Exam relevant readings
Kindly find the relevant readings on SharePoint under Block 3 Client Advice and Relationship.
Mixed multiple choice / short essay: 20 questions (equally weighted). To keep the time investment to a reasonable level while still being able to test the fundamentals, we decided to work with a mixture between essay and multiple-choice questions.
Describe loss aversion. Loss aversion is a term in economics that describes a person’s desire to avoid a loss versus acquiring gains. The person prefers to avoid the chance of encountering a loss (no matter how remote) over receiving a gain, which could be beneficial.Is loss aversion a cognitive bias or a preference feature (like aversion to risk)? Carefully read the top of p. 40 of the Ackert e.a. textbook Essay Question, ~100 words.)Yes, loss aversion is a cognitive bias. Some call it a function of just being human. Cognitive biases are the tendency to do the same things repeatedly that lead to a pattern of behavior even if this behavior is deemed different from business as usual. Loss aversion is not a preference feature like risk aversion. Moreover, loss aversion is different from risk aversion, even though the two could appear similar on the surface. Loss aversion is different from risk aversion since there is only a probability in the latter whereas there is a certainty (of a loss) in the former.
A cognitive bias is:
Not being able to do arithmetic correctly
Inference or actions that are incorrect given the objective truth
Define the disposition effect. (Essay Question, ~50 words)The disposition effect is trying to hold onto investments that are classified as losers rather than those that are winning or doing well in the stock market. This behavioral finance anomaly occurs because investors do not want to recognize losses even if selling these losing investments would help them. The disposition effect is related to loss aversion because the investor is avoiding coming to terms with a loss.
Many cognitive biases such as loss aversion emerge because of inappropriate reference/aspiration points. Discuss. (Essay Question, ~100 words)Most people evaluate a gain or loss based on a reference point. This reference point is usually the status quo. Most people tend to feel a loss more than a gain. This occurs even if the gain is of an equal or better value than the loss. Since value is defined by a gain or loss (value function) as compared to a reference point, the person with loss aversion is (cognitively) biased and looking back at the point when they had a (possibly devastating) loss. They are then using that reference point to make his/her decisions. This could mean that he/she is not always making the best decisions due to this cognitive bias. However, they are fine with this since he/she is operating at his/her comfort level.
If investors overweigh recent performance in forecasting the future, what cognitive bias are they exhibiting? If investors place too much importance on current performance and then act overconfidently when forecasting the future, they are exhibiting a representativeness bias. In a way, they are using the current performance to act as a representative of the way the future could look (even if this may not be true).
Universally bad for investments
An integral part of reasonable investment choices
The opposite of rationality
The disposition effect is the consequence of setting the wrong reference point. Discuss. (Essay Question, ~50 words) When an investor has the disposition effect, they are holding onto a loss based on an irrational fear and flawed reference point. This flawed reference point supplies the investor with the erroneous information that the loss is somewhat worthy of holding on to even if it could be deleterious to the investor’s financial portfolio.
Define what probability weighting in prospect theory refers to. (Essay Question, ~25 words)Probability weighting in prospect theory refers to how an investor’s weighting function shifts farther away from linearity as their choice becomes driven by emotions. (Prospect theory has a strong emotional basis and refers to how people make decisions when faced with risky options.)
Define ambiguity aversion (or uncertainty aversion) and give one pointed example. (Essay Question, ~25 words)Ambiguity aversion is when an investor takes a chance with a familiar risk rather than an unfamiliar risk. For example, someone with ambiguity aversion would rather guess from a box where they knew there were 20 green cubes and 20 blue cubes rather from one where they are told there are 40 green cubes and an unknown amount of blue cubes.
Look up the rules of the Monty Hall game (e.g., http://math.ucsd.edu/~crypto/Monty/monty.html), you want to switch choices after the quizmaster opens a door behind which there is no present because
You should take chances
You are ambiguity averse
While you don’t improve your chances compared to not switching, it makes the game all the more interesting
2/3 of the time the present will be behind the door you switch to
Principle 1 on p 329 of the Ackert e.a. text states that it is OK to accommodate cognitive biases of more wealthy clients. What do you think? (Essay Question, ~100 words.)Principle 1 states that it is okay to accommodate cognitive biases, such as loss aversion, on wealthy clients because wealthy clients would be less affected by the negative consequences that this cognitive bias could cause. For example, someone, who is not wealthy could be clinging to the notion of loss aversion and using this cognitive bias to dictate how this investor interacts with the stock market. This investor may be staying away from equity stocks because he/she thinks that this stock with its risk profile will lead to a loss. It may actually turn out that the equity stock would produce a high ROI but the loss aversive investor cannot see this. Not reaping the rewards (ROI) of this equity stock would greater affect a less wealthy investor than a wealthy one.
Mental accounting can be a good thing. Why? (Essay Question, ~50 words)Mental accounting can be good because people use it to make their decision-making more manageable. Using mental accounting, they are able to evaluate, organize, and monitor their financial issues before making a choice. For an investor that feels overwhelmed with financial decisions, mental accounting is a good way of simplifying the decision-making process.
Define overconfidence in a way that it can be measured accurately. (Essay Question, ~25 words)Overconfidence is when someone feels like they know more than they actually do. For example, if someone has a confidence level of 90% that they will pass a test but then actually only get 70%; he/she is overconfident.
Cognitive biases are never good.
Agreed. It is never good to be, say, overconfident.
Disagreed. To be, say, overconfident allows one to sometimes obtain results that one could not get otherwise.
Agreed, but it is easy to get rid of them.
Disagreed. Without, say, overconfidence, nobody would ever invest in risky securities such as equity.
Briefly evaluate the disadvantages and merits of the « 1/N » diversification rule (also known as « diversification heuristics ») (Essay Question, ~100 words.)Financially speaking, one disadvantage of the « 1/N » diversification rule is that it could spread assets so thin that tangible gains cannot be felt. This rule suggests that people like to try a little bit of everything instead of sticking to a few tried and true things. For example, someone could see their favorite dish at an all-you-can-eat buffet. However, instead of eating a few servings of this dish, they rather sample a little bit or everything for fear that they may “miss out.” This could leave them unsatisfied because they do not get to eat enough their favorite dish. Conversely, the « 1/N » diversification rule has a merit in that one will not take as much risks as say someone that is underdiversified.
Swissquote is known to have online customers (who trade on their own) that on average beat many professional investors. At the same time, these customers trade less than most professional investors. Comment what this means for Barber and Odean’s US results that state that US online traders underperform. (Essay Question, ~100 words.)The Swissquote example confirms everything that Barber and Odean have researched and documented. They found that the 20% of investors, who traded the most underperformed in the market. This means that maybe Swissquote’s online customers are on to something. They are trading less yet they are beating professional investors in the market. Barber and Odean found that investors, who are making the most trades are not necessarily doing so because they have superior information. Rather, they are making these multiple trades because they have the perception of superior information. In actuality, the driving force behind their multiple trades is misinformation or overconfidence.
Heuristics are simple rules of thumb used to solve complex problems.
This is universally bad.
The heuristics can be well adapted to a particular environment, but inappropriate in other settings
Heuristics always lead to cognitive biases
Heuristics should be avoided as much as one canAnswer: b
Explain gambler’s fallacy. How is it related to the momentum effect ? (Essay Question, ~100 words.)Gambler’s fallacy is the erroneous belief that if something happens frequently in a certain window of time then it will happen less frequently in the future. Conversely, gambler’s fallacy also believes that if something happens less frequently in a certain window of time then it will happen more frequently in the future. The momentum effect in finance states that if a stock price (for example) keeps rising, it will continue to rise (i.e., it has momentum). Conversely, the momentum effect states that if a (stock) price is falling that it will continue to keep falling. Gambler’s effect and momentum effect only agree in the first portion of each phenomenon. In the second portion of the gambler’s fallacy, the starting behavior turns to an opposite behavior whereas in the momentum effect there is a continuum of behavior between the starting and concluding behaviors.
You sense that your client is extremely loss averse. Nevertheless, it is appropriate that your client invest in common stock. What would you do minimize the effect of loss aversion? (Essay Question, ~100 words; REMEMBER: loss aversion is NOT an attitude towards uncertainty, but a cognitive bias)Since my client has loss aversion, losses seem bigger than gains. Even if she/he had a looming gain on a stock, for example, she would rather not take advantage of it because of the fear of a loss. To minimize the effect of loss aversion for my client, I plan to advise my client to purchase common stocks where the expected return on the stock is expected to be very high, otherwise my loss averse investor would not want to hold on it. Doing this will minimize the effect that my client will feel like these types of common stocks are one that she/he cannot in good sense and judgement refuse.
Imagine a bin with 15 colored balls in total. 5 are red, and an unknown number of the remaining 10 balls are green or blue. A ball is about to be drawn from the bin. Consider the following gambles (due to Ellsberg, the person who wrote the “Pentagon Papers”). (R) You receive one dollar if the ball is red. (G) You receive one dollar if the ball is green. (RB) You receive one dollar if the ball is either red or blue. (GB) You receive one dollar if the ball is green or blue. Most people would choose R over G because they are ambiguity averse. At the same time, they prefer GB over RB. Why does this make no sense (and hence, why does ambiguity aversion make no sense? (Essay Question, ~100 words.)Preferring GB over RB does not make sense because the unconditional likelihood of success in either case is identical. That is, the chance that this person will receive more money from either choice will be the same. Additionally, this does not make sense for the same reason that ambiguity aversion does not make sense. Ambiguity aversion is caused by the fact that people prefer to have risk over uncertainty. The risk phenomenon happens when someone knows the exact probability distribution. Uncertainty occurs when this person does not know the exact probability distribution. Either choice will yield the same result demonstrating why this and ambiguity aversion does not many any sense.