Behavioral Economics Practice Exam

Question 1 Behavioral Economics

What is the hindsight bias?

The mistaken belief that a person who has experienced success has a greater chance of further success in random or independent events. The tendency to believe, after an event has occurred, that one "always knew" it would happen, distorting memory and lessons learned from past decisions. A speculative bubble in late 1990s–2000 where internet company stocks soared based on hype and optimism, then crashed when expected revenues failed to materialize. The philosophy behind nudge theory: designing environments that guide people toward welfare-enhancing choices while preserving their freedom to choose otherwise.

Question 2 Behavioral Economics

How does anchoring manifest in financial markets?

Having too many options can paralyze decision-making, reduce satisfaction, and lead to suboptimal choices, as shown in Iyengar and Lepper's jam study. A decision-making paradox showing that people violate expected utility theory by preferring certainty in some gambles while choosing risky options in structurally identical ones. Investors anchor to metrics like 52-week highs, IPO prices, or round numbers, which can distort valuation judgments and trading behavior. Israeli-American psychologists who pioneered research on cognitive biases and prospect theory, fundamentally reshaping the field of behavioral economics.

Question 3 Behavioral Economics

What is the decoy effect (asymmetric dominance)?

A theory developed by Kahneman & Tversky (1979) stating that people evaluate outcomes relative to a reference point and are more sensitive to losses than to equivalent gains. The tendency to continue an endeavor because of previously invested resources (time, money, effort) rather than evaluating future costs and benefits objectively. The mistaken belief that past random events affect future probabilities, e.g., thinking a coin that landed heads five times is "due" for tails. Adding a third, clearly inferior option (the decoy) to a choice set to make one of the other options appear more attractive by comparison.

Question 4 Behavioral Economics

What did the famous jam study by Iyengar and Lepper find?

Countries with opt-out (presumed consent) systems have much higher organ donation rates than opt-in countries, illustrating the power of defaults. Any aspect of the choice architecture that predictably alters behavior without forbidding options or significantly changing economic incentives. Shoppers who saw a display of 24 jams were less likely to purchase than those who saw only 6 jams, demonstrating that excess choice can reduce action. The tendency to think of money in nominal terms (face value) rather than real terms (adjusted for inflation), affecting spending and wage negotiations.

Question 5 Behavioral Economics

What is the gambler's fallacy?

The mistaken belief that past random events affect future probabilities, e.g., thinking a coin that landed heads five times is "due" for tails. Studies of taxi drivers show they set daily income targets and quit early on high-demand days while working longer on slow days, contrary to rational supply predictions. Sellers typically demand roughly 2 to 3 times the price that buyers are willing to pay for the same object. A decision-making paradox showing that people violate expected utility theory by preferring certainty in some gambles while choosing risky options in structurally identical ones.

Question 6 Behavioral Economics

What causes herd behavior in financial markets?

A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting. Companies may continue funding failing projects because executives feel compelled to justify the resources already spent, rather than cutting losses. Factors include informational cascades (inferring information from others' actions), social pressure, and the career risk of deviating from consensus. Any aspect of the choice architecture that predictably alters behavior without forbidding options or significantly changing economic incentives.

Question 7 Behavioral Economics

What is fairness bias and how does it affect markets?

System 1 is fast, automatic, and intuitive; System 2 is slow, deliberate, and analytical. Many biases arise because System 1 dominates routine decisions. People are willing to punish unfair behavior even at personal cost, as shown in ultimatum games, which can affect pricing, wages, and market transactions. Countries with opt-out (presumed consent) systems have much higher organ donation rates than opt-in countries, illustrating the power of defaults. The tendency of individuals to mimic the actions of a larger group, often disregarding their own information or analysis in favor of following the crowd.

Question 8 Behavioral Economics

What is prospect theory?

A theory developed by Kahneman & Tversky (1979) stating that people evaluate outcomes relative to a reference point and are more sensitive to losses than to equivalent gains. The value function is S-shaped: concave for gains (risk aversion) and convex for losses (risk seeking), and it is steeper for losses than for gains. Auto-enrollment in 401(k) plans dramatically increases participation rates because the default option is set to "enrolled" rather than "not enrolled." Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain.

Question 9 Behavioral Economics

What is present bias?

In auctions, the winning bidder often overpays because the winner tends to be the person who most overestimated the item's value. The tendency to give disproportionate weight to immediate payoffs over future ones, leading to procrastination and under-saving for retirement. The psychological pain of paying for something diminishes over time, which is why pre-paid vacations feel "free" and why people prefer flat-rate pricing. A theory developed by Kahneman & Tversky (1979) stating that people evaluate outcomes relative to a reference point and are more sensitive to losses than to equivalent gains.

Question 10 Behavioral Economics

How does Thaler's "Save More Tomorrow" program use behavioral insights?

It combines present bias (commitment starts in the future), loss aversion (increases tied to pay raises), and inertia (auto-escalation) to dramatically boost retirement savings. A person might refuse to spend $50 from a "savings" account on dinner but happily spend a $50 gift card on the same meal, even though both have equal monetary value. Investors anchor to metrics like 52-week highs, IPO prices, or round numbers, which can distort valuation judgments and trading behavior. Overconfidence, herd behavior, and mental accounting led homebuyers, lenders, and investors to underestimate risk and fuel unsustainable housing price appreciation.

Question 11 Behavioral Economics

What is the certainty effect in prospect theory?

People disproportionately prefer outcomes that are certain over those that are merely probable, even when the expected value of the probable outcome is higher. Traders may expect a stock on a losing streak to reverse simply because it has fallen for several consecutive days, ignoring actual market conditions. The tendency for people to place disproportionately high value on products they partially created, regardless of the quality of the outcome. Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on.

Question 12 Behavioral Economics

What is myopic loss aversion?

The combination of loss aversion and frequent portfolio evaluation, leading investors who check returns often to take less risk because short-term losses feel painful. The tendency for people to place disproportionately high value on products they partially created, regardless of the quality of the outcome. People with low competence overestimate their abilities while experts may underestimate theirs, contributing to novice investors taking on excessive risk. Investors may demand a higher price to sell a stock they own than they would be willing to pay to buy the same stock, creating market inefficiencies.

Question 13 Behavioral Economics

What is a default option nudge?

The tendency to think of money in nominal terms (face value) rather than real terms (adjusted for inflation), affecting spending and wage negotiations. The tendency to search for, interpret, and remember information that confirms pre-existing beliefs while ignoring contradictory evidence. Loss aversion concerns the pain of actual losses, while regret aversion involves the anticipated emotional pain of having made a wrong decision. Setting the pre-selected choice to the socially or individually optimal option, exploiting the tendency of people to stick with the status quo.

Question 14 Behavioral Economics

What is loss aversion?

The philosophy behind nudge theory: designing environments that guide people toward welfare-enhancing choices while preserving their freedom to choose otherwise. The empirical finding that losses loom roughly twice as large as gains of the same magnitude, i.e., losing $100 feels about twice as painful as gaining $100 feels pleasurable. A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting. Investors tend to hold losing stocks too long (hoping to break even) and sell winning stocks too early (locking in gains), a pattern called the disposition effect.

Question 15 Behavioral Economics

What is the availability heuristic?

In colonoscopy experiments, patients rated a longer but gradually easing procedure as less painful than a shorter one with an abrupt end, despite more total discomfort. A concept introduced by Richard Thaler describing how people categorize, evaluate, and track financial activities in separate mental accounts rather than treating money as fungible. Homeowners often set asking prices anchored to their purchase price, refusing to sell at a loss even when market conditions have changed significantly. Judging the probability of an event based on how easily examples come to mind, leading to overestimation of dramatic or recent events (e.g., plane crashes).

Question 16 Behavioral Economics

How does bounded rationality differ from full rationality assumed in neoclassical economics?

Neoclassical models assume agents process all available information and maximize utility perfectly, while bounded rationality acknowledges cognitive limitations and the use of heuristics. System 1 automatically generates an initial estimate based on the anchor, and System 2 insufficiently adjusts from it, leaving the final judgment biased toward the anchor. The combination of loss aversion and frequent portfolio evaluation, leading investors who check returns often to take less risk because short-term losses feel painful. The tendency to adopt the behavior of others in a group, assuming that the group's collective action reflects correct behavior, especially under uncertainty.

Question 17 Behavioral Economics

What is the representativeness heuristic?

The empirical finding that losses loom roughly twice as large as gains of the same magnitude, i.e., losing $100 feels about twice as painful as gaining $100 feels pleasurable. When a person's preferences change over time such that what is preferred at one point is no longer preferred later, even without new information. A concept by Herbert Simon stating that human decision-making is limited by available information, cognitive capacity, and time constraints, leading people to satisfice rather than optimize. Judging probabilities based on how closely something resembles a prototype, often ignoring base rates and leading to conjunction fallacies.

Question 18 Behavioral Economics

How does status quo bias relate to loss aversion?

Any change from the status quo involves potential losses in some dimensions, and because losses loom larger than gains, people disproportionately favor staying put. Risk preferences reverse between the gain and loss domains: people are risk-averse for gains but risk-seeking for losses. The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. Investors anchor to metrics like 52-week highs, IPO prices, or round numbers, which can distort valuation judgments and trading behavior.

Question 19 Behavioral Economics

How does loss aversion affect investor behavior?

In auctions, the winning bidder often overpays because the winner tends to be the person who most overestimated the item's value. Investors tend to hold losing stocks too long (hoping to break even) and sell winning stocks too early (locking in gains), a pattern called the disposition effect. Setting the pre-selected choice to the socially or individually optimal option, exploiting the tendency of people to stick with the status quo. Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain.

Question 20 Behavioral Economics

How did Kahneman and Tversky demonstrate framing effects?

Setting the pre-selected choice to the socially or individually optimal option, exploiting the tendency of people to stick with the status quo. The tendency to believe, after an event has occurred, that one "always knew" it would happen, distorting memory and lessons learned from past decisions. In the Asian Disease Problem, participants preferred a sure option when outcomes were framed as lives saved (gains) but chose the risky option when framed as lives lost (losses). Evaluating each financial decision in isolation rather than considering it as part of a broader portfolio, leading to suboptimal risk management.

Question 21 Behavioral Economics

How does herd behavior contribute to market bubbles?

As more investors buy into a rising asset, others follow based on social proof rather than fundamentals, inflating prices far beyond intrinsic value. Investors may demand a higher price to sell a stock they own than they would be willing to pay to buy the same stock, creating market inefficiencies. Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain. People prefer known risks over unknown risks, choosing gambles with known probabilities even when the expected values are identical.

Question 22 Behavioral Economics

How does prospect theory explain insurance purchasing behavior?

Judging probabilities based on how closely something resembles a prototype, often ignoring base rates and leading to conjunction fallacies. People judge an experience based on how they felt at its most intense point (peak) and at its end, rather than on the sum or average of every moment. People are willing to punish unfair behavior even at personal cost, as shown in ultimatum games, which can affect pricing, wages, and market transactions. People buy insurance even at unfavorable premiums because the utility of eliminating a potential loss (which weighs heavily) exceeds the disutility of the certain premium payment.

Question 23 Behavioral Economics

How does ambiguity aversion affect investment decisions?

The tendency to avoid actions that might lead to future regret, often causing investors to make overly conservative choices or follow the herd. Risk preferences reverse between the gain and loss domains: people are risk-averse for gains but risk-seeking for losses. Investors favor familiar domestic stocks over foreign equities (home bias), preferring known risks even when international diversification would improve returns. People with low competence overestimate their abilities while experts may underestimate theirs, contributing to novice investors taking on excessive risk.

Question 24 Behavioral Economics

What is framing effect?

The phenomenon where people's decisions are influenced by how information is presented (e.g., "90% survival rate" vs. "10% mortality rate") rather than by the objective facts alone. In the Asian Disease Problem, participants preferred a sure option when outcomes were framed as lives saved (gains) but chose the risky option when framed as lives lost (losses). A concept by Herbert Simon stating that human decision-making is limited by available information, cognitive capacity, and time constraints, leading people to satisfice rather than optimize. The observation that stock returns have historically exceeded bond returns by a margin too large to be explained by standard risk-aversion models.

Question 25 Behavioral Economics

What are commitment devices?

Strategies people use to lock themselves into future behavior, overcoming present bias; examples include automatic savings deductions and public goal announcements. A concept introduced by Richard Thaler describing how people categorize, evaluate, and track financial activities in separate mental accounts rather than treating money as fungible. As more investors buy into a rising asset, others follow based on social proof rather than fundamentals, inflating prices far beyond intrinsic value. The observation that stock returns have historically exceeded bond returns by a margin too large to be explained by standard risk-aversion models.

Question 26 Behavioral Economics

What is "choice architecture"?

A concept introduced by Richard Thaler describing how people categorize, evaluate, and track financial activities in separate mental accounts rather than treating money as fungible. It combines present bias (commitment starts in the future), loss aversion (increases tied to pay raises), and inertia (auto-escalation) to dramatically boost retirement savings. The practice of designing the environment in which people make decisions, including option layout, defaults, and information presentation, to influence outcomes. Making decisions one at a time instead of considering them as part of a broader set, leading to choices that may be locally sensible but globally suboptimal.

Question 27 Behavioral Economics

What is an informational cascade?

The combination of loss aversion and frequent portfolio evaluation, leading investors who check returns often to take less risk because short-term losses feel painful. Companies may continue funding failing projects because executives feel compelled to justify the resources already spent, rather than cutting losses. A situation where individuals sequentially observe others' decisions and rationally choose to follow them, ignoring their own private signals, potentially leading the group astray. Evaluating each financial decision in isolation rather than considering it as part of a broader portfolio, leading to suboptimal risk management.

Question 28 Behavioral Economics

How did Benartzi and Thaler use myopic loss aversion to explain the equity premium puzzle?

A person might refuse to spend $50 from a "savings" account on dinner but happily spend a $50 gift card on the same meal, even though both have equal monetary value. The initial asking price serves as an anchor; even arbitrary starting points significantly pull final negotiated prices toward the anchor value. Traders may expect a stock on a losing streak to reverse simply because it has fallen for several consecutive days, ignoring actual market conditions. They showed that if investors evaluate portfolios annually and are loss-averse, they would demand a high premium for stocks, matching observed equity premiums despite rational models predicting lower premiums.

Question 29 Behavioral Economics

What is the distinction between "Econs" and "Humans" in Thaler's framework?

Econs are the perfectly rational agents of economic theory; Humans are real people who use heuristics, have biases, and are influenced by context and emotions. Auto-enrollment in 401(k) plans dramatically increases participation rates because the default option is set to "enrolled" rather than "not enrolled." The tendency to think of money in nominal terms (face value) rather than real terms (adjusted for inflation), affecting spending and wage negotiations. Studies of taxi drivers show they set daily income targets and quit early on high-demand days while working longer on slow days, contrary to rational supply predictions.

Question 30 Behavioral Economics

How does the endowment effect apply to stock trading?

Evaluating each financial decision in isolation rather than considering it as part of a broader portfolio, leading to suboptimal risk management. The psychological pain of paying for something diminishes over time, which is why pre-paid vacations feel "free" and why people prefer flat-rate pricing. Israeli-American psychologists who pioneered research on cognitive biases and prospect theory, fundamentally reshaping the field of behavioral economics. Investors may demand a higher price to sell a stock they own than they would be willing to pay to buy the same stock, creating market inefficiencies.

Question 31 Behavioral Economics

Give an example of mental accounting in everyday life.

The tendency to give disproportionate weight to immediate payoffs over future ones, leading to procrastination and under-saving for retirement. A person might refuse to spend $50 from a "savings" account on dinner but happily spend a $50 gift card on the same meal, even though both have equal monetary value. Investors tend to hold losing stocks too long (hoping to break even) and sell winning stocks too early (locking in gains), a pattern called the disposition effect. In auctions, the winning bidder often overpays because the winner tends to be the person who most overestimated the item's value.

Question 32 Behavioral Economics

What is hyperbolic discounting?

A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting. The tendency for people to place disproportionately high value on products they partially created, regardless of the quality of the outcome. Homeowners often set asking prices anchored to their purchase price, refusing to sell at a loss even when market conditions have changed significantly. Investors seek out news and analysis that supports their positions, creating an echo chamber that prevents them from recognizing when to exit a losing trade.

Question 33 Behavioral Economics

Who first demonstrated the endowment effect experimentally?

Richard Thaler coined the term, and classic mug-trading experiments by Kahneman, Knetsch, and Thaler (1990) provided strong experimental evidence. When a person's preferences change over time such that what is preferred at one point is no longer preferred later, even without new information. Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on. The observation that stock returns have historically exceeded bond returns by a margin too large to be explained by standard risk-aversion models.

Question 34 Behavioral Economics

What is the Dunning-Kruger effect and how does it relate to market behavior?

People with low competence overestimate their abilities while experts may underestimate theirs, contributing to novice investors taking on excessive risk. The tendency to adopt the behavior of others in a group, assuming that the group's collective action reflects correct behavior, especially under uncertainty. Richard Thaler coined the term, and classic mug-trading experiments by Kahneman, Knetsch, and Thaler (1990) provided strong experimental evidence. Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain.

Question 35 Behavioral Economics

What is mental accounting's "payment depreciation" concept?

The tendency to avoid actions that might lead to future regret, often causing investors to make overly conservative choices or follow the herd. The tendency to disregard components shared by all options and focus on what differs, which can lead to inconsistent preferences depending on how choices are framed. The psychological pain of paying for something diminishes over time, which is why pre-paid vacations feel "free" and why people prefer flat-rate pricing. A speculative bubble in late 1990s–2000 where internet company stocks soared based on hype and optimism, then crashed when expected revenues failed to materialize.

Question 36 Behavioral Economics

What is social proof in behavioral economics?

The tendency to adopt the behavior of others in a group, assuming that the group's collective action reflects correct behavior, especially under uncertainty. A decision-making paradox showing that people violate expected utility theory by preferring certainty in some gambles while choosing risky options in structurally identical ones. Overconfidence, herd behavior, and mental accounting led homebuyers, lenders, and investors to underestimate risk and fuel unsustainable housing price appreciation. Any aspect of the choice architecture that predictably alters behavior without forbidding options or significantly changing economic incentives.

Question 37 Behavioral Economics

What is the sunk cost fallacy?

Judging probabilities based on how closely something resembles a prototype, often ignoring base rates and leading to conjunction fallacies. Investors anchor to metrics like 52-week highs, IPO prices, or round numbers, which can distort valuation judgments and trading behavior. People continue investing in a failing project because they have a mental account tracking prior expenditures and feel compelled to justify those sunk costs. The tendency to continue an endeavor because of previously invested resources (time, money, effort) rather than evaluating future costs and benefits objectively.

Question 38 Behavioral Economics

What explains the endowment effect under prospect theory?

The preference for the current state of affairs, where changes from the baseline are perceived as losses and thus resisted even when change would be beneficial. Giving up a good is coded as a loss relative to the ownership reference point, making it feel more costly than the gain a buyer anticipates. Having too many options can paralyze decision-making, reduce satisfaction, and lead to suboptimal choices, as shown in Iyengar and Lepper's jam study. The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers.

Question 39 Behavioral Economics

What is the IKEA effect?

A market condition where asset prices rise to levels significantly above fundamental value, driven by exuberant buying and the expectation that prices will continue to increase. Investors tend to hold losing stocks too long (hoping to break even) and sell winning stocks too early (locking in gains), a pattern called the disposition effect. Any aspect of the choice architecture that predictably alters behavior without forbidding options or significantly changing economic incentives. The tendency for people to place disproportionately high value on products they partially created, regardless of the quality of the outcome.

Question 40 Behavioral Economics

How does the sunk cost fallacy manifest in business decisions?

Companies may continue funding failing projects because executives feel compelled to justify the resources already spent, rather than cutting losses. It combines present bias (commitment starts in the future), loss aversion (increases tied to pay raises), and inertia (auto-escalation) to dramatically boost retirement savings. The tendency to believe, after an event has occurred, that one "always knew" it would happen, distorting memory and lessons learned from past decisions. A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting.

Question 41 Behavioral Economics

What is a reference point in prospect theory?

As more investors buy into a rising asset, others follow based on social proof rather than fundamentals, inflating prices far beyond intrinsic value. Econs are the perfectly rational agents of economic theory; Humans are real people who use heuristics, have biases, and are influenced by context and emotions. The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. The baseline against which outcomes are judged as gains or losses; it is often the status quo or an expectation level, not an absolute wealth measure.

Question 42 Behavioral Economics

Name a famous historical market bubble.

The Dutch Tulip Mania (1637), where tulip bulb prices reached extraordinarily high levels before collapsing dramatically. Econs are the perfectly rational agents of economic theory; Humans are real people who use heuristics, have biases, and are influenced by context and emotions. The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on.

Question 43 Behavioral Economics

What is overconfidence bias?

The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. A field that combines insights from psychology and economics to explain why people often make decisions that deviate from the predictions of standard rational-choice models. The Dutch Tulip Mania (1637), where tulip bulb prices reached extraordinarily high levels before collapsing dramatically. Companies may continue funding failing projects because executives feel compelled to justify the resources already spent, rather than cutting losses.

Question 44 Behavioral Economics

How does the gambler's fallacy affect trading?

Traders may expect a stock on a losing streak to reverse simply because it has fallen for several consecutive days, ignoring actual market conditions. The tendency for investors to overweight domestic securities in their portfolios despite potential gains from international diversification, partly driven by ambiguity aversion and familiarity bias. Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on. They showed that if investors evaluate portfolios annually and are loss-averse, they would demand a high premium for stocks, matching observed equity premiums despite rational models predicting lower premiums.

Question 45 Behavioral Economics

What is the affect heuristic?

People continue investing in a failing project because they have a mental account tracking prior expenditures and feel compelled to justify those sunk costs. Investors favor familiar domestic stocks over foreign equities (home bias), preferring known risks even when international diversification would improve returns. Participants who spun a rigged wheel gave estimates of African UN membership that were strongly influenced by the arbitrary number the wheel landed on. Making judgments based on current emotions rather than objective analysis; for example, fearing investments in industries one has negative feelings about regardless of fundamentals.

Question 46 Behavioral Economics

What is behavioral economics?

The tendency to think of money in nominal terms (face value) rather than real terms (adjusted for inflation), affecting spending and wage negotiations. Countries with opt-out (presumed consent) systems have much higher organ donation rates than opt-in countries, illustrating the power of defaults. Judging probabilities based on how closely something resembles a prototype, often ignoring base rates and leading to conjunction fallacies. A field that combines insights from psychology and economics to explain why people often make decisions that deviate from the predictions of standard rational-choice models.

Question 47 Behavioral Economics

What is the typical loss-aversion coefficient (λ) found in experiments?

The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. Approximately λ ≈ 2.25, meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain. Analysts often anchor to previous price targets or consensus estimates, adjusting insufficiently even when fundamentals change dramatically. A market condition where asset prices rise to levels significantly above fundamental value, driven by exuberant buying and the expectation that prices will continue to increase.

Question 48 Behavioral Economics

What was the Dot-Com Bubble?

It combines present bias (commitment starts in the future), loss aversion (increases tied to pay raises), and inertia (auto-escalation) to dramatically boost retirement savings. A speculative bubble in late 1990s–2000 where internet company stocks soared based on hype and optimism, then crashed when expected revenues failed to materialize. Overconfident investors trade excessively, believing they can outperform the market, which typically leads to lower net returns after transaction costs. Analysts often anchor to previous price targets or consensus estimates, adjusting insufficiently even when fundamentals change dramatically.

Question 49 Behavioral Economics

What is the concept of "choice overload"?

Countries with opt-out (presumed consent) systems have much higher organ donation rates than opt-in countries, illustrating the power of defaults. Having too many options can paralyze decision-making, reduce satisfaction, and lead to suboptimal choices, as shown in Iyengar and Lepper's jam study. The tendency for people to overestimate their own knowledge, abilities, or the precision of their predictions, common among investors and fund managers. Neoclassical models assume agents process all available information and maximize utility perfectly, while bounded rationality acknowledges cognitive limitations and the use of heuristics.

Question 50 Behavioral Economics

How does the value function in prospect theory differ from standard utility theory?

A model of intertemporal choice where discount rates are higher for near-term delays and lower for delays further in the future, unlike the constant rate in exponential discounting. A field that combines insights from psychology and economics to explain why people often make decisions that deviate from the predictions of standard rational-choice models. The tendency to avoid actions that might lead to future regret, often causing investors to make overly conservative choices or follow the herd. The value function is S-shaped: concave for gains (risk aversion) and convex for losses (risk seeking), and it is steeper for losses than for gains.