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 Chapter 08

Behavioral Finance and the Psychology of Investing

Multiple Choice Questions

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.

8-1
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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

8-2
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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

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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 is the study of which one 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

8-4
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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.

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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.

8-6
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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. Phil 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.

8-7
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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

8-8
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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

8-9
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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.

8-10
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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.

8-11
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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

8-12
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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

8-13
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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

43. According to Dow theory, which one of the following is the primary means of eliminating
secondary market trends?

A. corrections
B. confirmations
C. continuations
D. conversions
E. coordinated trades

44. If you are a proponent of the Elliott wave theory, you are most apt to do which one of the
following?

A. sell on wave 2
B. sell on wave 3
C. buy on wave A
D. buy on wave 2
E. buy on wave 5

8-14
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45. According to technical analysis, which one of the following is best seen as a buying
opportunity?

A. a breakout of a resistance level

B. an MSI value of 0.1 or less
C. a downward sloping advance/decline line
D. a flat advance/decline line
E. top of Elliott wave 5

46. You recently heard a news announcer state that the market is approaching its support level.
Which one of the following is the best interpretation of that statement?

A. The market is approaching the lowest level that is reasonably expected.

B. The federal government will step in to help the market retain its value should the market
slip much further.
C. The market is almost at a peak and is expected to start declining in the near future.
D. The market is almost to the point where trading will be suspended temporarily.
E. The market is almost equivalent in value to the international markets so price stabilization
is expected.

47. Which one of the following advance/decline lines is the most bullish signal?

A. relatively flat
B. slightly upward sloping
C. slightly downward sloping
D. steeply upward sloping
E. steeply downward sloping

8-15
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48. Which of the following are bullish indicators?

I. flat advance/decline line

II. breakout of a support level
III. Arms ratio of .38
IV. heavy advancing volume

A. I and II only
B. III and IV only
C. I and III only
D. II and III only
E. I and IV only

49. If the closing tick of the day is +32, this means that the:

A. DJIA ended the day up 32 basis points.

B. discount rate at the end of the day was 3.20 percent.
C. number of stocks closing on an uptick was 32.
D. number of stocks closing on an uptick exceeded those closing on a downtick by 32.
E. number of stocks closing on an uptick was 32 more than on the prior trading day.

50. Which one of the following Arms values is the most bearish?

A. .28
B. .45
C. .88
D. 1.03
E. 1.26

8-16
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51. For the past year, a particular stock has a relative strength value of 1.03 as compared to the
market. This means that the stock:

A. increased in value 3 percent more than the market for the day.
B. has 3 percent more risk than the average security.
C. outperformed the market for the period.
D. had 3 percent higher trading volume on a growth basis as compared to the market.
E. is selling for 103 percent of the market value per share.

52. A "block trade" is a trade in excess of how many shares?

A. 1,000
B. 5,000
C. 10,000
D. 50,000
E. 100,000

53. Which one of the following statements is correct concerning an open-high-low-close bar
chart?

A. The prices indicated by the two horizontal lines are the maximum and minimum daily
prices.
B. The upper trendline indicates the support level.
C. If the overall price movement is downward, the lower trendline is called the channel line.
D. If the overall price movement is upward, the upper trendline is called the head line.
E. The final price of the day is indicated by a horizontal line to the left side of the vertical line.

8-17
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54. According to technical analysts, pricing patterns such as the head and shoulders are
indicators of potential:

A. reversals from the main trend line.

B. upcoming corrections which will return the market to the current main trend line.
C. increasing strength for the main trend line.
D. decreasing market activity.
E. increasing market activity.

55. Which one of the following is correct concerning a head and shoulders top pattern?

A. The outside of the right shoulder is a bullish signal.

B. The shoulders are higher than the head.
C. The left shoulder must be higher than the right shoulder, but lower than the head.
D. A piercing of the neckline is a reversal signal.
E. The trendline must be relatively flat throughout the pattern.

56. Which one of the following statements is correct regarding moving averages?

A. The 50-day moving average reflects the long-term trend of the market.
B. An exponential moving average is a weighted average.
C. Moving averages are used primarily to measure trading volume.
D. Short-term and long-term moving averages always move in the same direction.
E. Moving averages are generally computed using average daily prices.

8-18
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57. Assume the 50-day moving average is currently intersecting the 200-day moving average.
Also assume the 50-day average is downward sloping and the 200-day average is upward
sloping. Which one of the following statements is accurate based on this information?

A. The 50-day moving average is bullish.

B. The short-term forecast is bullish.
C. The long-term trend may be preparing to change.
D. The long-term outlook is bearish.
E. The short-term trend will change to match the long-term trend.

58. Bollinger bands:

A. graphically reflect the differences between two moving averages.

B. graphically depict the relative strength of a security as compared to the market.
C. are a graphical representation of an exponential moving average.
D. depict a 2-standard deviation bound around a moving average.
E. are equal to the 20-day moving average plus or minus one standard deviation.

59. A stock's price has been relatively constant for an extended period of time. In this instance,
the Bollinger bands are:

A. relatively close to each other.

B. non-existent.
C. vertical.
D. steeply upsloping.
E. steeply downsloping.

8-19
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60. Investors who use the MACD indicator as a signal for trading are most apt to buy a security
when the MACD:

A. equals zero.
B. is equal to 1.0.
C. rises above the signal line.
D. parallels the signal line.
E. falls below the signal line.

61. Which of the following are considered in the computation of money flows?

I. last trade price

II. current trade price
III. volume of each trade
IV. time of each trade

A. I and IV only
B. II and III only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV

62. Assume a stock's price remains relatively stable while the money flow becomes highly
positive. Which one of the following is most expected given this scenario?

A. price decrease
B. stable price
C. price increase
D. increasing trading volume
E. decreasing trading volume

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