Question 1

Which of the following characteristics are referred to as representativeness?
I. hesitating to sell stocks at a loss
II. basing conclusions on small samples
III. underestimating the effects of random chance
IV. underestimating the level of risk in an investment

Accepted Answer

Representativeness involves basing conclusions on small samples (II) and underestimating the effects of random chance (III), which are cognitive biases in decision-making.

Question 2

In the last year, Bradley purchased 3 stocks on recommendations from his broker, Emily. All of the stocks have increased in value, so he decides to act on all of Emily's recommendations in the future. Over the same period, the S&P 500 was up 15%. Bradley exhibits the tendency known as

Accepted Answer

Bradley is exhibiting representativeness by assuming that Emily's recommendations will always be successful based on a small sample of past successes, without considering other factors like market conditions.

Question 3

The efficient market hypothesis has some trouble explaining the existence of market anomalies.

Accepted Answer

The efficient market hypothesis (EMH) posits that all available information is already reflected in stock prices, making it impossible to consistently achieve higher returns. Market anomalies, such as the January effect or momentum investing, challenge this view by suggesting that predictable patterns can lead to abnormal returns, indicating that markets may not always be fully efficient.

Question 4

Which of the following accurately reflect appropriate investment guidelines?
I. Always invest in last years best performing mutual fund.
II. Trade frequently to increase your investment returns.
III. Sell losing stocks unless you are willing to buy them at the current price.
IV. Take corrective action when so indicated.

Accepted Answer

III and IV are considered appropriate investment guidelines. III suggests a rational approach to evaluating underperforming investments, implying that one should only hold onto stocks that they believe are worth their current market price. IV emphasizes the importance of monitoring investments and making adjustments as necessary, which is a fundamental principle of sound investment management. I and II, on the other hand, are not considered good investment practices. Investing based on past performance (I) does not guarantee future returns, and frequent trading (II) can lead to higher costs and taxes, potentially lowering net investment returns.

Question 5

What are some of the more important disagreements between the efficient market hypothesis and the findings of behavioral finance?

Accepted Answer

The answer of What are some of the more important...

Question 6

Evidence suggests that the price of a stock continues to move up or down for a period of

Accepted Answer

Stock prices tend to exhibit momentum, meaning they continue moving in the same direction for periods, but the consensus among studies suggests this momentum effect is most pronounced over shorter terms, like 6 to 12 months, rather than over several years.

Question 7

Heather has the equivalent of one year's income in an insured savings account. Her 401-K fund offers a choice of a government bond fund, an S&P 500 Index fund, and a balanced fund that holds roughly equal amounts of stocks and bonds. If she decided to allocate 1/3 of her retirement investments to each fund, she may be a victim of

Accepted Answer

Narrow framing refers to the mistake of viewing each investment in isolation rather than as part of a whole portfolio. By allocating her retirement investments equally among the three funds without considering how they interact with her overall financial situation, including her savings, Heather may not be diversifying her investments as effectively as she thinks, which is a form of narrow framing.

Question 8

The so-called Super Bowl effect is a serious challenge to the efficient market hypothesis.

Accepted Answer

The answer of The so-called Super Bowl effect is a...

Question 9

People tend to

Accepted Answer

People often exhibit confirmation bias, where they favor information that confirms their existing beliefs and ignore contradictory information.

Question 10

Four "decision traps " identified by behavioral finance are

Accepted Answer

Overconfidence, representativeness, loss aversion, and narrow framing are indeed recognized as decision traps in behavioral finance. These biases can lead individuals to make less optimal financial decisions by overestimating their knowledge, relying too heavily on stereotypes, fearing losses more than valuing gains, and viewing decisions without considering all alternatives or implications.

Question 11

Investor overconfidence leads to

Accepted Answer

Investor overconfidence often results in overly optimistic predictions about the future performance of investments, leading investors to underestimate risks and expect higher returns than might be realistic.

Question 12

Recent academic studies in behavioral finance confirm that markets are even more efficient than previously believed.

Accepted Answer

Recent academic studies in behavioral finance have actually highlighted various inefficiencies in markets, such as biases and irrational behaviors among investors, which can lead to prices that do not always reflect all available information.

Question 13

The most important lesson investors can learn from behavioral finance is

Accepted Answer

Behavioral finance emphasizes the importance of recognizing and mitigating the impact of emotions and cognitive biases on investment decisions, helping investors make more rational and objective choices.

Question 14

Which of the following statements correctly present recommendations based on behavioral finance?
I. Don't hesitate to sell a losing stock.
II. Trade frequently.
III. Chase performance.
IV. Be humble and open-minded.

Accepted Answer

I. Don't hesitate to sell a losing stock - This aligns with the recommendation to avoid the disposition effect, where investors hold onto losing stocks too long in the hope they will rebound.IV. Be humble and open-minded - This is advised to counteract overconfidence bias, where investors might overestimate their knowledge or the accuracy of their predictions.

Question 15

The tendency of investors to blame others for their failures and take personal credit for their successes is referred to as

Accepted Answer

Self-attribution bias is the tendency where individuals attribute their successes to personal characteristics or skills and blame failures on external factors. This cognitive bias affects how people perceive their own successes and failures, often leading to an inflated sense of personal achievement and an externalization of blame.

Question 16

Which of the following are common but dysfunctional investor behaviors?
I. overinvesting in companies with familiar names
II. dividing their funds equally among available choices, even if several of the choices serve the same purpose
III. holding on to a stock that has dropped in value because you would be willing to buy it at its current price
IV. overestimating one's ability to pick successful investments

Accepted Answer

I, II, and IV are all common but dysfunctional investor behaviors. Overinvesting in companies with familiar names can lead to a lack of diversification and increased risk. Dividing funds equally among available choices, even if several of the choices serve the same purpose, can result in a portfolio that is not well-balanced. Overestimating one's ability to pick successful investments can lead to poor investment decisions and losses.

Question 17

Jason has decided to sell his stock in an energy company because gas and oil prices as well the price of his stock have declined in 5 of the last 6 months. Jason has most likely fallen into the trap known as

Accepted Answer

The answer of Jason has decided to sell his stock...

Question 18

Jordan purchased 400 shares of GE at $16 per share. The price has dropped to $11 and he is disappointed in his purchase, but he is determined not to sell until the price again reaches $16. His decision is based on

Accepted Answer

Jordan's decision is based on loss aversion, which is the tendency to prefer avoiding losses to acquiring equivalent gains. He doesn't want to sell his shares at a loss, so he's waiting for the price to return to his purchase price before selling.

Question 19

Stocks of small companies have a historical tendency to outperform large cap stocks in the month of January.

Accepted Answer

This phenomenon is known as the "January Effect," where small-cap stocks, on average, outperform large-cap stocks at the beginning of the year. This is often attributed to tax-loss selling effects reversing and investors buying back into positions they sold in December for tax reasons, among other factors.

Question 20

One of the calendar effect market anomalies indicates that in value during January.

Accepted Answer

DThe January effect is a hypothesis that there's a seasonal anomaly in the financial market where stock prices, especially those of small caps, increase more than in other months. This is due to year-end tax considerations and the buying surge that typically happens when investors return to the market in January. Thus, small cap stocks tend to outperform large cap stocks (C), and equities in general tend to increase (D).

Quiz 9: Market Efficiency and Behavioral Finance

Which of the following characteristics are referred to as representativeness? I. hesitating to sell stocks at a loss II. basing conclusions on small samples III. underestimating the effects of random chance IV. underestimating the level of risk in an investment