Unit 1 Behavioral Economics Review

Personal Finance Unit 1: Behavioral Finance Test Review

Section 1: Your Values and Money

• Inner Value:: Strong inner values translate to trusting one’s gut or following the inner voice, which can give the person the resourcefulness to overcome a sudden money crunch.
• Social Value:: How we handle money is, in part, tied up in our unique family histories. Habits and cultural preferences we learn early from our families and other social relationships influence later money habits
• Physical Value:: A person with strong physical values also might prioritize getting more insurance to protect their valuables, and might spend more than others on home and self-care (e.g., gym memberships, beauty treatments, dry cleaning, interior design). This is not felt to be frivolous, but to protect his or her investment.
• Financial Value:” Those with strong financial values likely think more about the sustainability of their money and generally have more in reserve. When one does not have a strong concern about the appropriateness of their purchases, he or she might be less prepared for financial emergencies.

Section 2: Your Brain and Money

• Overconfidence Bias: The tendency people have to be more confident in their own abilities or opinions when compared to others. It may lead to a person believing to think they are a better than average driver or investor.
• Cognitive Bias: A cognitive bias is a systematic error in thinking that occurs when people are processing and interpreting information in the world around them and affects the decisions and judgments that they make….Everyone exhibits cognitive bias.
• Behavioral Economists: View people as irrational beings who sometimes let emotions influence their decisions.
• Traditional Economists:  View people as completely rational beings who always make perfect, logical decisions that serve their best interests.

Section 3: Loss Aversion

• Loss Aversion: We tend to feel the effect of losses more than the effect of similar gains
• Overcoming Loss Aversion: Reframe the situation so that you focus on the potential gains
• Loss Aversion Strategy:
• Free Trials and Samples: When given access to a paid service, you gain a sense of ownership. When that access is set to expire, the hope is that you’ll choose to pay for continued ownership rather than losing access
• Coupons: The purpose of the coupon is to get you to purchase the item because you don’t want to miss out on
• Scarcity and Urgency: when there is limited time or very few of an item left, you might feel pressured to act now
• Buy now, get it tomorrow: This strategy hopes that the thought of losing out on having this item as soon as possible will motivate you to act now.
• Buy now get it X% off: the hope is by giving you an incentive that can only be received by buying within a limited window of opportunity, you will feel just enough pressure to make the purchase
• Protect people from loss: This strategy hopes that your fear of losing something important to you will cause you to make a purchase to protect it.
• Progress Bars: The hope is you will see the progress you’ve made and not want to give up as you get closer to finishing.

Section 4: Endowment Effect and Sunk Cost

• Endowment Effect: Valuing things we own more highly just because we own them
• Sunk Cost: Investments of time, effort, and money that cannot be recovered no matter what we do, so they shouldn’t be considered when making decisions.

Section 5: Herd Mentality and Fomo

• Herd Mentality: The tendency to choose an option that the majority chooses is due to a cognitive bias called Herd Mentality, also known as The Bandwagon Effect.
• FOMO: The Fear of Missing out

Section 6: Confirmation Bias and Overconfidence

• Confirmation Bias: is our tendency to seek out and interpret information in a way that confirms what we already believe.
• Overconfidence: is a tendency for a person to overestimate their abilities.

Section 7: Happiness and Hedonic Adaptation

• How does a positive event initially impact our emotional state? What happens to our emotional state after some time passes?

• A positive event initially makes us feel high levels of happiness. After some time passes we tend to return to our normal, or baseline, level of happiness.

• What role does hedonic adaptation play when a negative event occurs?

• Similar to what happens when a positive event occurs, a negative event initially causes our level of happiness to decrease, but after some time passes we tend to return to our baseline level of happiness.

• Hedonic Adaptation:

1. How can a person’s values and experiences affect how they make financial decisions?

A. Personal values and experiences are generally the same for most people across the board, which is why we all spend and save similarly

B. Personal values and experiences differ based on each person, which explains why people make different decisions around money

C. Personal values and experiences fluctuate every few weeks, which can cause someone to spend and save in dramatically different ways over the course of a year

D. Personal values and experiences can change depending on what type of bank account you have, which determines how you spend and save your money

2. How might scarcity of financial resources impact decision making?

A. When money is tight, people cannot live full or meaningful lives

B. When money is tight, people make bad financial decisions weekly or even daily

C. When money is tight, people tend to prioritize wants over needs

D. When money is tight, people rely on their values to make tough choices

3. What are social values, as they pertain to money?

A. How you, personally, care and think about finances

B. How your family, friends, and community members impact your feelings about money

C. How companies and advertisement make you feel about money

D. How banks and other financial institutions treat you and your money

4. Behavioral economics…

A. Is a field of economics that studies people who make rational and objective decisions

B. Analyzes how different economies around the world behave over time

C. Tracks and examines stock market trends over a certain period of time

D. Combines economics and psychology to study why people behave the way they do in the real world

5. Cognitive bias is…

A. An error in the way we think that can influence our decisions

B. The desire to seek out information that confirms our existing beliefs

C. The belief that our abilities are better than they actually are

D. The concept of placing more value on an item when we own it

6. You go to a restaurant and order a big meal. Even though you’re full, you keep eating because it was expensive. This is an example of…

A. Mental Accounting

B. Sunk Cost

C. Fear of Missing Out

D. The Endowment Effect

7. Loss aversion is the idea that…

A. We tend to make investments that lose money

B. We tend to avoid telling people about our losses

C. If you lose money, you shouldn’t be in charge of making financial decisions

D. We tend to feel the effect of losses more than the effect of similar gains

8. Which of the following loss aversion strategies best describes a streaming service that allows you to watch its content free for 30 days?

A. Coupons

B. Scarcity and urgency

C. Buy now, get free shipping

D. Free trials and samples

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9. One way to overcome loss aversion is to…

A. Avoid making a decision at all

B. Reframe the situation so that you focus on the potential gains

C. Ask a friend what they’d do and follow their example

D. Think of the best case scenario and base your decision on how you feel

E. 10. Alisha is trying to sell some of her childhood toys at a garage sale, but nobody is buying them. Which of the following demonstrates that Alisha may be influenced by the endowment effect?

A. Alisha is selling each toy at a comparable price for similar, used toys

B. Alisha is offering a “Buy One, Get One Free” promotion for the toys

C. Alisha is selling her childhood toys at a higher price than they are available new

D. Alisha is willing to lower the price of her old toys if a buyer wants to negotiate

11. Sunk costs are when we spend time, money, or effort that…

A. Our friends and family disagrees with

B. Increase our tax liability

C. Cannot be recovered

D. Increases our net worth

12. You purchased an expensive meal at a restaurant. Halfway through you realize you are full to the point where another bite would cause you discomfort. Which of the following scenarios is an example of allowing

sunk costs to impact your decision?

A. Letting the server take your plate

B. Asking for a to-go box

C. Allowing your friend to finish your meal

D. Eating the rest of the meal to get your money’s worth

13. Which of the following BEST demonstrates herd mentality?

A. Sophie sees an ad for a pair of shoes on Instagram and decides to buy them

B. Will really likes an android phone his dad has but chooses to buy an iPhone because his friends all have one

C. Charlie decides to buy a jacket they saw a friend wearing that they really liked

D. Juan is in a department store, sees a shirt he likes, and decides to buy it

14. Due to FOMO, many people are…

A. Spending money they don’t have and going into debt

B. Making purchases that align with their values

C. Quitting social media for good, costing companies billions ofdollars

D. Saving unprecedented amounts of money for their futures

15. One realistic way to combat the influence of herd mentality and FOMO is…

A. Immediately delete your social media profiles

B. Close all of your credit card accounts

C. Follow a budget and align your spending with your financial goals and priorities

D. Put away half of your paycheck in a savings account

16. Confirmation bias is…

A. Valuing your own opinions over the opinions of others

B. The tendency to interpret new evidence as proof of one's existing beliefs or theories

C. Believing that you are better at something then you actually are

D. An exaggerated certainty that a person is correct

17. All of the following are types of confirmation bias EXCEPT…

A. Interpreting information to support your existing belief

B. Purposely ignoring information that challenges your belief

C. Only remembering details that uphold your belief

D. Seeking out objective facts that go against your belief

18. Roger finds a stock that he is interested in buying. Which of the following behaviors demonstrates his overconfidence bias?

A. Roger seeks out sources that contradict his decision to buy the stock

B. Roger decides not to purchase the stock because it is not worth the risk

C. Roger invests the majority of his available money into buying shares of this stock

D. Roger waits 2 to 3 days before buying the stock

19. Rita purchases a new jacket. What would you expect to happen over time due to hedonic adaptation?

A. Rita’s happiness will increase and she’ll remain at her new, higher level of happiness

B. Rita’s happiness will remain at its baseline level over time

C. Rita’s happiness will decrease and she’ll remain at her new, lower level of happiness

D. Rita’s happiness will initially increase and then decrease to her baseline level of happiness over time

20. All of the following are common explanations for why we are driven to buy more stuff EXCEPT…

A. We like new things

B. We want to help others

C. We want to feel special

D. We like to feel good

21. Isaiah learned about hedonic adaptation and wants to spend his money more wisely. Which of the following actions is the BEST way to do so?

A. Buying a case for his phone a month after getting a new one

B. Donating money to a local charity that supports a cause he cares about

C. Purchasing a shirt impulsively after seeing an ad on social media

D. Getting the latest model of his laptop even though his old one works fine

Part II: Short answer questions

1. Explain how values and cognitive biases may help you have better financial decisions.

2. How does social media create a sense of FOMO?

3. How can endowment effects lead to irrational decisions?

4. Why is it important to ignore sunk cost?