NISM Series X-B · Unit 5 of 6 · about 7% of the paper
Behavioural finance: NISM Series X-B notes and practice questions
10 marks. Recognising biases in clients and in oneself.
What to know in Unit 5
- Cognitive and emotional biases.
- Prospect theory.
- Managing client behaviour.
Key terms, examples and exam traps
Behavioural finance
It studies how psychology influences financial decisions and markets, in contrast to the view that investors are always rational.
Example. A client panics and sells in a fall.
Exam trap. This statement is false: It assumes investors always act rationally.
Prospect theory
Prospect theory says people value gains and losses relative to a reference point and feel losses more strongly than equal gains.
Example. A client dislikes a loss more than she likes the same gain.
Exam trap. This statement is false: It says people weigh gains and losses equally.
Loss aversion
Loss aversion is the tendency to feel the pain of a loss more than the pleasure of an equal gain.
Example. A client refuses to sell a stock at a loss.
Exam trap. This statement is false: Loss aversion makes clients take more risk.
Disposition effect
Investors tend to sell winners too early and hold losers too long.
Example. A client books a small profit but keeps a falling stock.
Exam trap. This statement is false: Investors sell losers quickly.
Anchoring
Anchoring is relying heavily on an initial number, like the purchase price, when making decisions.
Example. A client waits for a price to return to her buying level.
Exam trap. This statement is false: Anchoring is making decisions using fresh information.
Overconfidence
Overconfident investors overestimate their knowledge and ability, trade too often and under-diversify.
Example. A client believes she can time the market.
Exam trap. This statement is false: Overconfidence reduces trading.
Herding
Herding is following the actions of the crowd rather than one's own analysis.
Example. Clients rush into a rising stock because others do.
Exam trap. This statement is false: Herding means making independent decisions.
Confirmation bias
Confirmation bias is seeking information that supports existing beliefs and ignoring contrary evidence.
Example. A client reads only positive news on her holding.
Exam trap. This statement is false: It means testing views against evidence.
Recency bias
Recency bias gives too much weight to recent events and extrapolates them into the future.
Example. A client assumes last year's rally will continue.
Exam trap. This statement is false: Recency bias values long-term history.
Availability bias
Judging the likelihood of an event by how easily examples come to mind.
Example. A client avoids equity after hearing of a crash.
Exam trap. This statement is false: It means using full statistics.
Mental accounting
People treat money differently depending on its source or purpose, such as treating a bonus as free money.
Example. A client spends a windfall recklessly.
Exam trap. This statement is false: It treats all money as the same.
Endowment effect
People value what they own more than identical things they do not own.
Example. A client refuses to sell an inherited stock.
Exam trap. This statement is false: It means pricing assets at market value.
Status quo bias
A preference to keep things as they are and avoid change.
Example. A client leaves money idle in a savings account.
Exam trap. This statement is false: It drives clients to rebalance often.
Regret aversion
Avoiding decisions that may cause regret, leading to inaction or following the crowd.
Example. A client delays investing for fear of a fall.
Exam trap. This statement is false: It makes clients eager to take bold bets.
Framing
The way information is presented influences the decision, even when facts are the same.
Example. A fund described as 90% success is liked more than one with 10% failure.
Exam trap. This statement is false: Framing has no effect on choices.
Cognitive and emotional biases
Cognitive biases arise from faulty reasoning and can be reduced with information, while emotional biases arise from feelings and are harder to correct, so the adviser adapts to them.
Example. An adviser accepts an emotional bias and designs around it.
Exam trap. This statement is false: Emotional biases are easy to remove with data.
Managing client behaviour
Advisers help by setting a written policy, pre-agreeing rebalancing rules and using goal-based buckets to reduce emotional decisions.
Example. A written plan guides a client during a fall.
Exam trap. This statement is false: Advisers should follow every client impulse.
Self-attribution
Crediting success to skill and failure to bad luck.
Example. An investor claims her gains came from her analysis only.
Exam trap. This statement is false: Self-attribution leads to learning from errors.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which term is described here? Cognitive biases arise from faulty reasoning and can be reduced with information, while emotional biases arise from feelings and are harder to correct, so the adviser adapts to them.
- Debt mutual funds
- Cognitive and emotional biases
- Old and new regime
- Regret aversion
Q2. Which term is described here? Herding is following the actions of the crowd rather than one's own analysis.
- Herding
- Section 80C
- Private trust
- Overconfidence
Q3. Which term is described here? Overconfident investors overestimate their knowledge and ability, trade too often and under-diversify.
- Employees' Provident Fund
- Risk treatment options
- Managing client behaviour
- Overconfidence
Q4. Which statement best describes “Behavioural finance”?
- Direct plans have lower expense ratios because no distributor commission is paid, which matters for fee-only advisers.
- People treat money differently depending on its source or purpose, such as treating a bonus as free money.
- A will must be in writing, signed by the testator and attested by two witnesses, and registration is optional.
- It studies how psychology influences financial decisions and markets, in contrast to the view that investors are always rational.
Q5. Which statement best describes “Loss aversion”?
- A will can be changed or revoked any time before death, and a later will overrides the earlier one.
- A new life policy can be returned within the free-look period for a refund subject to deductions.
- Loss aversion is the tendency to feel the pain of a loss more than the pleasure of an equal gain.
- Tax liability depends on residential status; residents are taxed on global income and non-residents on India-sourced income.
Q6. Which statement best describes “Managing client behaviour”?
- The emergency fund of three to six months of expenses is kept in liquid, safe instruments.
- Communication should be clear, in the client's language, honest about risks and avoiding jargon and promises.
- Advisers help by setting a written policy, pre-agreeing rebalancing rules and using goal-based buckets to reduce emotional decisions.
- Confirmation bias is seeking information that supports existing beliefs and ignoring contrary evidence.
Frequently asked questions
How much of NISM Series X-B comes from Unit 5?
Unit 5 (Behavioural finance) usually carries about 7% of the questions. The whole exam has 120 questions and the pass mark is 60%.
What should I study in NISM Series X-B Unit 5?
Cognitive and emotional biases. Prospect theory. Managing client behaviour.
Are these NISM Series X-B practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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