The Behavioral Biases of Individuals

### Which of the following best describes the difference between cognitive errors and emotional biases? - [x] Cognitive errors stem from faulty thinking or information processing, while emotional biases arise from feelings or impulses. - [ ] Cognitive errors involve only mathematical mistakes, while emotional biases involve moral judgments. - [ ] Cognitive errors are always intentional, emotional biases are always unintentional. - [ ] Cognitive errors cannot be mitigated, but emotional biases can. > **Explanation:** Cognitive errors come from limitations in how we process data and reason, whereas emotional biases come from the investor’s emotions and psychological impulses. ### An investor who refuses to sell a losing position because they are “sure it will bounce back” is most likely exhibiting: - [ ] Herding - [x] Loss aversion - [ ] Representativeness - [ ] Anchoring > **Explanation:** Loss aversion occurs when investors are overly worried about committing to a loss, so they hold onto losing positions too long in hopes of recouping losses. ### Which behavioral bias might lead investors to jump into a popular stock without conducting personal research? - [x] Herding - [ ] Anchoring - [ ] Overconfidence - [ ] Representativeness > **Explanation:** Herding is the tendency to mimic the trades of the majority or the crowd, often ignoring personal analysis or fundamentals. ### A person’s tendency to cling to the first piece of information they receive about a security, perhaps its IPO price, is an example of: - [ ] Overconfidence - [ ] Herding - [ ] Loss aversion - [x] Anchoring > **Explanation:** Anchoring occurs when an investor relies too heavily on initial data or reference points when formulating decisions. ### Which phenomenon can partially explain why a stock may rise beyond its intrinsic value when investors all follow the crowd? - [ ] Representativeness - [ ] Loss aversion - [x] Herding - [ ] Confirmation bias > **Explanation:** When many investors think the same way (i.e., follow one another), they can push a stock to levels far above what fundamentals justify. ### An investor overestimates their ability to select winning tech stocks because they have had a few successes in the past. What bias is this? - [x] Overconfidence - [ ] Anchoring - [ ] Herding - [ ] Loss aversion > **Explanation:** Overconfidence arises when investors believe they have greater skill in stock-selection or timing than they actually do. ### Which bias frequently motivates someone to overreact to short-term performance and assume it will continue indefinitely? - [ ] Loss aversion - [ ] Anchoring - [x] Representativeness - [ ] Herding > **Explanation:** Representativeness involves drawing conclusions based on a small sample or short-term results, leading to overemphasis on recent trends. ### Why do behavioral biases often lead to inadequate diversification in a portfolio? - [ ] Because market efficiency ensures all portfolios converge to similar asset mixes. - [ ] Because regulations require only local holdings. - [x] Because biases such as home bias or overconfidence lead investors to concentrate on familiar assets. - [ ] Because foreign markets are always riskier than local ones. > **Explanation:** Emotional and cognitive biases often push investors to feel safer investing in assets they know, leading to concentrated (and less diversified) portfolios. ### What might be a good way to combat anchoring in investment decisions? - [x] Use a structured approach, such as re-evaluating a stock consistently based on updated fundamentals. - [ ] Only invest in stocks with stable anchors. - [ ] Avoid all reference points altogether. - [ ] Double down on your initial anchor’s data to validate its correctness. > **Explanation:** A disciplined, fundamental reassessment over time helps break the anchoring bias by refocusing on objective, up-to-date data rather than old reference points. ### A massive surge in asset prices fueled by collective exuberance and overconfidence that eventually collapses can be described as: - [x] A market bubble - [ ] An efficient market scenario - [ ] Hedging - [ ] A perfectly rational cycle > **Explanation:** Market bubbles stem from collective behavior and emotional buying, pushing prices beyond their intrinsic worth until a final trigger event precipitates a crash.