio. At their most recent meeting, Phil stated he believes the stock market is going to decline in value over the next six months. Thus, Phil instructed Mike to sell every stock he owns that is currently worth more than what he paid to purchase it. Phil also instructed Mike to retain any stock that would create a capital loss if sold. Phil is displaying the behavior known as:

A) Over-confidence.
B) Arbitrage theory.
C) The disposition effect.
D) The house money effect.
E) A confirmation bias.

Question 49

Assume you are an overconfident manager. You are most apt to do which one of the following more so than you would if you were not overconfident?

A) Research a project more thoroughly before committing funds to commence it.
B) Accept risky projects that turn out to be less profitable than you expected.
C) Wait until new technology proves its worth before incorporating it into your firm's operations.
D) Avoid mergers and acquisitions.
E) Invest excess company cash more conservatively than your peers at other firms.

Question 50

Provide an explanation of availability bias:

Question 51

Behavioural finance is best defined as:

A) The area of finance dealing with the implications of reasoning errors on financial decisions.
B) The belief that your abilities are better than they really are.
C) Taking an overly optimistic view of potential outcomes
D) Searching for (and giving more weight to) information and opinion that confirms what you believe rather than information and opinion to the contrary.
E) The tendency of individuals to make different (and potentially inconsistent) decisions depending on how a question or problem is framed.

Question 52

Overconfidence is best defined as:

A) The area of finance dealing with the implications of reasoning errors on financial decisions.
B) The belief that your abilities are better than they really are.
C) Taking an overly optimistic view of potential outcomes
D) Searching for (and giving more weight to) information and opinion that confirms what you believe rather than information and opinion to the contrary.
E) The tendency of individuals to make different (and potentially inconsistent) decisions depending on how a question or problem is framed.

Question 53

What is the best definition of money illusion

A) The tendency to focus on avoiding short-term losses, even at the expense of long-term gains.
B) The tendency to avoid making a decision because you fear that the decision would have been less than optimal.
C) The tendency to consider something that you own to be worth more than it would be if you did not own it.
D) Confusion between real buying power and nominal buying power.
E) The reliance on instinct instead of analysis in making decisions.

Question 54

What is the best definition of endowment effect?

A) The tendency to focus on avoiding short-term losses, even at the expense of long-term gains.
B) The tendency to avoid making a decision because you fear that the decision would have been less than optimal.
C) The tendency to consider something that you own to be worth more than it would be if you did not own it.
D) Confusion between real buying power and nominal buying power.
E) The reliance on instinct instead of analysis in making decisions.

Question 55

Which one of the following statements is true?

A) Market crashes tend to be accompanied by low market volume.
B) The Asian market crash was followed by a quick recovery.
C) The market crash of 1929 and the crash of 1987 are very similar in both the percentage decline in market value and in the ensuing market recovery.
D) Market crashes tend to follow market bubbles.
E) Market bubbles and crashes prove that financial markets are inefficient.

Question 56

Confirmation bias is best defined as:

A) The area of finance dealing with the implications of reasoning errors on financial decisions.
B) The belief that your abilities are better than they really are.
C) Taking an overly optimistic view of potential outcomes
D) Searching for (and giving more weight to) information and opinion that confirms what you believe rather than information and opinion to the contrary.
E) The tendency of individuals to make different (and potentially inconsistent) decisions depending on how a question or problem is framed.

Question 57

Over-optimism is best defined as:

A) The area of finance dealing with the implications of reasoning errors on financial decisions.
B) The belief that your abilities are better than they really are.
C) Taking an overly optimistic view of potential outcomes
D) Searching for (and giving more weight to) information and opinion that confirms what you believe rather than information and opinion to the contrary.
E) The tendency of individuals to make different (and potentially inconsistent) decisions depending on how a question or problem is framed.

Question 58

What is the best definition of myopic loss aversion?

A) The tendency to focus on avoiding short-term losses, even at the expense of long-term gains.
B) The tendency to avoid making a decision because you fear that the decision would have been less than optimal.
C) The tendency to consider something that you own to be worth more than it would be if you did not own it.
D) Confusion between real buying power and nominal buying power.
E) The reliance on instinct instead of analysis in making decisions.

Question 59

Provide three categories of cognitive errors when making investment decisions. Expand on each category.

Question 60

You have saved a total of $200,000 over the past several years. Jane, a trusted business associate, recently approached you with an offer. She has offered you a partnership in a new firm that she expects to be exceedingly profitable. Your initial investment in the partnership would be $125,000. However, Jane cannot give you any odds on that success occurring. You have decided to keep your $125,000 and forego this opportunity simply because you don't know the probability of success. Which one of the following behavior characteristics do you have?

A) Aversion to ambiguity.
B) Recency bias.
C) Sentiment-based risk aversion.
D) Clustering illusion.
E) Money illusion.

Question 61

Provide a definition of myopic loss aversion.

Question 62

Provide an explanation of recency bias.

Question 63

Provide a definition of representativeness heuristic.

Question 64

Provide a definition of endowment effect.

Question 65

Provide a definition of frame dependence.

Question 66

Provide an explanation of the law of small numbers.

Question 67

Provide a definition of affect heuristic.

Question 68

Explain 1) the concept of house money, 2) why the house money concept is such a common behavior for so many individuals and 3) why house money is an irrational behavior.

Question 69

Provide a definition of regret aversion.

Question 70

Provide a definition of a sentiment-based risk.

Question 71

Provide a definition of a noise trader.

Question 72

Provide an explanation of aversion to ambiguity,

Question 73

Explain why a low-priced, low trading volume stock is more apt to present limits to arbitrage than is a high-priced, high trading volume stock.

Question 74

Explain the difference between a bubble and a crash.

Question 75

Provide a definition of money illusion.

Question 76

Provide an explanation of anchoring and adjustment: