PFIN 1-3 Lesson Review

What is the main concept that traditional economics relies on?

• Rational choice theory

• Cognitive bias

• Herd mentality

• Personal Finance

Answer explanation

Cognitive bias refers to systematic deviations from rational thinking due to mental shortcuts. Herd mentality is the tendency to mimic the actions of a group. Personal finance is the management of an individual's financial decisions. Rational choice theory, however, is the concept that traditional economics relies on, suggesting individuals make decisions through rational calculations to maximize self-interest.

Which cognitive bias describes valuing something more just because you own it?

• Loss aversion

• Sunk cost fallacy

• Endowment effect

• Anchoring bias

Answer explanation

Loss aversion is the discomfort felt from losing value perceived as greater than the pleasure from gaining value. The sunk cost fallacy is justifying further investments based on previously incurred, unrecoverable costs. Anchoring bias involves placing undue emphasis on the first piece of information received. The endowment effect is the cognitive bias where people ascribe more value to things merely because they own them.

In behavioral economics, what is a heuristic?

• A financial strategy to increase savings

• A mental shortcut used for decision-making

• An investment in technology stocks

• Another word for cognitive bias

Answer explanation

A mental shortcut or rule of thumb that simplifies decision-making processes, often used in behavioral economics. Heuristic is not another word for cognitive bias. Instead, heuristics lead to oversimplification and errors. These missteps are called cognitive biases. Heuristics are not related to financial strategies or investing in stocks.

Which cognitive bias is exemplified by holding onto a declining stock to avoid realizing a loss?

• Endowment effect

• Herd mentality

• Sunk cost fallacy

• Anchoring bias

Answer explanation

The endowment effect is valuing something more because you own it. Herd mentality is following the actions of a group. The sunk cost fallacy involves further investing based on past, unrecoverable costs. Loss aversion, however, is the cognitive bias where the discomfort of something losing value is perceived as greater than the pleasure from it gaining value, causing people to hold onto a declining stock.

What is cognitive bias?

• A financial strategy to maximize savings and investments.

• A theory that individuals make decisions based on their upbringing and the natural biases they have.

• A systematic deviation from rational thinking, leading to illogical judgments and decisions due to mental shortcuts and influences.

• A theory that individuals make decisions to maximize their self-interest.

Answer explanation

A financial strategy to maximize savings and investments is not related to cognitive bias. Cognitive bias does not have anything to do with an individual's upbringing and their biases, morals, or values. The theory that individuals make decisions to maximize their self-interest is rational choice theory. Cognitive bias is a systematic deviation from rational thinking due to mental shortcuts and influences, leading to illogical judgments and decisions.

What does the rational choice theory suggest about how individuals make decisions?

• They make decisions based on gut feelings and emotions.

• They make decisions based on their upbringing and natural biases.

• They make decisions to maximize their self-interest.

• They make decisions to minimize risks and losses.

Answer explanation

Making decisions based on gut feelings and emotions is not aligned with rational choice theory; it falls more under the influence of cognitive biases. Following the actions and opinions of a group is related to herd mentality. Making decisions based on mental shortcuts and cognitive biases is a concept from behavioral economics. Rational choice theory suggests that individuals make decisions through rational calculations to maximize their self-interest, based on preferences, constraints, and available information.

What term describes the tendency to follow the actions and decisions of a group?

• Rational choice theory

• Anchoring bias

• Herd mentality

• Mental accounting

Answer explanation

Anchoring bias involves emphasizing the first piece of information. Mental accounting categorizes money based on its purpose. Rational choice theory suggests decisions are made through rational calculations. Herd mentality, on the other hand, is the cognitive bias where individuals mimic the actions and decisions of a group.

When someone decides to keep their vacation savings separate from their debt repayment funds, which cognitive bias are they demonstrating?

• Herd mentality

• Anchoring bias

• Mental accounting

• Rational choice theory

Answer explanation

The sunk cost fallacy justifies further investments based on past, unrecoverable costs. The endowment effect is valuing something more because you own it. Anchoring bias involves emphasizing the first piece of information.

Mental accounting is categorizing and treating money differently based on its origin or intended purpose, such as keeping vacation savings separate from debt repayment funds.

Which cognitive bias justifies further investments based on past, unrecoverable costs?

• Sunk cost fallacy

• Endowment effect

• Anchoring bias

• Mental accounting

How can individuals mitigate (lessen) the negative influence of cognitive biases on financial decisions?

• Make decisions quickly

• Avoid setting financial goals

• Boost financial literacy

• Ignore other opinions

Answer explanation

Making decisions quickly, avoiding setting financial goals, and ignoring other opinions can exacerbate cognitive biases. Boosting financial literacy, however, expands knowledge of personal finance and builds a logical foundation for decision-making, helping to mitigate the negative influence of cognitive biases.