Download and confirmation bias can affect decision making

Chapter 22
Behavioral Finance: Implications for Financial Management
Multiple Choice Questions
1. Amy is the chief financial officer of a retail toy store. Recently, she decided that
the firm should expand its operations and open two additional stores. Within a
very brief period, it was obvious that Amy had made a very bad decision in
opening those stores, given that the economy is in the middle of a severe
recession. In reflecting back on her decision, Amy realizes that she made a bad
decision due to a reasoning error. 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
2. 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
3. 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. overconfidence
C. gambler's fallacy
D. confirmation bias
E. overoptimism
4. The tendency for a decision maker to search for confirmation 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
5. Which one of the following refers to the fact that an individual may reply
differently if a question is asked in a different manner?
A. loss aversion
B. gambler's fallacy
C. frame dependence
D. overconfidence
E. format reference
6. General rules used as the basis for decision making are referred to as:
A. a loss aversion technique.
B. heuristics.
C. self-attribution.
D. narrow framing.
E. confirmation bias.
7. 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.
8. Old Country Productions requires skilled furniture finishers to put the final
touches on all of the furniture it produces. The firm hired two individuals last
year who had been students in Mr. Tedwell's wood shop class in high school.
Both of these employees have demonstrated exceptional skills and have
already been promoted to senior finishing positions. The firm currently has an
opening for one additional finisher. Tom, the head of the finishing section, has
stipulated that he only wants to interview candidates who have completed Mr.
Tedwell's course. Tom's behavior is typical of someone who has which one of
the following characteristic behaviours?
A. endowment effect
B. framing effect
C. representativeness heuristic
D. narrow framing
E. affect heuristic
9. In an efficient market, it is believed by some individuals that the actions of
traders who constantly buy and sell on any perceived market mispricings 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
10. Stewart is a fellow finance student at your school who is addicted to day
trading and thus buys and sells stocks between classes and over his lunch
break. He never has time to really analyze a security so just trades the stock
symbols that other investors appear to be trading. Stewart is which one of the
following?
A. noise trader
B. arbitrageur
C. crasher
D. regret averter
E. myopic loss averter
11. 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
12. Most people would tend to agree that technology stocks were highly
overvalued in the late 1990's. This time period is best described as a
technology:
A. crash.
B. circle.
C. bubble.
D. limit.
E. arbitrage.
13. A sudden and severe decline in market prices is best described as a market:
A. crash.
B. revolver.
C. bubble.
D. limit.
E. mispricing.
14. Which one of the following best illustrates an error which you, as a manager,
might make due to overconfidence?
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
15. 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
16. Marzella Corp. is analyzing a project that involves expanding the firm into a
new product line. The project includes the construction of a new
manufacturing facility and the creation of a new distribution system. 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
17. When weighing a decision, Kate places greater emphasis on opinions that
match her own than she does on opinions offered by others that disagree with
her personal point of view. Kate illustrates which one of the following?
A. frame dependence
B. overconfidence
C. gambler's fallacy
D. confirmation bias
E. overoptimism
18. Kaiser Marketing recently conducted a survey on behalf of Health Products.
The primary purpose of the survey was to illustrate to Health Products that it
was relying on results of previous studies that, according to Kaiser, were
unreliable due to the wording of the survey questions. To prove this point,
Kaiser conducted a two-prong survey. In the first prong, the survey questions
were worded such that the answers tended to sound positive. In the second
prong, the survey questions were re-worded such that 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
19. 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 five 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. overoptimisim
B. affect heuristic
C. loss aversion
D. house money
E. get-evenitis
20. Amy has been investing in stocks so she can accumulate sufficient money to
purchase her own home. These savings are currently valued at $82,500. As
recently as last month, her savings were worth in excess of $110,000. Today,
Amy found the perfect house. She knows she can withdraw her savings to pay
on this house and borrow the remaining balance from her father at zero
percent interest. However, Amy is refusing now to buy any house until her
savings increase in value back to their $110,000 previous valuation. Amy is
displaying which one of the following behaviors?
A. representativeness heuristic
B. loss aversion
C. house money effect
D. underconfidence
E. confirmation bias
21. 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 suffering
most from which one of the following behavioral conditions?
A. representativeness heuristic
B. house money
C. get-evenitis
D. randomness
E. arbitrage reaction
22. Mike is a stock broker and financial planner. Phil is one of Mike's clients. Phil
prefers to meet with Mike just once a year to review his investment portfolio.
At their most recent meeting, Phil stated he believes the stock market is going
to decline in value over the next six months. Thus, Phil instructed Mike to sell
every stock he owns that is currently worth more than what he paid to
purchase it. Phil also instructed Mike to retain any stock that would create a
capital loss if sold. Phil is displaying the behavior known as:
A. overconfidence.
B. arbitrage theory.
C. the disposition effect.
D. the house money effect.
E. a confirmation bias.
23. Over the past six months, you have watched as your parent's retirement
savings have declined in value by 45 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 behavior characteristic have you developed as a result of the
market downturn?
A. myopic loss aversion
B. get-evenitis
C. self-attribution bias
D. mental accounting
E. regret aversion
24. Ramon opened a combination laundry and dry cleaning establishment three
years ago. Due to his excellent service and reasonable prices, his business has
grown and is doing quite well financially. 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 behavior characteristics?
A. self-attribution bias
B. overconfidence
C. regret aversion
D. house money effect
E. frame dependence
25. Phyllis is planning for her retirement in fifteen years. She knows that she can
currently live reasonably well on $38,000 a year given that she is debt-free.
Based on her family history she expects to die ten years after she retires. Thus,
she computes her retirement need as $38,000 a year for 10 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
26. 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
27. 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 that 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
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
29. Up until three years ago, A.C. Dime opened an average of ten new retail stores
a year. One of those 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 6 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.
30. 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.
31. You don't particularly like to shop so only go to the mall once a month. To help
make the trek more enjoyable, you always have lunch at the restaurant located
inside the mall. Since you are such a creature of habit, you always order the
same meal. You've noticed that the price of that meal has increased every time
you have been there over the past six months. Thus, you expect the meal to
increase in price next month. 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
32. You started an online business three weeks ago. Thus far, you have averaged
10 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 10 sales a day and
know that level of income would support you in a comfortable fashion. The
belief that you will have 10 sales per day on average if this becomes your fulltime 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
33. 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
34. You have saved a total of $200,000 over the past several years. Jane, a trusted
business associate, recently approached you with an offer. She has offered you
a partnership in a new firm that she expects to be exceedingly profitable. Your
initial investment in the partnership would be $125,000. However, Jane cannot
give you any odds on that success occurring. You have decided to keep your
$125,000 and forego this opportunity simply because you don't know the
probability of success. Which one of the following behavior characteristics do
you have?
A. aversion to ambiguity
B. recency bias
C. sentiment-based risk aversion
D. clustering illusion
E. money illusion
35. 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
store-wide sale and offer 10 percent off all merchandise for a 3-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
36. Which of the following create limits to arbitrage?
I. risks related to an individual firm
II. implementation costs
III. rational traders
IV. noise traders
A. I and III only
B. II and IV only
C. I, II, and III only
D. I, II, and IV only
E. I, II, III, and IV
37. 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
38. Which of the following have been offered as factors contributing to the market
crash of 1987?
I. requirement for only a 10 percent cash payment to purchase a stock
II. program trading
III. irrational investors
IV. preceeding bear market
A. I and III only
B. I and IV only
C. II and III only
D. I, II, and III only
E. I, II, and IV only
39. Which one of the following statements related to market crashes is correct?
A. Financial market crashes are unique to the United States.
B. A severe market decline tends to occur over a multi-day period.
C. Once the market finally crashed in 1929, stock prices began to slowly
increase again.
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.
40. 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 crash of 1929 and the crash of 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.
41. 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 55 percent of the time on average.
C. The longer the time span, the more apt a professional money manager is to
outperform an index fund, such as the S&P 500.
D. Historical data supports the statement that arbitrage is unlimited and
results in a totally efficient market.
E. The financial markets appear to be efficient because, on average, they
outperform professional money managers.
42. Which of the following statements are correct?
I. Many professional fund managers are paid well but fail to outperform as
expected.
II. Professional fund managers that have tenures in excess of ten years, tend to
consistently outperform the market on a long-term basis.
III. If a market is truly efficient, then all investments in that market are zero net
present value opportunities.
IV. Actively managing a fund appears to be the key to outperforming the
market.
A. I and III only
B. II and IV only
C. II and III only
D. I, II, and III only
E. I, II, III, and IV
Essay Questions
43. Provide an example of a managerial decision that illustrates each one of the
following behaviors:
Behavior: Overconfidence
Example:
Behavior: Affect heuristic
Example:
Behavior: Loss aversion
Example:
44. Explain 1) the concept of house money, 2) why the house money concept is
such a common behavior for so many individuals and 3) why house money is
an irrational behavior.
45. Explain why a low-priced, low trading volume stock is more apt to present
limits to arbitrage than is a high-priced, high trading volume stock.
Chapter 22 Behavioral Finance: Implications for Financial Management Answer
Key
Multiple Choice Questions
1.
Amy is the chief financial officer of a retail toy store. Recently, she decided
that the firm should expand its operations and open two additional stores.
Within a very brief period, it was obvious that Amy had made a very bad
decision in opening those stores, given that the economy is in the middle of
a severe recession. In reflecting back on her decision, Amy realizes that she
made a bad decision due to a reasoning error. 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
Refer to section 22.1
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.1
Topic: Behavioral finance
2.
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
Refer to section 22.2
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Overconfidence
3.
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. overconfidence
C. gambler's fallacy
D. confirmation bias
E. overoptimism
Refer to section 22.2
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Overoptimism
4.
The tendency for a decision maker to search for confirmation 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
Refer to section 22.2
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Confirmation bias
5.
Which one of the following refers to the fact that an individual may reply
differently if a question is asked in a different manner?
A. loss aversion
B. gambler's fallacy
C. frame dependence
D. overconfidence
E. format reference
Refer to section 22.3
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Frame dependence
6.
General rules used as the basis for decision making are referred to as:
A. a loss aversion technique.
B. heuristics.
C. self-attribution.
D. narrow framing.
E. confirmation bias.
Refer to section 22.4
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Heuristics
7.
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.
Refer to section 22.4
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Affect heuristic
8.
Old Country Productions requires skilled furniture finishers to put the final
touches on all of the furniture it produces. The firm hired two individuals last
year who had been students in Mr. Tedwell's wood shop class in high school.
Both of these employees have demonstrated exceptional skills and have
already been promoted to senior finishing positions. The firm currently has
an opening for one additional finisher. Tom, the head of the finishing
section, has stipulated that he only wants to interview candidates who have
completed Mr. Tedwell's course. Tom's behavior is typical of someone who
has which one of the following characteristic behaviours?
A. endowment effect
B. framing effect
C. representativeness heuristic
D. narrow framing
E. affect heuristic
Refer to section 22.4
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Representativeness heuristic
9.
In an efficient market, it is believed by some individuals that the actions of
traders who constantly buy and sell on any perceived market mispricings 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
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Limits to arbitrage
10.
Stewart is a fellow finance student at your school who is addicted to day
trading and thus buys and sells stocks between classes and over his lunch
break. He never has time to really analyze a security so just trades the stock
symbols that other investors appear to be trading. Stewart is which one of
the following?
A. noise trader
B. arbitrageur
C. crasher
D. regret averter
E. myopic loss averter
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Noise trader
11.
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
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Sentiment-based risk
12.
Most people would tend to agree that technology stocks were highly
overvalued in the late 1990's. This time period is best described as a
technology:
A. crash.
B. circle.
C. bubble.
D. limit.
E. arbitrage.
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Bubble
13.
A sudden and severe decline in market prices is best described as a market:
A. crash.
B. revolver.
C. bubble.
D. limit.
E. mispricing.
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Crash
14.
Which one of the following best illustrates an error which you, as a manager,
might make due to overconfidence?
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
Refer to section 22.2
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Overconfidence
15.
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
Refer to section 22.2
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Overconfidence
16.
Marzella Corp. is analyzing a project that involves expanding the firm into a
new product line. The project includes the construction of a new
manufacturing facility and the creation of a new distribution system. 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
Refer to section 22.2
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Overoptimism
17.
When weighing a decision, Kate places greater emphasis on opinions that
match her own than she does on opinions offered by others that disagree
with her personal point of view. Kate illustrates which one of the following?
A. frame dependence
B. overconfidence
C. gambler's fallacy
D. confirmation bias
E. overoptimism
Refer to section 22.2
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Section: 22.2
Topic: Confirmation bias
18.
Kaiser Marketing recently conducted a survey on behalf of Health Products.
The primary purpose of the survey was to illustrate to Health Products that
it was relying on results of previous studies that, according to Kaiser, were
unreliable due to the wording of the survey questions. To prove this point,
Kaiser conducted a two-prong survey. In the first prong, the survey
questions were worded such that the answers tended to sound positive. In
the second prong, the survey questions were re-worded such that 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
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Frame dependence
19.
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 five 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. overoptimisim
B. affect heuristic
C. loss aversion
D. house money
E. get-evenitis
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: House money
20.
Amy has been investing in stocks so she can accumulate sufficient money to
purchase her own home. These savings are currently valued at $82,500. As
recently as last month, her savings were worth in excess of $110,000. Today,
Amy found the perfect house. She knows she can withdraw her savings to
pay on this house and borrow the remaining balance from her father at zero
percent interest. However, Amy is refusing now to buy any house until her
savings increase in value back to their $110,000 previous valuation. Amy is
displaying which one of the following behaviors?
A. representativeness heuristic
B. loss aversion
C. house money effect
D. underconfidence
E. confirmation bias
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Loss aversion
21.
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 suffering most from which one of the following behavioral
conditions?
A. representativeness heuristic
B. house money
C. get-evenitis
D. randomness
E. arbitrage reaction
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Loss aversion, get-evenitis
22.
Mike is a stock broker and financial planner. Phil is one of Mike's clients. Phil
prefers to meet with Mike just once a year to review his investment
portfolio. At their most recent meeting, Phil stated he believes the stock
market is going to decline in value over the next six months. Thus, Phil
instructed Mike to sell every stock he owns that is currently worth more
than what he paid to purchase it. Phil also instructed Mike to retain any
stock that would create a capital loss if sold. Phil is displaying the behavior
known as:
A. overconfidence.
B. arbitrage theory.
C. the disposition effect.
D. the house money effect.
E. a confirmation bias.
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Disposition effect
23.
Over the past six months, you have watched as your parent's retirement
savings have declined in value by 45 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 behavior characteristic have you developed as
a result of the market downturn?
A. myopic loss aversion
B. get-evenitis
C. self-attribution bias
D. mental accounting
E. regret aversion
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Myopic loss aversion
24.
Ramon opened a combination laundry and dry cleaning establishment three
years ago. Due to his excellent service and reasonable prices, his business
has grown and is doing quite well financially. 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 behavior characteristics?
A. self-attribution bias
B. overconfidence
C. regret aversion
D. house money effect
E. frame dependence
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Regret aversion
25.
Phyllis is planning for her retirement in fifteen years. She knows that she can
currently live reasonably well on $38,000 a year given that she is debt-free.
Based on her family history she expects to die ten years after she retires.
Thus, she computes her retirement need as $38,000 a year for 10 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
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Money illusion
26.
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
Refer to section 22.3
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: Endowment effect
27.
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 that 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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Affect heuristic
28.
Roger's Meat Market is a chain of retail stores that limits its sales to freshcut 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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Representativeness heuristic
29.
Up until three years ago, A.C. Dime opened an average of ten new retail
stores a year. One of those 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 6 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.
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Clustering illusion
30.
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.
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Gambler's fallacy
31.
You don't particularly like to shop so only go to the mall once a month. To
help make the trek more enjoyable, you always have lunch at the restaurant
located inside the mall. Since you are such a creature of habit, you always
order the same meal. You've noticed that the price of that meal has
increased every time you have been there over the past six months. Thus,
you expect the meal to increase in price next month. 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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Recency bias
32.
You started an online business three weeks ago. Thus far, you have averaged
10 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 10 sales a day and
know that level of income would support you in a comfortable fashion. The
belief that you will have 10 sales per day on average 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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Law of small numbers
33.
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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Availability bias
34.
You have saved a total of $200,000 over the past several years. Jane, a
trusted business associate, recently approached you with an offer. She has
offered you a partnership in a new firm that she expects to be exceedingly
profitable. Your initial investment in the partnership would be $125,000.
However, Jane cannot give you any odds on that success occurring. You have
decided to keep your $125,000 and forego this opportunity simply because
you don't know the probability of success. Which one of the following
behavior characteristics do you have?
A. aversion to ambiguity
B. recency bias
C. sentiment-based risk aversion
D. clustering illusion
E. money illusion
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: Aversion to ambiguity
35.
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
store-wide sale and offer 10 percent off all merchandise for a 3-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
Refer to section 22.4
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.4
Topic: False consensus
36.
Which of the following create limits to arbitrage?
I. risks related to an individual firm
II. implementation costs
III. rational traders
IV. noise traders
A. I and III only
B. II and IV only
C. I, II, and III only
D. I, II, and IV only
E. I, II, III, and IV
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Limits to arbitrage
37.
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
Refer to section 22.5
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Market mispricing
38.
Which of the following have been offered as factors contributing to the
market crash of 1987?
I. requirement for only a 10 percent cash payment to purchase a stock
II. program trading
III. irrational investors
IV. preceeding bear market
A. I and III only
B. I and IV only
C. II and III only
D. I, II, and III only
E. I, II, and IV only
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Market crash of 1987
39.
Which one of the following statements related to market crashes is correct?
A. Financial market crashes are unique to the United States.
B. A severe market decline tends to occur over a multi-day period.
C. Once the market finally crashed in 1929, stock prices began to slowly
increase again.
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.
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Market crashes
40.
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 crash of 1929 and the crash of 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.
Refer to section 22.5
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Market bubbles and crashes
41.
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 55 percent of the time on average.
C. The longer the time span, the more apt a professional money manager is
to outperform an index fund, such as the S&P 500.
D. Historical data supports the statement that arbitrage is unlimited and
results in a totally efficient market.
E. The financial markets appear to be efficient because, on average, they
outperform professional money managers.
Refer to section 22.6
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.6
Topic: Market efficiency
42.
Which of the following statements are correct?
I. Many professional fund managers are paid well but fail to outperform as
expected.
II. Professional fund managers that have tenures in excess of ten years, tend
to consistently outperform the market on a long-term basis.
III. If a market is truly efficient, then all investments in that market are zero
net present value opportunities.
IV. Actively managing a fund appears to be the key to outperforming the
market.
A. I and III only
B. II and IV only
C. II and III only
D. I, II, and III only
E. I, II, III, and IV
Refer to section 22.6
AACSB: Analytic
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.6
Topic: Market efficiency and professional managers
Essay Questions
43.
Provide an example of a managerial decision that illustrates each one of the
following behaviors:
Behavior: Overconfidence
Example:
Behavior: Affect heuristic
Example:
Behavior: Loss aversion
Example:
Student answers will vary but should correctly display the type of behavior
indicated.
Feedback: Refer to sections 22.2, 22.3, and 22.4
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 22-01 How behaviors such as overconfidence; overoptimism;
and confirmation bias can affect decision making.
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Learning Objective: 22-03 How the use of heuristics can lead to suboptimal
financial decisions.
Section: 22.2, 22.3 and 22.4
Topic: Irrational behavior examples
44.
Explain 1) the concept of house money, 2) why the house money concept is
such a common behavior for so many individuals and 3) why house money is
an irrational behavior.
House money relates to the concept that individuals treat money differently
depending upon the source of that money. They are more conservative with
dollars they have had to work hard to earn and less so with dollars that have
been easy to obtain. The term "house money" relates this concept to
gamblers who are willing to lose their prior winnings (the house's money)
but who are unwilling to lose their initial investment (personal money). This
behavior is irrational because any dollar you posses has equal purchasing
power.
Feedback: Refer to section 22.3
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 22-02 How framing effects can result in inconsistent and/or
incorrect decisions.
Section: 22.3
Topic: House money
45.
Explain why a low-priced, low trading volume stock is more apt to present
limits to arbitrage than is a high-priced, high trading volume stock.
A low-priced stock may be less known to investors causing those investors to
be more noise traders than informed traders. Further, any trading by a
rational trader will tend to cause the stock price to move if the trade is of
significant size. Rational traders with limited dollars may not trade in the
stock due to the potential for trading costs to outweigh any profit from a
mispricing.
Feedback: Refer to section 22.5
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 22-04 The shortcomings and limitations to market efficiency
from the behavioral finance view.
Section: 22.5
Topic: Limits to arbitrage