Question

In: Finance

1. Overconfidence is most likely to be displayed by: A) A financial advisor with a three-year...

1. Overconfidence is most likely to be displayed by:

A) A financial advisor with a three-year record of outperformance

B) An individual investor with 100% allocation to a broad equity index

C) The board of trustees of a college endowment fund comprised of liberal arts professors

D) A foundation with 100% allocation to risk-free government bonds because of low risk tolerance

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2. A rational investor would most likely:

A) Use emotional cues to re-balance portfolios

B) Take shortcuts when making asset allocation decisions

C) Completely and accurately process covariance data

D) Be influenced by the frame of an investment decision

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3. Sarah recently reviewed her portfolio as part of her year-end performance assessment. She sold several stocks that had positive results for the year but held on to two stocks that were below her purchase price. She did not re-evaluate the potential performance for these stocks. Which form of bias is she exhibiting?

A) Hindsight bias

B) Confirmation bias

C) Loss aversion

D) Overconfidence bias

Solutions

Expert Solution

1. A) A financial advisor with a three-year record of outperformance

Overconfidence bias arises due to past good performance. Here, a person who has a record of outperformance might show the overconfidence bias. Option B), C) and D) are less likely to display overconfidence bias as they have taken lesser risk and there is no proof of past superior performance.

2. C) Completely and accurately process covariance data

A rational investor studies the market data and the covariance between the individual securities and is not carried away by emotions or any different investment theories. Also, a rational investor does not take any shortcuts when making decisions.

3 C) Loss aversion

The loss aversion bias is displayed when the investor fears losses and do not sell stock which are in losses even though there is a further possibility of their downside. Confirmation bias deals with recalled information, hindsight bias deals with over-estimation of one's capabilities to predict outcome which is not displayed by Sarah.


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