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

A client faces a choice between a certain gain of 400 and a 50% chance of gaining 1,000 (otherwise nothing), and also between a certain loss of 400 and a 50% chance of losing 1,000 (otherwise nothing). Consistent with loss aversion as described by prospect theory, the client is most likely to choose:

The client is most likely to take the certain gain and gamble on the loss. Prospect theory predicts risk aversion when outcomes are gains and risk seeking when outcomes are losses, because a sure loss is painful and the gamble offers a chance of avoiding it.

  1. Athe certain gain and the gamble on the lossCorrect
  2. Bthe gamble on the gain and the certain loss
  3. Cthe certain gain and the certain loss

Explanation

Both gambles have expected values of 500 gain and 500 loss, which are larger in magnitude than the certain 400. Prospect theory predicts risk aversion in gains (take the sure 400) and risk seeking in losses (gamble to avoid a sure loss). The other combinations reverse or ignore this pattern.

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