NISM Series X-B Chapter 16: Basics of Behavioral Finance Practice Questions

Question 1

A client is highly emotional about funding their daughter’s higher education, even if it means compromising their own retirement. According to the text, what is a crucial role an Investment Adviser plays in managing such client emotions and assisting in decision-making?

Accepted Answer

To provide a cool and calming influence, objectively pointing out compromises for vital goals and suggesting alternatives like partial education loans.. The text states, 'The Investment Adviser can point out the extent of compromise that is being done for a vital goal like retirement and also point out alternatives like partial education loan for the higher education... This kind of objective role played by the Investment Adviser is crucial in assisting the clients to take the right decisions even as they are highly emotional.' It also mentions the 'cool and calming influence of the Investment Adviser'

Question 2

The text compares investing based on past performance to 'driving a car by looking in the rear view mirror.' What fundamental flaw does this analogy highlight regarding investment strategy?

Accepted Answer

It assumes that past performance is indicative of future results, ignoring asset class cycles and inevitable reversal to the mean.. The text explains, 'This behaviour, based on the performance in the immediate past, assumes that what did well last year will do so this year as well. Most asset classes have a cycle of growth and decline and there is an inevitable reversal to the mean.' The analogy warns against this assumption

Question 3

What is the primary negative outcome highlighted when investors buy insurance purely for tax saving, rather than for appropriate and adequate coverage?

Accepted Answer

It results in buying the wrong kind of insurance and/or completely inadequate insurance.. The text states, 'At least 3 generations of Indians have grown up on a diet of buying insurance for tax saving alone. As a result, they end up buying the wrong kind of insurance and/or completely inadequate insurance.'

Question 4

What is the primary consequence of the bias where clients buy insurance solely for tax-saving purposes, and what is the recommended 'cure' for this bias?

Accepted Answer

It leads to buying the wrong kind and/or completely inadequate insurance; the cure is to highlight the need for adequate pure insurance products and the poor returns from investment-cum-insurance products.. The text states: 'At least 3 generations of Indians have grown up on a diet of buying insurance for tax saving alone. As a result, they end up buying the wrong kind of insurance and/or completely inadequate insurance.' It further adds: 'The only cure for this bias to buy insurance purely for the sake of tax saving is to highlight the need for adequate pure insurance products and the poor returns from investment cum insurance products as compared to equivalent investments combined with pure insurance plans.'

Question 5

A client, experiencing overconfidence after a successful individual stock bet, is tempted to over-invest in that asset class and modify their existing asset allocation. According to the text, what is the Investment Adviser's critical role in this scenario?

Accepted Answer

To act as a crucial influence that stands between the client and a potentially significant mistake.. The text states, 'Based on overconfidence arising from the bet that materialised, the client may be tempted to over-invest in an asset class or security and modify the existing asset allocation. In times like these, the Investment Adviser’s influence can stand between the client and her big mistake.'

Question 6

According to the text, what is the primary impact of 'action bias' on an investor's behavior, and how can an Investment Adviser (IA) help to curb this tendency?

Accepted Answer

It causes investors to make too frequent and too many transactions, turning investing into trading; the IA should prime clients with the benefits of patience and long-term investing.. The text states: 'Humans have an action bias or the need to do something whereas investing requires long term consistency and long years of patience. The action bias combined with other biases induces clients to have too frequent and too many transactions, which has the impact of turning an investment activity into a trading activity. The only way to induce the client to curb such a tendency is to prime them in advance with the benefits of patience and long term investing.'

Question 7

According to the text, what is the primary impact of action bias combined with other biases on an investor's activity?

Accepted Answer

It transforms an investment activity into a frequent trading activity.. The text states, 'The action bias combined with other biases induces clients to have too frequent and too many transactions, which has the impact of turning an investment activity into a trading activity.'

Question 8

According to the text, what is the primary impact of "action bias" combined with other biases on client investment behavior?

Accepted Answer

It leads to too frequent and too many transactions, turning investment into trading.. The text states: "The action bias combined with other biases induces clients to have too frequent and too many transactions, which has the impact of turning an investment activity into a trading activity."

Question 9

Based on the provided text, what is the primary behavior exhibited by investors who suffer from 'chasing past performance' bias?

Accepted Answer

They invest in securities or asset classes that have performed well in the immediate past.. The text states, 'Some investors simply invest in last year’s winners – whether it be asset classes or specific security within an asset class. When Gold goes up they invest in Gold and when equity markets rise they shift their investments to Equities.' This directly describes chasing past performance

Question 10

When a client is emotional about prioritizing a goal like their daughter's higher education over their own retirement due to insufficient resources, what objective action should the Investment Adviser take?

Accepted Answer

Point out the extent of compromise being made for the vital retirement goal and suggest alternatives like a partial education loan.. The text states, 'The Investment Adviser can point out the extent of compromise that is being done for a vital goal like retirement and also point out alternatives like partial education loan for the higher education which can then be paid by the daughter from her earnings after completion of the education course. This kind of objective role played by the Investment Adviser is crucial in assisting the clients to take the right decisions even as they are highly emotional.'

Question 11

What is identified as the primary negative consequence when clients buy insurance solely for tax-saving purposes?

Accepted Answer

It results in buying the wrong kind of insurance and/or completely inadequate insurance.. The text states: "As a result, they end up buying the wrong kind of insurance and/or completely inadequate insurance."

Question 12

According to the text, in situations where a client has insufficient resources to meet all their financial goals (e.g., daughter's higher education and retirement), what crucial objective role can the Investment Adviser play in managing client emotions?

Accepted Answer

Point out the extent of compromise for vital goals and suggest alternatives, such as partial education loans, to assist in objective decision-making.. The text states, 'The Investment Adviser can point out the extent of compromise that is being done for a vital goal like retirement and also point out alternatives like partial education loan for the higher education which can then be paid by the daughter from her earnings after completion of the education course. This kind of objective role played by the Investment Adviser is crucial in assisting the clients to take the right decisions even as they are highly emotional.'

Question 13

Apart from lack of familiarity and comfort, which of the following is NOT listed in the text as a reason for investors not investing in overseas securities or asset classes?

Accepted Answer

The inherent superior performance of domestic markets over global markets.. The text lists several reasons for not investing in overseas securities, including lack of knowledge, home country laws, lack of access/high cost, compliances, and lack of expert advice. The 'inherent superior performance of domestic markets over global markets' is not mentioned as a reason

Question 14

A client boasts about making a 5X return on an individual stock in three months and attributes it solely to their exceptional skill. Based on the provided text, what is this behavior indicative of, and what potential mistake might it lead to?

Accepted Answer

It indicates overconfidence, potentially leading the client to over-invest in an asset class or security and modify existing asset allocation.. The text explains under 'Overconfidence and dilution in risk management': 'In the arena of investments, this manifests itself in terms of attributing skill to their bets that have come off which can lead to overconfidence on the part of the client. For example, the client made a small bet on an individual stock that became a 5X in 3 months’ time.' It further states, 'Based on overconfidence arising from the bet that materialised, the client may be tempted to over-invest in an asset class or security and modify the existing asset allocation.'

Question 15

How does overconfidence typically manifest in the arena of investments, and what critical role can an Investment Adviser play in such situations?

Accepted Answer

It leads to attributing market luck to skill, tempting clients to over-invest or modify asset allocation; the IA can prevent clients from making big mistakes.. The text explains: 'In the arena of investments, this manifests itself in terms of attributing skill to their bets that have come off which can lead to overconfidence on the part of the client... Based on overconfidence arising from the bet that materialised, the client may be tempted to over-invest in an asset class or security and modify the existing asset allocation. In times like these, the Investment Adviser’s influence can stand between the client and her big mistake.'

Question 16

Which of the following is cited as a primary reason for investors to exhibit home country bias?

Accepted Answer

Familiarity with local markets, the companies involved, and the regulatory environment.. The text states, 'Most investors prefer to invest in the securities available in their home countries due to familiarity with the markets, the companies involved as well as the regulatory environment.'

Question 17

In situations where a client is highly emotional, such as prioritizing a daughter's higher education over their own retirement due to insufficient resources, what critical role does the Investment Adviser play according to the text?

Accepted Answer

To provide objective analysis, highlight compromises to vital goals, and suggest alternatives like partial education loans.. The text explicitly states: "The Investment Adviser can point out the extent of compromise that is being done for a vital goal like retirement and also point out alternatives like partial education loan for the higher education... This kind of objective role played by the Investment Adviser is crucial in assisting the clients to take the right decisions even as they are highly emotional." Options A, C, and D contradict the adviser's role in managing emotions and preventing mistakes

Question 18

All of the following are listed reasons for investors not investing in overseas securities or asset classes, *except*:

Accepted Answer

Guaranteed higher returns from domestic investments compared to overseas options.. The text lists several reasons for home country bias, including "Lack of knowledge on opportunities outside their home country," "Home country laws may prevent domestic investors from investing outside India," and "Lack of expert advice on such asset classes as the advisers themselves are not well versed with such asset classes." It does not mention guaranteed higher returns from domestic investments as a reason

Question 19

According to the text, what is the recommended antidote for the 'Home Country Bias'?

Accepted Answer

For the adviser to get educated on the benefits and opportunities in global investing and, in turn, educate their clients.. The text explicitly states, 'The antidote for Home country Bias is for the advisor to get educated on the benefits and opportunities in global investing and, in turn, educate their clients about the same.'

Question 20

Which of the following is NOT listed as a reason for investors typically not investing in overseas securities or asset classes, as per the provided text?

Accepted Answer

The inherent higher risk associated with foreign markets compared to domestic ones.. The text lists several reasons for not investing in overseas securities: 'a) Lack of knowledge on opportunities outside their home country, b) Home country laws may prevent domestic investors from investing outside India, c) Lack of access and high cost of access where available, d) Compliances with the tax and other laws of the other country, which at times may be in conflict with the local laws, e) Lack of expert advice on such asset classes as the advisers themselves are not well versed with such asset classes.' The inherent higher risk of foreign markets is not explicitly mentioned as a reason in the provided list

Question 21

Regarding portfolio diversification, the text discusses two extreme investor behaviors: too much diversification and a highly concentrated portfolio. What is the Investment Adviser's vital role in addressing these?

Accepted Answer

To find the 'golden mean' for an appropriately diversified investment portfolio based on the client's risk profile, available resources, and time frame for goals.. The text states: 'Many investors have so many securities in their portfolio that they find it impossible to manage their investments. Diversification does not come from buying many securities. It can come simply by buying an index representing that asset class... Conversely, some investors will have their entire investment portfolio in a couple of specific securities or investment without adequate diversification... The Adviser has a vital role to play in finding the golden mean for an appropriately diversified investment portfolio for their clients, based on the clients’ risk profile, available resources and time frame for goals.'

Question 22

The text highlights a common bias among Indian investors where they buy insurance primarily for tax saving. What is identified as the main negative consequence of this behavior?

Accepted Answer

It results in clients buying the wrong kind of insurance or completely inadequate insurance.. The text states, 'As a result [of buying insurance for tax saving alone], they end up buying the wrong kind of insurance and/or completely inadequate insurance.'

Question 23

Which of the following best describes the advice given in the text to counter the bias of "chasing past performance"?

Accepted Answer

Implement a pre-decided asset allocation policy with upper limits for each asset class.. The text states: "A pre-decided asset allocation policy that has upper limits for each asset class makes sure that overexposure to a specific asset class is avoided." It also compares chasing past performance to "driving a car by looking in the rear view mirror."

Question 24

According to Economic Nobel Laureate Paul Samuelson and the text, what is 'action bias' in the context of investing?

Accepted Answer

The need to do something, which often leads to too frequent and too many transactions.. The text states, 'Humans have an action bias or the need to do something whereas investing requires long term consistency and long years of patience. The action bias combined with other biases induces clients to have too frequent and too many transactions, which has the impact of turning an investment activity into a trading activity.'

Question 25

Which of the following is NOT listed as a reason why investors may exhibit Home Country Bias and avoid investing in overseas securities or asset classes?

Accepted Answer

The inherent desire to gain benefits of diversification from global markets.. The text explicitly states that Home Country Bias leads to 'The benefits of diversification which come from investing into asset classes which do not move in tandem with the local securities is thus denied to them.' Therefore, an inherent desire to gain diversification benefits would work against home country bias, not be a reason for it. Options A, B, and D are all listed as reasons for investors not investing in overseas securities

Ch.16: Basics of Behavioral Finance

What You Will Learn in This Chapter

Multiple Choice Questions (25)

Ready to Test Yourself Under Exam Conditions?