R02 Behavioural finance: free practice questions

1. Question 1 of 5

   What does behavioural finance try to explain?

   Option A: How central banks set interest ratesOption B: Market anomalies that traditional finance models can'tOption C: How to calculate a share's beta against the marketOption D: Why markets are always fully efficient at all times

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   The answer is B: Market anomalies that traditional finance models can't

   Behavioural finance explores how emotional and psychological factors affect investment decisions, explaining anomalies, bubbles and crashes that models such as MPT and the EMH don't.

   Why the other options are wrong

   A

   That isn't its focus.

   C

   That's part of the CAPM.

   D

   It challenges that view.

2. Question 2 of 5

   A client refuses to sell a share that's halved in value, saying the loss isn't real until she sells. Which bias is this?

   Option A: Anchoring on the FTSE 100's levelOption B: Overconfidence in a rising marketOption C: Herding with other investorsOption D: Regret and loss aversion

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   The answer is D: Regret and loss aversion

   Fear of regret and loss aversion make investors reluctant to sell losers, avoiding the pain of admitting a bad decision and treating the loss as only 'on paper'.

   Why the other options are wrong

   A

   Her reference point is her purchase price, not an index.

   B

   The behaviour is about avoiding the pain of realising a loss.

   C

   She's acting on her own feelings about the loss.

3. Question 3 of 5

   How does over- and underreaction show itself in investor behaviour?

   Option A: Too much weight is given to recent trendsOption B: Investors ignore all new informationOption C: Investors always follow long-run averagesOption D: Investors become more cautious as markets rise

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   The answer is A: Too much weight is given to recent trends

   Investors tend to be more optimistic as markets rise and more pessimistic as they fall, giving too much weight to recent trends that often run against long-run averages and statistical odds.

   Why the other options are wrong

   B

   They tend to overweight recent information.

   C

   They tend to ignore long-run averages.

   D

   They tend to become more optimistic.

4. Question 4 of 5

   Which events does behavioural finance use to show that psychology can matter as much as economics?

   Option A: Regular changes to the dividend allowanceOption B: Speculative bubbles and stock market crashesOption C: Quarterly reviews of the FTSE 100Option D: Gilt auctions by the DMO

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   The answer is B: Speculative bubbles and stock market crashes

   Bubbles, such as the 1999 technology bubble, and crashes, such as those of 1987, 2008 and 2020, show irrational reactions to information driving prices away from fundamentals.

   Why the other options are wrong

   A

   Tax changes aren't the examples used.

   C

   Index reviews aren't psychological events.

   D

   These are routine market operations.

5. Question 5 of 5

   Which market effect is overconfidence linked to?

   Option A: Unusually low trading volumes across the marketOption B: Prices that always match their fundamental valueOption C: Excessive trading volumes and speculative bubblesOption D: A preference for holding cash

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   The answer is C: Excessive trading volumes and speculative bubbles

   Overconfidence leads investors to overestimate their knowledge and control and underestimate risk, which can lead to excessive trading volumes and speculative bubbles.

   Why the other options are wrong

   A

   Overconfidence tends to increase trading.

   B

   Overconfidence can push prices away from value.

   D

   Overconfident investors tend to take more risk, not less.

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