CFA Level II ExamPortfolio Management and Wealth PlanningEasy
A portfolio manager observes that her clients tend to hold on to losing investments for too long, hoping they will recover, and sell winning investments too early to 'lock in' gains. This behavior consistently leads to suboptimal portfolio performance. Which behavioral bias is most evident in her clients' actions?
- AAnchoring
- BLoss Aversion
- CMental Accounting
- DConfirmation Bias
Show answer & explanationAnswer & explanation
Correct answer: B. Loss Aversion
Loss aversion describes the tendency for individuals to prefer avoiding losses over acquiring equivalent gains. Holding on to losing investments (disposition effect) and selling winners too early are classic manifestations of loss aversion, as investors feel the pain of a loss more acutely than the pleasure of an equivalent gain.
Why the other options are wrong
- A. Anchoring is the tendency to rely too heavily on the first piece of information offered (the 'anchor') when making decisions, which isn't the primary behavior described.
- C. Mental accounting involves treating different sums of money differently depending on how they are categorized, which is not the core issue presented.
- D. Confirmation bias involves seeking out information that confirms existing beliefs and ignoring contradictory evidence, which isn't directly described here.
Loss Aversion
A cognitive bias where individuals feel the pain of a loss more intensely than the pleasure of an equivalent gain, leading to irrational decision-making.
- Often results in holding losing investments too long (disposition effect).
- Can also lead to selling winning investments too early.
- Impacts risk-taking behavior: more risk-averse for gains, more risk-seeking for losses.
Memory trick: Biases: The Brain's Investment Bugs.