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What do cognitive errors relate to?
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Gilbert Khoury, a restaurateur in a large city with many competing restaurants, has become extremely popular as a chef. He believes the fact he has surpassed breakeven profitability after only six months indicates his restaurant will be a long-term success. However, statistics indicate that 80 percent of restaurants go out of business or change hands in the first three years. Which of the following actions that Khoury could take would be indicative of sample-size neglect? a) He opens another restaurant across town to duplicate his success. b) He renegotiates for an additional 5-year extension on the location's lease. c) He does not react to his initial success and continues along the original plan.b) He renegotiates for an additional 5-year extension on the location's lease.What is base-rate neglect?investors overreact to new information on a company without considering the underlying base probability for an eventWhat is sample-size neglect?investors draw a conclusion that the entire population is similar to a very small sampleWhat is the solution to base-rate neglect and sample-size neglect?FMPs must recognize the tendency of relying on patterns rather than determining probabilities and should use an asset allocation strategy to improve long-term portfolio returnsWhat is illusion of control bias and how can it be fixed?occurs when FMPs believe they have more control over a situation than they actually have; investors should be educated to acknowledge global investing is a probabilistic activity over which they have very little control, in addition, searching for contrary opinions on what might go wrong can help FMPs avoid mistakesWhat is hindsight bias and how can it be fixed?individuals perceive past events as having been predictable, so this bias has aspects of both selective perception and selective retention; education is important to recognize this and the investor should reflect on their mistakes and carefully record reasons for making investment decisionsWhat is anchoring and adjustment bias and how can it be fixed?describes how people base their initial forecast on some past experience (anchor) and adjust that estimate as new information presents itself; FMPs should ask themselves whether they are giving irrational weight to an entry point, or some other state that has become their anchor, or strictly rely on rational analysisWhat is mental accounting bias and how can it be fixed?results when investors assign different levels of importance to different "pots" of money; FMPs can detect mental accounting bias by looking at their investments as a single portfolio and identify whether cash balances among the layers are higher than necessary when the portfolio is considered in the aggregateWhat is framing bias and how can it be fixed?it happens when individuals answer the same question differently depending on how it is asked; FMPs should focus on future investment prospects rather than consider gains and losses that already occurredWhat is availability bias?occurs when people overestimate the probability of an event occurring based on the "availability" of their memory of the eventWhat are some availability biases?- retrievability - categorization - narrow range of experience - resonanceWhat is retrievability?people tend to place more importance on things and events they rememberWhat is categorization?people use search sets to categorize dataWhat is narrow range of experience?people tend to overestimate the probability of something they experience personally and project that estimate onto the rest of the worldWhat is resonance?people often overestimate the number of "like-minds" when it comes to activities they enjoy while underestimate the number when it comes to activities they dislikeA risk averse investor with a long time horizon would be most likely to select a portfolio with 10-year return of: a) 4% with a standard deviation of 1% b) 10% with a standard deviation of 15% c) 4% with a 95% probability of 2% to 6%b) 10% with a standard deviation of 15%A risk averse investor with a long time horizon would be most likely to select a portfolio with 10-year return of: a) 4% with a standard deviation of 1% b) 4% with a 95% probability of 2% to 6% c) 10% with a 95% probability of -20% to 40%b) 4% with a 95% probability of 2% to 6%Stephen Mullen, CFA, is CEO of New Galaxy Investments, a company he started from scratch and built into a multibillion-dollar company. Due to his successful backstory, Mullen has always favored new companies run by their founders in his portfolio, and his portfolio has consistently been overweight such companies. Which of the following behavioral biases is Mullen most likely to be exhibiting?Availability.An investment manager is asked by a client about the risk management of a fund in which they are a large investor. The manager informs the clients that they use a value-at-risk (VaR) methodology to measure the risk of the fund, and that the one-month, 5% VaR of the fund is 8%. When the client asks what this figure means, the manager states that it is estimated that there is a 5% chance that the fund will lose 8% or more in any given month. The investor states that this sounds like an unacceptable level of risk. However, when the manager explains that this means there is a 95% chance the fund will not lose 8% or more in any month, the investor is reassured that the fund risk levels are acceptable. Which of the following behavioral biases is the client most likely to be exhibiting?Framing.Which of the following statements about self-control bias is most appropriate with respect to investor behavior?Excessive portfolio risk may be taken to make up for lost savings.A large brokerage firm recently picked up coverage on a high-tech company that your father left shares of for you in his estate. Coverage opened at a price of $15 and the shares are now at $1 less than their $25 price target. Your financial situation would benefit from the windfall if you sold the shares and you told yourself you would sell when they reach their price target. Yesterday, the brokerage firm reduced its target to $20 based on changes in the underlying fundamentals. If you decide to hold the shares, you would most likely be exhibiting:anchoring bias.What are the emotional biases?- loss-aversion bias - overconfidence bias - self-control bias - status quo bias - endowment bias - regret-aversion biasWhat is loss aversion bias and how can it be fixed?occurs when investors make decisions designed to avoid losses rather than to seek gains; advisors can advise their clients to realistically consider the probabilities of gains and losses over the investment horizonWhat is the disposition effect?describes how FMPs will hold losing positions with no hope of increasing in value and cash out of winning positions likely to continue positive returnsWhat is myopic loss aversion?the view that short-term losses will be as painful and make adjustments that might be detrimental to their long term goalsWhat is overconfidence bias and how can it be fixed?occurs when people overestimate their knowledge, abilities, or access to information and consequently have too much faith in their intuition, reasoning, or judgement; should examine their investment results over the last two years and calculate the reduction to return from trading costsWhat is illusion of knowledge bias?people believe they are smarter than they really areWhat is prediction overconfidence bias?FMPs assign narrow confidence intervals based on lower standard deviations than justified by fundamental analysisWhat is certainty overconfidence bias?FMPs overestimate the probability of events, especially positive returns, and are likely to replace failing investments with new ones certain to generate better returnsWhat is self attribution bias?people believe positive results derive from their abilities and judgement while negative results derive from bad luck or from others mistakesWhat is self enhancing bias?FMPs claim too much credit for their successesWhat is self protecting bias?stemming from a need to protect self esteem, FMPs mat deny personal responsibility for failuresWhat is self control bias and how can it be fixed?occurs when FMPs fail to support their long term goals with short term behavior; craft a carefully written financial planFMPs exhibiting an overconfidence bias will most likely: a) overestimate risks and expected returns because of their intuition b) trade less based on the certainty of their selections and not fundamental analysis c) experience lower returns than the market because of their own perceived abilitiesc) experience lower returns than the market because of their own perceived abilitiesWhat is status quo bias and how can it be fixed?results primarily from inertia rather than conscious choice and will fail to explore alternatives, preferring to stick with the status quo rather than make any attempt to further improve their situation; an advisor can help an investor understand the importance of diversification and proper asset allocationWhat is endowment bias and how can it be fixed?people attach more value to the assets they own or inherited than assets they do not own; by showing how an objectively determined asset allocation differs from the current portfolio allocationWhat is regret aversion bias and how can it be fixed?investors resist situations that require a decision for fear of a negative outcome; important for advisors to educate on the proper asset allocation for the determined risk level; FMPs must realize that losses happen to everyone, and that the long term outcome should not be sacrificed to follow the current trendWhat is errors of commission?regret from actions takenWhat is error of omission?regret from actions not takenWhat is herding behavior?a tendency to invest in the same investments as their friends or only in stocks of well-known companiesDonna Metier is reluctant to invest in high-tech securities because she doesn't want to make the wrong decision. Metier most likely exhibits:regret aversion bias.Belief perseverance errors are best described as a type of bias related to:cognitive dissonance.Giving more weight to evidence which supports our existing beliefs could best be described as:confirmation bias.