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CFA Level I · CFA Level I Exam · The Behavioral Biases of Individuals

A behavioral finance proponent argues that markets can be inefficient even when many investors are rational. Which statement most accurately supports this argument?

Limits to arbitrage best support the argument. Costs, risk, and constraints can stop rational investors from fully correcting mispricing caused by biased investors, so inefficiency may persist. The claims that arbitrage is immediate or that biases cancel out reflect the traditional view, not the behavioral one.

  1. ARational investors always trade away mispricing immediately, so inefficiency cannot persist
  2. BLimits to arbitrage can prevent rational investors from fully correcting mispricing caused by biased investorsCorrect
  3. CBiased investors average out to unbiased behavior, so prices always equal intrinsic values

Explanation

Costs, risks, and constraints on arbitrage mean rational traders may be unable or unwilling to eliminate mispricing created by biased investors, so inefficiency can persist. Option A is the traditional claim that behavioral finance disputes. Option C assumes biases are random and offset, but biases are often systematic and correlated.

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