chap022

Chapter 22 - Behavioral Finance: Implications for Financial Management

Chapter 22Behavioral 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 ethicsB. financial statement analysisC. managerial financeD. debt managementE. 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 fallacyB. frame dependenceC. overconfidenceD. representativeness heuristicE. 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 dependenceB. overconfidenceC. gambler's fallacyD. confirmation biasE. overoptimism

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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. overconfidenceB. overoptimismC. affect heuristicD. confirmation biasE. 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 aversionB. gambler's fallacyC. frame dependenceD. overconfidenceE. format reference

6. A general rule used as the basis for decision making is referred to as: A. a loss aversion technique.B. heuristics.C. self-attribution.D. narrow framingE. 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.

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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 effectB. framing effectC. representativeness heuristicD. narrow framingE. 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 fallacyB. limits to arbitrageC. availability biasD. false consensusE. 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 traderB. arbitrageurC. crasherD. regret averterE. myopic loss averter

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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 riskB. inflation riskC. supply chain riskD. interest rate riskE. 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 outcomeB. assuming that a new project will be profitable since similar projects in the past were successfulC. assuming that your expectations of the future outcome from a project are more accurate than the expectations of others within your organizationD. listening to the advice of subordinates with whom you agree while ignoring the advice of subordinates with whom you tend to disagreeE. downplaying the cost of future failure of an existing project since the project has already paid for itself

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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 itB. accept risky projects that turn out to be less profitable than you expectedC. wait until new technology proves its worth before incorporating it into your firm's operationsD. avoid mergers and acquisitionsE. 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 also creating 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. over estimated construction costsB. over estimated expensesC. over estimated net present valuesD. under estimated profitsE. under estimated 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 dependenceB. overconfidenceC. gambler's fallacyD. confirmation biasE. overoptimism

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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 accountingB. overconfidenceC. self attribution biasD. confirmation biasE. 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. overoptimisimB. affect heuristicC. loss aversionD. house moneyE. 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 heuristicB. loss aversionC. house money effectD. underconfidenceE. confirmation bias

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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 heuristicB. house moneyC. get-evenitisD. randomnessE. 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 aversionB. get-evenitisC. self-attribution biasD. mental accountingE. regret aversion

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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 biasB. overconfidenceC. regret aversionD. house money effectE. 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 aversionB. money illusionC. self-attribution biasD. endowment effectE. 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 aversionB. house money effectC. money illusionD. self-attribution biasE. endowment effect

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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 aversionB. endowment effectC. money illusionD. affect heuristicE. 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 biasB. endowment effectC. money illusionD. affect heuristicE. 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.

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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 biasB. anchoring and adjustmentC. frame dependenceD. aversion to ambiguityE. 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 full-time occupation is based on which one of the following? A. mental accountingB. anchoring and adjustmentC. law of small numbersD. bubble and crash theoryE. confirmation bias

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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 biasB. arbitrage limitsC. law of small numbersD. representativeness heuristicE. 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 ambiguityB. recency biasC. sentiment-based risk aversionD. clustering illusionE. 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 biasB. law of small numbersC. gambler's fallacyD. false consensusE. money illusion

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36. Which of the following create limits to arbitrage?I. risks related to an individual firmII. implementation costsIII. rational tradersIV. noise traders A. I and III onlyB. II and IV onlyC. I, II, and III onlyD. I, II, and IV onlyE. I, II, III, and IV

37. AB Industries is an all-equity firm that has $8 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. $7B. $8C. $10D. $12E. $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 stockII. program tradingIII. irrational investorsIV. preceeding bear market A. I and III onlyB. I and IV onlyC. II and III onlyD. I, II, and III onlyE. I, II, and IV only

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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.

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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 onlyB. II and IV onlyC. II and III onlyD. I, II, and III onlyE. I, II, III, and IV

Essay Questions

43. Provide an example of a managerial decision that illustrates each one of the following behaviors:

Behavior: OverconfidenceExample:

Behavior: Affect heuristicExample:

Behavior: Loss aversionExample:

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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.

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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 ethicsB. financial statement analysisC. managerial financeD. debt managementE. behavioral finance

Refer to section 22.1

AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-1Section: 22.1Topic: Behavioral finance

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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 fallacyB. frame dependenceC. overconfidenceD. representativeness heuristicE. sentiment-based risk attitudes


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: 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 dependenceB. overconfidenceC. gambler's fallacyD. confirmation biasE. overoptimism


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: Overoptimism

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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. overconfidenceB. overoptimismC. affect heuristicD. confirmation biasE. representativeness heuristic


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: 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 aversionB. gambler's fallacyC. frame dependenceD. overconfidenceE. format reference


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: Frame dependence

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6. A general rule used as the basis for decision making is referred to as: A. a loss aversion technique.B. heuristics.C. self-attribution.D. narrow framingE. confirmation bias


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: Affect heuristic

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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 effectB. framing effectC. representativeness heuristicD. narrow framingE. affect heuristic


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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 fallacyB. limits to arbitrageC. availability biasD. false consensusE. clustering illusion


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Limits to arbitrage

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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 traderB. arbitrageurC. crasherD. regret averterE. myopic loss averter


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: 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 riskB. inflation riskC. supply chain riskD. interest rate riskE. sentiment-based risk


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Sentiment-based risk

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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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: 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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Crash

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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 outcomeB. assuming that a new project will be profitable since similar projects in the past were successfulC. assuming that your expectations of the future outcome from a project are more accurate than the expectations of others within your organizationD. listening to the advice of subordinates with whom you agree while ignoring the advice of subordinates with whom you tend to disagreeE. downplaying the cost of future failure of an existing project since the project has already paid for itself


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: 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 itB. accept risky projects that turn out to be less profitable than you expectedC. wait until new technology proves its worth before incorporating it into your firm's operationsD. avoid mergers and acquisitionsE. invest excess company cash more conservatively than your peers at other firms


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: Overconfidence

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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 also creating 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. over estimated construction costsB. over estimated expensesC. over estimated net present valuesD. under estimated profitsE. under estimated sales estimates


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: 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 dependenceB. overconfidenceC. gambler's fallacyD. confirmation biasE. overoptimism


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-1Section: 22.2Topic: Confirmation bias

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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 accountingB. overconfidenceC. self attribution biasD. confirmation biasE. frame dependence


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: 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. overoptimisimB. affect heuristicC. loss aversionD. house moneyE. get-evenitis


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: House money

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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 heuristicB. loss aversionC. house money effectD. underconfidenceE. confirmation bias


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: 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 heuristicB. house moneyC. get-evenitisD. randomnessE. arbitrage reaction


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: Loss aversion, get-evenitis

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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.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: 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 aversionB. get-evenitisC. self-attribution biasD. mental accountingE. regret aversion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: Myopic loss aversion

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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 biasB. overconfidenceC. regret aversionD. house money effectE. frame dependence


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: 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 aversionB. money illusionC. self-attribution biasD. endowment effectE. myopic loss aversion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: Money illusion

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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 aversionB. house money effectC. money illusionD. self-attribution biasE. endowment effect


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-2Section: 22.3Topic: 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 aversionB. endowment effectC. money illusionD. affect heuristicE. representativeness heuristic


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: Affect heuristic

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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 biasB. endowment effectC. money illusionD. affect heuristicE. representativeness heuristic


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: Clustering illusion

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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.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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 biasB. anchoring and adjustmentC. frame dependenceD. aversion to ambiguityE. clustering illusion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: Recency bias

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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 accountingB. anchoring and adjustmentC. law of small numbersD. bubble and crash theoryE. confirmation bias


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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 biasB. arbitrage limitsC. law of small numbersD. representativeness heuristicE. regret aversion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: Availability bias

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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 ambiguityB. recency biasC. sentiment-based risk aversionD. clustering illusionE. money illusion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: 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 biasB. law of small numbersC. gambler's fallacyD. false consensusE. money illusion


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-3Section: 22.4Topic: False consensus

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36. Which of the following create limits to arbitrage?I. risks related to an individual firmII. implementation costsIII. rational tradersIV. noise traders A. I and III onlyB. II and IV onlyC. I, II, and III onlyD. I, II, and IV onlyE. I, II, III, and IV


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Limits to arbitrage

37. AB Industries is an all-equity firm that has $8 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. $7B. $8C. $10D. $12E. $13


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Market mispricing

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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 stockII. program tradingIII. irrational investorsIV. preceeding bear market A. I and III onlyB. I and IV onlyC. II and III onlyD. I, II, and III onlyE. I, II, and IV only


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: 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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: Market crashes

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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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.5Topic: 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.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 22-4Section: 22.6Topic: Market efficiency

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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 onlyB. II and IV onlyC. II and III onlyD. I, II, and III onlyE. I, II, III, and IV


AACSB: N/ABloom's: ComprehensionDifficulty: IntermediateLearning Objective: 22-4Section: 22.6Topic: Market efficiency and professional managers

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Essay Questions

43. Provide an example of a managerial decision that illustrates each one of the following behaviors:

Behavior: OverconfidenceExample:

Behavior: Affect heuristicExample:

Behavior: Loss aversionExample:

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 thinkingBloom's: AnalysisDifficulty: IntermediateLearning Objective: 22-1Learning Objective: 22-2Learning Objective: 22-3Section: 22.2, 22.3 and 22.4Topic: Irrational behavior examples

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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 thinkingBloom's: ComprehensionDifficulty: IntermediateLearning Objective: 22-2Section: 22.3Topic: 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 thinkingBloom's: AnalysisDifficulty: IntermediateLearning Objective: 22-4Section: 22.5Topic: Limits to arbitrage

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marketbased risk

behavioral finance

financial management

firm based risk

managementrelated risk

inflation risk

rate risk

investment risk