Fundamentals of Investments, 8e (Jordan)
Chapter 8 Behavioral Finance and the Psychology of Investing
1) What is the area of finance called that addresses issues such as how reasoning errors affect
investment decisions?
A) logical
B) individual
C) behavioral
D) rational
E) personal
2) Which one of the following is the basis for prospect theory?
A) Investors react differently to prospective gains and losses.
B) Investors make cognitive errors.
C) Some investors are irrational.
D) Investors react differently depending on the day of the week.
E) Investors suffer from money illusion.
3) Which one of the following defines frame dependence?
A) Investors react differently to prospective gains and losses.
B) Investors tend to make more cognitive errors when they view investing as gambling.
C) Investors tend to be more irrational in bear markets than in bull markets.
D) Investors react differently depending on how an opportunity is presented.
E) Investors suffer from money illusion in bull markets but not in bear markets.
4) Mental accounting is the process of associating a stock with its:
A) prior day’s market value.
B) expected value.
C) desired value.
D) purchase price.
E) lowest value.
5) Loss aversion is defined as:
A) the inability to mentally acknowledge a loss on a security.
B) selling any security for less than the price paid to acquire it.
C) selling a security as soon as it has increased significantly in value.
D) the reluctance to sell a security after it has decreased in value.
E) the tendency to quickly sell any investment that has decreased in value.
6) Representativeness heuristic is best explained as:
A) the process of assuming events are random even when they are not.
B) the creation of patterns in planned events.
C) concluding that casual factors cause random events when in fact they do not.
D) believing that random events that occur in clusters are truly random.
E) overconfidence in one’s own skills as an investor.
7) The belief that information you hold is superior to information held by other investors best
describes:
A) over-confidence.
B) the snakebite effect.
C) the illusion of knowledge.
D) the clustering illusion.
E) loss aversion.
8) An unwillingness to take a risk after a loss describes:
A) over-confidence.
B) the snakebite effect.
C) the illusion of knowledge.
D) the clustering illusion.
E) loss aversion.
9) Which one of the following is the tendency to believe that random events that occur in clusters
are not really random?
A) clustering illusion
B) sequential clustering
C) random grouping
D) representativeness heuristic
E) gambler’s fallacy
10) Which one of the following best describes heuristics?
A) clustering
B) rules of thumb
C) grouping
D) representativeness
E) herding
11) The concept that well-capitalized, rational traders may be unable to correct a mispricing
defines which one of the following terms?
A) noise trading bounds
B) market bounds
C) limits to arbitrage
D) implementation limits
E) sentiment borders
12) Which one of the following is a trader whose trades are not based on meaningful financial
analysis or information?
A) specialist
B) arbitrageur
C) noise trader
D) sentiment trader
E) market maker
13) Which one of the following risks is related to irrational beliefs?
A) systematic
B) firm-specific
C) industry-specific
D) sentiment-based
E) market
14) Technical analysis studies which of the following as the basis for trading?
A) systematic risk
B) historical prices
C) dividend growth
D) financial statements
E) investor’s required return
15) Dow theory is a method of predicting future market movements based on which of the
following Dow Jones averages?
I. industrial
II. transportation
III. utilities
IV. commodities
A) I and II only
B) II and III only
C) III and IV only
D) I and IV only
E) I, II, and III only
16) According to Elliott wave theory, market predictions should be based on which one of the
following?
A) eight-week repetitive trading patterns
B) the tidal waves created by the gravitational pull of the moon
C) series of historical market price swings
D) an industry’s historical rate of growth
E) market fads and trends
17) The minimum price at which a security is expected to trade is called the:
A) stop value.
B) par value.
C) Elliott wave price.
D) resistance level.
E) support level.
18) The maximum price at which a security is expected to trade is called the:
A) fourth wave.
B) stop limit.
C) relative point.
D) resistance level.
E) support level.
19) The measure of performance of one investment compared to another investment is called the:
A) wave height.
B) relative arm.
C) relative strength.
D) bar height.
E) support factor.
20) Prospect theory is based on the concept that investors are:
A) always risk takers.
B) risk-adverse regarding losses.
C) risk-taking regarding losses.
D) always risk-averse.
E) neutral regarding risk.
21) Which one of the following statements is correct regarding prospect theory?
A) Average investors tend to lose more money than they earn from investing.
B) Typical investors feel that losing $1 is twice as painful as the pleasure derived from making
$1.
C) Investors should focus on gains and losses in individual securities rather than their portfolio’s
total value.
D) Typical investors tend to react irrationally only when focusing on total portfolio value.
E) Average investors tend to prefer higher levels of risk.
22) Patrick is a contestant on a game show. At this point in the game, he can either accept $500
or spin a wheel for a chance of winning $100,000. Which type of behavior is he displaying if he
spins the wheel?
A) forward-looking
B) risk-adverse
C) prospective
D) introspective
E) risk-taking
23) Investors tend to make better decisions when looking at a decision:
A) based on historical performance.
B) only in respect to potential losses.
C) based on individual securities.
D) in broad terms.
E) based on historical costs.
24) Which one of the following is an example of mental accounting?
A) associating a security’s gains or losses based on its purchase price
B) calculating the gain or loss on a security on a daily basis
C) computing the amount of tax due on the gain from a stock sale
D) considering the gain realized when a stock pays a dividend
E) comparing the gains and losses on a portfolio to those of the overall market
25) According to the concept of loss aversion, individual investors are most apt to do which one
of the following?
A) sell stocks with gains more frequently than stocks with losses
B) sell stocks with losses more frequently than stocks with gains
C) hold stocks with gains and sell stocks with losses
D) sell all stocks after a pre-determined length of time
E) hold all stocks unless they decline more than ten percent in value
26) According to the concept of house money, individual investors are most apt to do which one
of the following?
A) take more risks with their initial investment than with the gains on that investment
B) value money differently depending upon its source
C) treat paper profits the same as initial cash investments
D) apply the same level of risk-aversion to all investments
E) place high value on paper profits but low value on paper losses
27) Peter hesitates when it comes to picking an individual stock to purchase as he feels that he
will later realize that a different stock would have been a better investment. Peter is suffering
from:
A) money illusion.
B) frame dependence.
C) regret aversion.
D) risk-taking.
E) mental accounting.
28) The tendency to overvalue an item because you own it is referred to as which one of the
following?
A) endowment effect
B) money illusion
C) regret aversion
D) myopic loss aversion
E) sunk cost fallacy
29) Yesterday, Krista stated that Overland stock was only worth $12 a share and since it was
selling for $15 a share, she declared it overpriced and refused to buy any shares. This morning,
she learned that she is inheriting 3,500 shares of Overland stock from her grandmother.
Suddenly, she is saying that Overland stock is a great buy at $15 and is probably worth at least
$17 a share. This is an example of which one of the following?
A) endowment effect
B) money illusion
C) regret aversion
D) myopic loss aversion
E) sunk cost fallacy
30) Ted constantly ignores the effects of inflation on money. Ted is suffering from which one of
the following?
A) endowment effect
B) money illusion
C) regret aversion
D) myopic loss aversion
E) sunk cost fallacy
31) Investors who tend to invest too heavily in the securities issued by their employer suffer from
the condition known as:
A) overconfidence.
B) loyalty adherence.
C) status quo.
D) local adhesion.
E) familiarity.
32) Which one of the following statements appears to be correct based on current research?
A) Single, female investors tend to earn lower returns than their male counterparts.
B) Overconfidence tends to result in lower returns.
C) Excessive trading tends to increase returns.
D) Men tend to trade less frequently than women.
E) Investors with higher incomes tend to be more risk-adverse than other investors.
33) The increased cash flows into mutual funds that have recently had superior returns is most
associated with which one of the following characteristics?
A) overconfidence
B) excess trading
C) clustering illusion
D) diversification
E) risk aversion
34) Tricia has lost money on a particular stock for the past three years. Thus, she believes the
stock will have a high positive rate of return this year because earning a good return is long
overdue. This assumption is best described as the:
A) law of small numbers.
B) house money effect.
C) gambler’s fallacy.
D) false consensus.
E) recency bias.
35) Four of the last five stocks your investment adviser recommended have outperformed the
market.Thus, you believe that if you continue to follow her advice, that 80 percent of your
investments will outperform the market over the long term. This belief is based on the:
A) gambler’s fallacy.
B) law of small numbers.
C) law of large numbers.
D) clustering illusion.
E) positive performance illusion.
36) According to the theory of recency bias, investors tend to believe the financial markets will:
A) gravitate to their long-term average rates of return.
B) react over the next year in direct opposition to the performance of the prior year.
C) have a maximum of three years of positive annual returns before declining somewhat.
D) continue to perform as they have over the past couple of years.
E) tend to reverse direction at least every five years.
37) Which one of the following is a characteristic of the self-attribution bias?
A) believing what you wish to believe
B) placing too much weight on information which you can gather easily
C) believing that other investors agree with your thinking
D) taking credit for the wins and blaming the losses on bad luck
E) believing that your recent performance is an indication of your future performance
38) Which of the following are impediments to the correction of a security’s mispricing?
I. sentiment-based risk
II. implementation costs
III. firm-specific risk
IV. noise trader risk
A) II only
B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, III, and IV
39) Which one of the following market sentiment index (MSI) values represents the best buying
opportunity?
A) 0.16
B) 0.29
C) 0.48
D) 0.61
E) 0.82
40) Which one of the following market sentiment index (MSI) values indicates that all polled
investors were bearish?
A) -1
B) 0
C) 1
D) 50
E) 100
41) Which one of the following indicates the long-run direction of the market according to Dow
Theory?
A) daily fluctuations
B) secondary reaction
C) monthly changes
D) primary trend
E) tertiary trend
42) What is the primary purpose of Dow theory?
A) to measure the level of investor optimism and pessimism
B) to analyze daily market movements
C) to identify and measure market waves
D) to eliminate market corrections
E) to signal changes in the market’s primary direction