August 2, 2019

IIMB PGP 2018-20, Term 4

STDM Test
Maximum marks: 15
Model Answers and Discussion

Q1.
In a classic experiment*, students were asked how they would invest a hypothetical inheritance.
Some received several million dollars in low-risk, low return bonds and typically chose to leave most
of the money untouched. The rest received higher risk securities – and also left most of the money
alone.

Members of either group could have invested some or all of the money in other ways to obtain
higher returns, or to pare risks. But they did not.

What explains this seemingly unusual behaviour? Write your answer in less than 75 words.

*Samuelson and Zech-hauser

Source: McKinsey Quarterly

Marks 3

Model answer:
This unusual behaviour or phenomenon is best explained by status quo effect. Both groups of people
see gain from the inheritance. In the ‘gains domain’ people tend to become risk averse because
they are satisfied with current gains. In this frame of mind they do not feel the need to exchange or
replace what they have with better alternatives, unless other options are far better by a factor of
2.5X or more. In this experiment the latter does not seem to have been the case.

Marking protocol:
Mention of status quo effect with correct and complete explanation: 3
Mention of status quo effect or framing the situation in the domain of losses: 2–3
Indicating that the cause is loss aversion without sufficient explanation: 1–2
Getting a part of the answer correct: 1.5
Other answers depending on explanation: 0–1
It will not be enough to merely mentioned status quo effect. Explanation showing you understand
the concept and can apply it correctly will be necessary.

Observations:
1. It is important to note that students in the experiment felt they were in the domain of gains in
both kinds of bonds. Some of you have answered saying that students in the first group were in
the domain of gains while others were in the quadrant of losses. This is incorrect.
2. Several have pointed out that it could be because of affective bias because they received an
inheritance. I'm afraid this assumption cannot be considered correct because it was an
experimental setting. The students knew they were part of an experiment and the inheritance
was not real. Affect heuristic is unlikely to have been at play. It may happen in real life when
one receives an inheritance from a dear relative, but I do not agree it would be so in this case.
3. Endowment effect occurs from perception of loss. In this case students were in the domain of
gains. Besides, and this is the more important factor, bonds and securities are instruments of
trade. They are held for exchange, not for possession and use. Experiments in endowment
effect have well established that it does not occur for goods that are tradable; it is prevalent
only for items that we possess for use. The use of endowment as the cause of the behaviour is
incorrect.
4. The argument that risky investments are perceived in the loss frame is quite incorrect. In this
frame they would have tried to pare the risk. Subjects who received high risk bonds would very
likely have made the effort to rebalance their portfolios. Experimenters did not observe such a
behaviour.
5. Application of fourfold pattern is not correct. It applies to very high or very low probabilities
together with large payoffs or losses. Securities are not usually products with high probability of
payoff, or very low probabilities of catastrophic loss.
 Many students have suggested that the group with low-risk low return inheritance were risk
averse because they were in the high probability, certainty effect. Does low-risk low return
bonds generate very large returns? They usually pay moderate returns because risks are low.
Therefore these experiment subjects were not in the first quadrant of the fourfold pattern.

Most others who chose to fourfold pattern to explain their answers suggested that students in
the high-risk high return inheritance group were risk averse because they had a very low
probability to lose a large sum of money. Once again this is erroneous. If they were risk averse
they would have preferred to accept an unfavourable settlement. In other words they would
probably trade the securities to pare the risk. That would have been evidence of risk aversion,
but they did not. In other words they accepted the high-risk bonds for the returns they could
expect.

As you can see from the above arguments fourfold pattern is not a good way to explain
behaviour of these students. Only status quo effect explains it well and consistently for both
groups.

6. A number of you have correctly suggested loss aversion but erroneously applied various
incorrect concepts ranging from affect, endowment effect, availability, and anchoring bias.

★★★

Q2.
Do investors who buy and sell stocks on the share market usually suffer from Endowment effect
when they sell? Why? Why not? Write your views in less than 50 words.

Marks 4

Model answer:
No, they do not. Investors who regularly buy and sell stocks know the shares they buy are tradable
commodities. They are purchased with the specific intention of selling them. Endowment effect is
not likely to be manifested in trading of goods that are held for exchange. It would be especially
absent in experienced investors.
Refer to textbook pages 297 – 299.

Marking protocol:
Pointing out that they do not suffer from endowment effect with appropriate explanation: 4
Pointing out that they do not suffer from endowment effect without due explanation: 2–3
Other explanations suggesting they suffer from endowment effect: 1

Observations:
1. Curiously some of you have answered the question without even mentioning whether or not
investors suffer from Endowment effect. They have gone about explaining how prospect theory
would apply, reference points would change, et cetera. But they have not specifically answered
whether or not endowment effect would apply.
2. The reluctance not to sell stocks in hand is not because of endowment. It is usually the result of
status quo effect, or framing the choice of selling as a sure loss. Status quo effect may make
some investors, especially novices, reluctant to sell when the market is rising. Loss framing may
cause them to hold onto existing investment when the share prices are falling. These behaviours
are not manifestations of endowment effect.
3. Here is perhaps the best answer to this question. From Armaan Lakra. Short, succinct, and exact.
“No they do not. Experienced traders view these stocks on the share market as items of trade
and exchange.”

★★★
Q3.
Family members of a person alleged to have committed a crime often defend him saying, “He could
not have done it. He is not like that.” Which one of the following options best explains this
phenomenon?

A. Loss aversion. They do not wish to lose our dear member of the family.
B. Members of the family may have experienced positive or good manners towards them and
others on many occasions. System 1 aided by WYSIATI (What You See Is All There Is) helps
them form a coherent picture that excludes deviant behaviour.
C. Close family bonds require them to be protective of each other.
D. Family members may be using Tactics from PARTS to create a favourable impression of the
person on others.
E. It is a kind of optimism bias. They hope he will get away without punishment.

Marks 2

Model answer:
Other alternatives are seemingly correct. They appear reasonable. But they are not correct. See the
explanations below for each of the alternatives other than B.
A. Prospective loss of a dear member of the family would cause affective bias, not loss
aversion.
C. This alternative does not use any STDM concept.
D. It can be argued that this alternative applies. However, we use PARTS in a game with others.
Do family members engage in games with neighbours, the press, or other members of society
in such a situation to manipulate their perceptions? Or, do they say these things because
they believe them to be true?
E. If it was optimism bias it is very unlikely that they would make statements that appear to
defend the alleged criminal. That is why this alternative, although it sounds reasonable, is
not correct.

★★★

Q4.
"Gut feel" is a common expression to describe how we often make decisions. To what may this term
have a connection?

Pick one of the following options that appears to be the best choice.

A. It is just an expression. There is no specific connection.

B. It is connected with Shakespeare. It was first used by him in one of his plays. It has been
popularly adopted since then.
C. “Gut feel” is a common expression that may have its origins in the bodily feelings we
sometimes experience when making a decision.
D. It refers to the “As if body loop” proposed by Dr Antonio Damasio in his somatic marker
hypothesis.

Marks 2

Model Answer:
Alternative C is the only one that uses an appropriate and correct STDM concept.
Alternative D appears to be correct but it is not. In as if body loop a person does not feel anything.
Gut feel is an expression of physical feeling.
Alternatives A and B are patently incorrect; they do not use any STDM concept.

★★★
Q5.
In an experiment** a large number of people are asked to draw a marble from any one of two jars
each containing red and blue marbles. Drawing a red marble will win them a prize.

The smaller jar has fewer total marbles but a slightly greater proportion of red ones. The larger jar
has more marbles overall but a smaller percentage of red ones compared to the smaller jar.

Which jar are more people likely to draw from and why? Pick the most appropriate of the following
statements.

A. They are likely to draw from either jar with equal probability.
B. The smaller jar. The probability of winning is clearly higher. It is the rational choice.
C. If they are rational subjects would ask the experimenter about the number of red and blue
marbles in each jar and then decide which one to draw from.
D. The bigger jar. The probability of winning appears higher because of Affect heuristic.

** Dan Ariely

Marks 2

Model answer:
Alternatives in A and B would be correct if people were rational. It is indeed possible that some
would choose one of these alternatives. In the experiment Dan Ariely found that the majority chose
to draw from the bigger jar. He interpreted this behaviour on the basis of Affect heuristic. The
bigger jar with more marbles created a more positive feeling in subjects. This distorted the
assessment of chance events.
Alternatives C should have been an easy option to reject. Subjects were not required to ask
experimenters any questions.

★★★

Q6.
Many people believe that large population is the principal cause of India’s economic and social
problems. Only one of the following statements is correct. Which one?

A. This misconception is likely to be an instance of Representativeness bias.

B. It is indeed the cause. Population is a big problem for India.
C. India’s problems are complex and humans have a natural tendency to simplify a complex
issue into a coherent story.
D. According to a population theory a large population creates severe competition for scarce
resources. This is the root of the problem.

Marks 2

Model Answer:
Alternative C is the only one of four options that uses an STDM concept. Our System 1 helps us make
quick and reasonably satisfactory judgements by simplifying complex problems. WYSIATI helps us do
that.

★★★