Factor & Behavioral Finance
Chapter: 6.6 Factor & Behavioral Finance Level: 1 — Recognition (MCQ, Matching, True/False with justification) Time Limit: 20 minutes Total Marks: 30
Section A — Multiple Choice (1 mark each, 10 marks)
Choose the single best answer.
Q1. Factor investing seeks to capture returns driven by:
- (a) Random luck of individual stock picks
- (b) Systematic, persistent characteristics that explain returns
- (c) Insider information only
- (d) Government subsidies
Q2. The value factor typically favours stocks with:
- (a) High price-to-book ratios
- (b) Low price-to-book (or low P/E) ratios
- (c) The highest recent returns
- (d) The largest market capitalisation
Q3. The momentum factor is based on the idea that:
- (a) Cheap stocks always outperform
- (b) Recent winners tend to keep winning in the short-to-medium term
- (c) Small stocks always beat large stocks
- (d) Low-volatility stocks earn the highest returns
Q4. The original Fama-French three-factor model adds which two factors to the market factor?
- (a) Momentum and quality
- (b) Size (SMB) and value (HML)
- (c) Low-volatility and profitability
- (d) Investment and momentum
Q5. The Fama-French five-factor model adds which two factors to the three-factor model?
- (a) Momentum and value
- (b) Profitability (RMW) and investment (CMA)
- (c) Size and low-volatility
- (d) Liquidity and quality
Q6. Smart beta strategies are best described as:
- (a) Pure active stock picking by a manager
- (b) Rule-based indexing that tilts toward chosen factors
- (c) Purely market-cap-weighted passive indexing
- (d) High-frequency trading algorithms
Q7. The disposition effect describes investors' tendency to:
- (a) Sell winners too early and hold losers too long
- (b) Sell losers quickly and hold winners forever
- (c) Ignore all price changes
- (d) Buy only during crashes
Q8. Anchoring bias occurs when an investor:
- (a) Follows the crowd blindly
- (b) Relies too heavily on an initial reference value (e.g., purchase price)
- (c) Overweights the most recent news
- (d) Seeks only confirming evidence
Q9. Herding behaviour in markets refers to:
- (a) Investors independently reaching the same conclusion
- (b) Investors mimicking the actions of the larger group
- (c) Diversifying across many assets
- (d) Rebalancing on a fixed schedule
Q10. The Efficient Market Hypothesis (EMH) in its semi-strong form states that prices reflect:
- (a) Only past price data
- (b) All publicly available information
- (c) All information including private/insider information
- (d) No information at all
Section B — Matching (1 mark each, 8 marks)
Match each term in Column X to its correct description in Column Y. Write the letter.
| # | Column X |
|---|---|
| Q11 | Quality factor |
| Q12 | Size factor (SMB) |
| Q13 | Low-volatility factor |
| Q14 | Loss aversion |
| Q15 | Confirmation bias |
| Q16 | Recency bias |
| Q17 | Weak-form EMH |
| Q18 | Momentum factor |
| Letter | Column Y |
|---|---|
| A | Tendency of small-cap stocks to outperform large-cap over the long run |
| B | Stocks with lower price fluctuations have earned surprisingly strong risk-adjusted returns |
| C | Favours firms with strong profitability, stable earnings and low debt |
| D | Buying past winners and selling past losers |
| E | The pain of a loss feels stronger than the pleasure of an equal gain |
| F | Seeking information that supports existing beliefs and ignoring contrary data |
| G | Overweighting the most recent events when forecasting the future |
| H | Prices already reflect all past price/volume information |
Section C — True/False with Justification (2 marks each: 1 mark T/F, 1 mark justification; 12 marks)
State True or False and give a one-line justification.
Q19. "In the value factor, growth stocks with high P/B ratios are classified as value stocks."
Q20. "Momentum and value factors are often negatively correlated, making them useful to combine in a portfolio."
Q21. "Smart beta strategies are actively managed and do not follow transparent rules."
Q22. "Under strong-form EMH, even insider information cannot be used to consistently beat the market."
Q23. "Herding and recency bias can help explain the formation of asset bubbles."
Q24. "Loss aversion implies investors are equally sensitive to gains and losses of the same size."
Answer keyMark scheme & solutions
Section A — MCQ (1 mark each)
| Q | Answer | Why |
|---|---|---|
| Q1 | (b) | Factor investing targets systematic, persistent drivers of return, not luck or insider data. |
| Q2 | (b) | Value = cheap relative to fundamentals → low P/B or low P/E. |
| Q3 | (b) | Momentum: recent winners continue outperforming short-to-medium term. |
| Q4 | (b) | FF3 = Market + SMB (size) + HML (value). |
| Q5 | (b) | FF5 adds RMW (profitability) and CMA (investment). |
| Q6 | (b) | Smart beta = rule-based, transparent factor tilts between passive and active. |
| Q7 | (a) | Disposition effect: sell winners early, hold losers too long (avoiding realising losses). |
| Q8 | (b) | Anchoring = over-reliance on an initial reference point. |
| Q9 | (b) | Herding = following the crowd's actions. |
| Q10 | (b) | Semi-strong EMH: prices reflect all public information. |
Section B — Matching (1 mark each)
| Q | Answer | Why |
|---|---|---|
| Q11 | C | Quality = profitability, earnings stability, low leverage. |
| Q12 | A | Size (SMB) = small-cap outperformance tendency. |
| Q13 | B | Low-vol anomaly: low-volatility stocks earn strong risk-adjusted returns. |
| Q14 | E | Loss aversion: losses hurt more than equivalent gains please. |
| Q15 | F | Confirmation bias: seek supporting evidence, ignore contrary data. |
| Q16 | G | Recency bias: overweight recent events. |
| Q17 | H | Weak-form EMH: prices reflect all past price/volume info. |
| Q18 | D | Momentum: buy winners, sell losers. |
Section C — True/False with Justification (2 marks each)
Q19. FALSE (1) — Growth stocks with high P/B are the opposite of value; value stocks have low P/B. (1)
Q20. TRUE (1) — Value and momentum tend to be negatively correlated, so combining them smooths returns and improves diversification. (1)
Q21. FALSE (1) — Smart beta is rule-based and transparent, not discretionary active management. (1)
Q22. TRUE (1) — Strong-form EMH claims prices reflect all information including private/insider info, so no one can consistently beat the market. (1)
Q23. TRUE (1) — Herding (following the crowd) and recency bias (extrapolating recent gains) drive prices above fundamentals, fuelling bubbles. (1)
Q24. FALSE (1) — Loss aversion means investors are more sensitive to losses than to equal-sized gains (roughly 2:1), not equally sensitive. (1)
[
{"claim":"Section A has 10 MCQs worth 1 mark each = 10 marks","code":"result = (10*1 == 10)"},
{"claim":"Section B has 8 matching items worth 1 mark each = 8 marks","code":"result = (8*1 == 8)"},
{"claim":"Section C has 6 T/F items worth 2 marks each = 12 marks","code":"result = (6*2 == 12)"},
{"claim":"Total paper marks sum to 30","code":"secA=10*1; secB=8*1; secC=6*2; result = (secA+secB+secC == 30)"},
{"claim":"Loss aversion typical ratio ~2:1 means loss coefficient exceeds gain coefficient","code":"loss_coeff=2; gain_coeff=1; result = (loss_coeff > gain_coeff)"},
{"claim":"Total question count is 24","code":"result = (10 + 8 + 6 == 24)"}
]