Deck 22: Behavioral Finance: Implications for Financial Management

Question 1

Peter has successfully managed the finances of A.D. Leadbetter 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

Answer 1

Overconfidence

Question 2

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

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

Answer 2

Frame dependence

Question 3

Phyllis is planning for her retirement in 15 years. She currently lives comfortably on $38,000 a year given that she is debt-free. Based on her family history she only expects to live ten years after she retires. Thus, she computes her retirement need as $38,000 a year for ten 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

Answer 3

Money illusion

Question 4

The tendency to sell winners and hold losers is known as the:

A) representativeness heuristic.
B) disposition effect.
C) house money effect.
D) self-attribution bias.
E) affect heuristic.

Question 5

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

A) Overconfidence
B) Overoptimism
C) Affect heuristic
D) Confirmation bias
E) Representativeness heuristic

Question 6

Consumer Marketing just conducted a two-phase survey. In the first phase, the survey questions were worded such that the answers tended to sound positive. In the second phase, the survey questions were reworded so 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 7

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 8

Ramon opened a combination laundry and dry cleaning establishment three years ago that is quite successful. 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 behavioral characteristics?

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

Question 9

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) Mental accounting
C) Endowment effect
D) Confirmation bias
E) Overoptimism

Question 10

Aivree wants to accumulate great wealth but she invests all of her funds in U.S. Treasury bills because she wants to avoid the potential losses she knows can occur in the stock markets. Aivree best illustrates which one of these characteristics?

A) Loss aversion
B) Gambler's fallacy
C) Disposition effect
D) Law of small numbers
E) Mental accounting

Question 11

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 primarily suffering from which one of the following behavioral conditions?

A) Representativeness heuristic
B) House money
C) Loss aversion
D) Randomness
E) Myopic loss aversion

Question 12

Marzella Corp. is analyzing a project that involves expanding the firm into a new product line. The project's financial projections will tend to have which one of the following characteristics if the person compiling those projections suffers from overoptimism?

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

Question 13

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

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 14

Over the past six months, you have watched as your parent's retirement savings have declined in value by 25 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 behavioral characteristic have you acquired as a result of the market downturn?

A) Myopic loss aversion
B) Get-evenitis
C) Self-attribution bias
D) Mental accounting
E) Regret aversion

Question 15

Jeremy believes he excels at picking stock winners and thus trades frequently. Which characteristic does he most likely represent?

A) Confirmation bias
B) Frame dependence
C) Overconfidence
D) Representativeness heuristic
E) Break-even effect

Question 16

Kate tends to hold onto assets that have lost value in the hope that their values will increase in the future. Kate illustrates which one of the following?

A) Frame dependence
B) Self-attribution bias
C) Gambler's fallacy
D) Break-even effect
E) Regret aversion

Question 17

Nadine made a business decision that turned out badly. In reflecting upon her decision, she decided it was a reasoning error that led to the faulty decision. 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 18

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 19

Alice believes she can accurately forecast the future and makes business decisions based on this belief. Which characteristics does this belief represent?

A) Overconfidence
B) Overoptimism
C) Affect heuristic
D) Confirmation bias
E) Representativeness heuristic

Question 20

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 5 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) Disposition effect
B) Affect heuristic
C) Gambler's fallacy
D) House money
E) Get-evenitis

Question 21

Which term refers to the tendency to shy away from the unknown?

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

Question 22

Which term refers to the reliance on stereotypes or limited samples to form opinions about an entire class?

A) Clustering illusion
B) Law of small numbers
C) Representativeness heuristic
D) False consensus
E) Recency bias

Question 23

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, 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 24

You started an online business two weeks ago. Thus far, you have averaged ten 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 ten sales a day and know that level of income would support you in a comfortable fashion. The belief that you will have ten sales per day 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 25

Your friends are all investing in a start-up company. You, on the other hand, refuse to invest in the company because you don't know the odds of it becoming successful. Which behavioral characteristic are you displaying?

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

Question 26

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 storewide sale and offer ten percent off all merchandise for a three-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 27

You have a tendency to take credit for the decisions you make that have good outcomes even when those outcomes are out of your control. On the other hand, you blame bad luck for your decisions that turn out badly. Which of these terms applies to you?

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

Question 28

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 29

It is believed by some individuals that, in an efficient market, the actions of traders who constantly buy and sell on any perceived market mispricing 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 are 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 30

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 31

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 32

The last six times you purchased a stock you earned high returns within one year. Thus, you believe you will have the same result with your next stock purchase. 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 33

All of the following create limits to arbitrage except:

A) firm-specific risk.
B) noise traders.
C) thinly traded securities.
D) rational traders.
E) implementation costs.

Question 34

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 35

Up until three years ago, A.C. Dime opened an average of ten new retail stores a year. One of every ten new stores had to be closed within two years due to poor sales. This 90 percent success ratio was fairly steady for over 30 years. Starting three years ago, the firm has opened 40 new stores and every one had significant profits within six months. Management believes their recent success is not just a random event and that all future stores will be profitable. Thus, the managers have decided to open a minimum of 15 new stores each year. The managers are suffering from:

A) arbitrage limitations.
B) anchoring and adjustment.
C) aversion to ambiguity.
D) the clustering illusion.
E) myopic aversion.

Question 36

A tendency to be overly conservative when faced with new information is referred to as:

A) anchoring and adjustment.
B) heuristics.
C) self-attribution.
D) loss aversion.
E) regret aversion.

Question 37

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 38

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 39

The last two promotions within a firm involved individuals who completed the same advanced managerial program. As a result, the company president has stipulated that all future management hires must be graduates of that program. This behavior is typical of someone who has which one of the following characteristics?

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

Question 40

Which word best describes the stock market during the month of October 1987?

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

Question 41

Which one of these statements related to the Crash of 1987 is false?

A) Program trading is at least partially to blame for the market meltdown.
B) Between August and October 1987 the market declined over 40 percent.
C) In some cases, it became impossible to contact a market maker.
D) Trading volume exceeded the market's capacity to handle the order flows.
E) Following the Crash of 1987, the market continued to slowly decline over the following year.

Question 42

Which one of the following statements is correct?

A) In a totally efficient market every investment has a zero net present value.
B) Portfolio managers with tenures greater than 10 years, consistently outperform the market.
C) The performance of professional money managers improves the longer the investment period.
D) Mutual funds that are actively managed outperform index funds over the long term.
E) The number of mutual funds outperforming the Vanguard 500 Index Fund over a 10-year period is steadily rising.

Question 43

Which one of the following statements related to market crashes is correct?

A) Financial market crashes are unique to the United States.
B) A market crash tends to occur within a week but have effects that last many years.
C) Once the market finally crashed in 1929, stock prices began a long period of steady increases.
D) The market crash of 1987 occurred on a day when trading volume was light indicating there were a limited number of irrational investors involved.
E) Actions in Washington, D.C., may have helped contribute to the market crash in 1929 but not to the 1987 crash.

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 60 percent of the time on average.
C) The longer the time span, the more likely a professional money manager will outperform an index fund, such as the S&P 500.
D) Historical data supports the statement that arbitrage results in a 100 percent totally efficient market.
E) The financial markets appear to be highly efficient because, on average, they outperform professional money managers.

Question 45

Following the Crash of 1929, the stock market:

A) began to slowly, but steadily, increase in value.
B) was flat for about three years and then began a slow, steady rise to pre-crash values.
C) continued to decline slightly before increasing over a 3-year period to its pre-crash values.
D) temporarily increased in value and then began a 3-year decline to ten percent of its pre-crash value.
E) recouped its 90 percent loss within the following three years.

Question 46

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 crashes of 1929 and 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 47

Approximately what percent of its total value did the stock market lose on "Black Monday"?

A) 19
B) 10
C) 23
D) 30
E) 38

Question 48

Which one of the following is given as a key reason why many of the dot-com companies failed following their IPO's?

A) Lack of a solid business model
B) Lack of internet access
C) Market crash in Asia
D) Change in government regulations
E) Program trading