GMAT (Graduate Management Admission Test) Verbal: Questions 1 of 30

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Passage two Risk in Investment

Risk is defined as volatility of returns where volatility indicates the unreliability of an investment. It is as a matter of convenience that volatility is considered as a proxy for risk, although it is not a comprehensive, sufficient and useful measure of risk.

To most investors, risk, first and foremost, is the likelihood of losing money. Risk is also subjective and personal, rather than intrinsic to the investment itself. Some of the popular ways of getting an idea about risk are as follows;

Falling short of one’s goal: Investors have differing needs, and for each investor the failure to meet those needs poses a risk. Falling short of the nest egg or amount required for a particular goal is one of the major risks an investor faces. This clearly implies that an investor has to be worried not only about the risk but also the returns, failing which he/she could face the risk of outliving his/her investments. The trade-off between risk and returns is the most intriguing and challenging job for most.

Unconventionality: It is always comfortable to walk on the beaten and conventional track. There is a saying: ”Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. ” What is conventional and habitual, brings in lot of comfort while regret out of unconventional methods of investing is much more than that of conventional means.

Illiquidity: Ability to convert your investment to cash at reasonable price at times when you require the funds determines the success of your investment. Absence of liquidity or conversion to cash at a huge impact cost would be a major deterrent.

Finally, emotional reactions to risky situations often diverge from cognitive assessments of such risk. When such divergence occurs, emotional reactions drive behaviour. Behavioural biases fall into two broad categories: Cognitive and emotional, though both yield irrational decisions. Because cognitive biases stem from faulty reasoning, better information and advice can often correct them. Conversely, because emotional biases originate from impulsive feelings or intuition, rather than conscious reasoning, they are difficult to correct. Cognitive biases include heuristics, such as anchoring and adjustment, availability and representativeness biases. Other cognitive biases include selective memory and overconfidence. Emotional biases include regret, self control, loss aversion, hinsight and denial.

Asset allocation is optimal if it suits the client’s preferences and his/her risk taking ability so that the client holds onto his/her strategy overtime. This strategy should be free from behavioural biases but it should take into account behavioural aspects of the client’s preferences such as loss aversion.

MCQ▾

Question

The word ‘heuristics’ used in the passage is synonymous with which of the following ideas?

Choices

Choice (5) Response

a.

Behavioural bias inherited genetically

b.

Representative bias exhibited from birth

c.

Cognitive bias developed because of faulty experience

d.

Emotional bias originating from irrational decisions

e.

Cognitive bias that has stemmed from impulsive reasoning

Analysis

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Answer

c.

Explanation

The word ‘heuristics’ means a study of how people use their experience to find answers to questions or to improve performance. In the passage, the word is used to describe cognitive bias in an investor that has developed because of flawed experience that can be rectified with better information and advice. So the right choice is (C). Heuristics is not something that is inherited genetically or exhibited from birth so options (A) and (B) can be eliminated. Heuristics in the passage is mentioned as a cognitive bias but option (D) states an emotional bias and can therefore be eliminated. Impulsiveness is an emotional bias and is unrelated to cognition and so option (E) can be eliminated as well.

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