An investor purchases a stock at Rs. 1,000. When severe negative fundamental news emerges and fair value drops to Rs. 400, the investor refuses to sell, insisting on holding until the price recovers to their original Rs. 1,000 purchase price, while actively seeking internet articles that support an optimistic view. Which two behavioral biases are demonstrated?

[ A ]Efficient Market Hypothesis and Capital Asset Pricing Model

[ B ]Anchoring Bias (fixating on the arbitrary historical purchase price of Rs. 1,000) and Confirmation Bias (selectively consuming information that validates pre-existing beliefs while ignoring negative facts)[ CORRECT ]

[ C ]Statistical Arbitrage and Modified Duration Hedging

[ D ]Fundamental Discounted Cash Flow Discipline and Cost of Carry Arbitrage

Takeaway

Option B is correct: Anchoring Bias (fixating on the arbitrary historical purchase price of Rs. 1,000) and Confirmation Bias (selectively consuming information that validates pre-existing beliefs while ignoring negative facts)

Derivation

Behavioral finance identifies cognitive distortions: (1) Anchoring Bias: The investor fixates on an irrelevant historical price benchmark (their initial purchase price of Rs. 1,000) as the reference point for decision-making, refusing to sell at Rs. 400 despite deteriorated fundamentals. Rational investing evaluates current price vs current intrinsic value, ignoring sunk acquisition costs. (2) Confirmation Bias: The investor selectively seeks out, interprets, and remembers only favorable commentary that validates their holding while actively ignoring adverse factual news. This tests investor psychology. A common error is confusing emotional biases with rational financial models.

Why the others fail

A — Efficient Market Hypothesis and Capital Asset Pricing Model

The Efficient Market Hypothesis assumes rational, unbiased investors who incorporate all news instantly, opposite to these emotional biases.

C — Statistical Arbitrage and Modified Duration Hedging

Statistical arbitrage is a mathematical quantitative trading strategy, completely unrelated to human cognitive behavioral biases.

D — Fundamental Discounted Cash Flow Discipline and Cost of Carry Arbitrage

Holding onto declining stocks based on sunk purchase costs directly violates fundamental DCF valuation discipline.