BEHAVIORAL FINANCE ANSWERS
Question 1

Statement
When he first started
investing, he thought
his MBA gave him
the expert knowledge
needed to be a
proficient investor.
Historically, X-wire
has performed well
and this led Clark to
believe it would
continue to do so in
the future.

After buying the Xwire stock it
continued to do well
for a short period of
time and then
decreased in price
below Clark’s
original purchase
price. Clark is
reluctant to sell it in
hopes of at least
breaking even in the
near future.

State the most

likely behavioral
bias being
exhibited.

Explain one consequence of the behavior from a
portfolio perspective.


Overconfidence
bias

Representativeness
bias

Loss aversion bias




Trade too frequently leading to higher
transactions costs and lower returns.
Under-diversified portfolios.
Under estimate risk and overestimate return.





Hold on to or buy recent winners.
Sell or avoid recent losers.

Excessive turnover.

Candidate discussion: Investors base decisions
on the recent past rather than unbiased
expectations of future performance, placing too
much emphasis on new information received and
too small of a data set.
 Hold onto losing stocks in hopes of breaking
even.
 Sell winners too soon to capture gains.
 Trade too frequently leading to higher
transactions costs and lower returns.
 Incur too much risk holding onto assets that
have lost value.
Candidate discussion: Fear of regret or regret
is a hindsight bias where the investor feels an
opportunity has passed them by thinking they
should have bought or sold a particular
investment. Myopic loss aversion is
overemphasizing short-term potential losses and
underemphasizing long-term return, resulting in
a risk premium on stocks that is too high given
long-term characteristics and under-weighting
stocks.

Sample Scoring Key:
1 point for each behavioral trait.
2 points for any one consequence from a portfolio perspective.

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Question 2
Part A
1. Status quo bias is when the investor leaves their asset allocation the same over time without
regard to changing circumstances such as age, wealth, and risk tolerance.
2. 1/n naïve diversification is investing equally amount various investment options within a
defined contribution plan.
Sample Scoring Key:
1 point each for correctly identifying the behavioral trait.
1 point each for describing each trait.

Part B
An advantage of pyramiding is (1) it’s easier for the investor to understand and (2) more likely
they will maintain the asset allocation, leading to their goals.
A disadvantage of pyramiding is the correlation of assets is ignored, leading to a less-thanoptimal asset allocation from a traditional finance perspective.
Sample Scoring Key:
2 points each for one advantage and one disadvantage of pyramiding.

Question 3
A.





Statement 1: Traditional finance is normative (or proscriptive) and explains how
investors should invest. (Or: Behavioral finance is descriptive in explaining how
investors actually invest.)
Statement 2: Behavioral finance assumes investors are limited in their cognitive ability.

(Or: Traditional finance assumes no limits to decision-making ability.)
Statement 2: Behavioral finance does not assume investors are always risk seekers, only
that, at some times or under some conditions, they could be.

Sample Scoring Key:
Any two of the three items identified and restated can be used. One point for each identification
and each restatement.
B.


Utility theory assumes that satisfaction (utility) depends on level of wealth, while loss
aversion assumes it depends on perceived gain versus loss.

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


Utility theory assumes investors are always risk averse, while loss aversion assumes risk
aversion for gains and risk seeking for loses.
Utility theory focuses on total portfolio value, while loss aversion focuses on each
position and increase or decrease in value (i.e., increasing or decreasing gain or loss).

Sample Scoring Key:
Any two of the three items can be used for 2 points each.
C.






Markets can be inefficient and exhibit technical momentum effects, where a period of
increasing stock price leads to further increases and, eventually, highly overvalued
(bubble) conditions.
Investors can exhibit herding, where all investors take the same action (buying), which
increases stock prices and leads to overvalued markets.
Investors may fear regret if they do not buy whatever is increasing in price, engage in
trend chasing and buy whatever is going up in price, or assume available positive
information on securities is representative of everything relative to their valuation; in the
process, investors push prices to unreasonably overvalued levels.

Sample Scoring Key:
One point for any one item discussed and two points for a discussion of how it leads to highly
overvalued conditions. Potentially, there are other acceptable answers to such an open-ended
question. If you review the CFA text and use an item directly discussed in the CFA text as
tied to a market bubble, it should be accepted. However, it is not acceptable to pick an item
not directly discussed in this context and apply your own “inherent” logic of why you think it
should be acceptable. In other words, you must answer based directly on the most relevant taught
material.
D. Each member brings their own individual biases, and in a poorly run group setting, the group
setting itself creates new issues as individuals feel inhibited in speaking freely or talk too
much. The chairman can:
 Establish an environment where members feel safe to voice their views.
 Encourage all members to speak up and voice dissenting opinions.
 Establish and stick to a relevant agenda.
 Require clear decisions be made and document those decisions.
 Require members to treat each other with professional respect.
Sample Scoring Key:
Two points for making it clear the group setting itself can be the problem as social proof, peer

pressure, and herding behavior inhibit free discussion. One point each for any two of the actions
the chairman can take.
Candidate discussion: Recruiting diverse and qualified members is also an appropriate
chairperson action but will receive no credit in this question. Reread the case facts; it is not an
issue for this committee.
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