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

An adviser notes that a client, after a strong run of gains in her account, begins taking larger and riskier positions, reasoning that she is now trading with "the market's money." This behavior is best described as:

This is best described as the house money effect. After prior gains, the investor treats profits as separate from her own money and becomes less loss averse, taking greater risk. The endowment effect and hindsight bias address different behaviors, namely attachment to owned assets and perceived predictability of past events.

  1. Athe house money effect, linked to a change in risk tolerance after gainsCorrect
  2. Bthe endowment effect, linked to attachment to inherited assets
  3. Chindsight bias, linked to believing past events were predictable

Explanation

After gains, investors may treat profits as separate from their own capital and become more risk seeking, which is the house money effect and is related to loss aversion being reduced after gains. The endowment effect concerns assets already owned, and hindsight bias concerns judging past outcomes as obvious.

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