Bob Jones is the CEO of ThinkSmart, a small software company. His firm has been in business for seven years. The company operated at a financial loss during the first few years, and Jones made capital infusions to keep the firm afloat. Eventually, ThinkSmart achieved positive cash flows, and emerged with an encouraging operating outlook. One year ago, Jones contributed half a million of the firms’ equity to his new holding company, ThinkSmart Opportunities or TSO, to capitalize on undervalued stocks. Jones, along with his wife, Mindy, have made all the investment decision for ThinkSmart Opportunities.
1. The first purchase TSO made was in Alpha, a maker of athletic shoes. The stock was purchased at $30 but has drifted down to $20. They have decided to retain the security until it appreciates back to $30, and then sell it unless a review of the company’s fundamentals indicates it should be retained. Such thinking is an example of:
a. overconfidence
b. representativeness
c. anchoring
d. loss aversion
2. Mindy makes the point to Bob that because the software industry has been so successful during the past 10 years and she believes the industry will do very well in the next three years. So Mindy suggest they buy more software firm stocks. Such thinking is an example of:
a. home bias
b. representativeness
c. anchoring
d. loss aversion
3. Mindy has decided that high portfolio turnover resulting from Bob’s frequent trading has reduced net returns. She knows the trading costs are significant and questions some of Bob’s trading dictions. Bog’s frequent trading most likely results from the behavioral finance paradigm of:
a. home bias
b. overconfidence
c. anchoring
d. representativeness
4. In light of her criticism of his trading frequency, Bob accuses Mindy of failing to change a forecast adequately based on current period returns. Mindy’s behavior would be best described as:
a. home bias
b. overconfidence
c. anchoring
d. representativeness