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FP511 General Financial Planning Principles, Professional Conduct, and Regulation > Module 2 > Flashcards

Flashcards in Module 2 Deck (44)
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1

Behavioral finance is...

...a field of study that relates behavioral and cognitive psychology to financial planning and economics in an attempt to understand why people act irrationally during the financial decision-making process.

2

What are the two types of biases?

1. Cognitive errors are often a result of faulty reasoning and typically arise from a lack of understanding of proper statistical analysis techniques, information processing mistakes, faulty reasoning, or memory errors. Such errors can often be corrected or mitigated with better coaching or information.

2. There are emotional biases, which often occur impulsively based on the feelings of an individual when a choice is made.

3

Define - Illusion of control bias (Cognitive Bias)

When clients believe they can control or affect outcomes of, say, the market when they cannot.

Note: It is often associated with an overconfidence bias, which is emotional in nature. Clients with overconfidence believe their abilities to be much better than they are.

4

Define - Money illusion (Cognitive Bias)

the misunderstanding people have in relating nominal rates or prices with real (inflation-adjusted) rates or prices. With this bias, individuals have a tendency to think one dollar has the same value today, tomorrow, and into the future, without considering inflation.

5

Defne - Conservatism bias (Cognitive Bias)

occurs when individuals initially form a rational view but fail to change that view as new information becomes available. They consider their original view and the information upon which it is based and do not consider new information important—especially if it is difficult to understand.

6

Define - Hindsight bias (Cognitive Bias)

a selective memory of past events, actions, or what was known in the past. Clients have a tendency to remember their correct views and forget the errors. They also overestimate what could have been known.

7

Define - Confirmation bias (cognitive bias)

occurs when individuals look for new information or distort new information to support an existing view. Clients who get involved with the portfolio process by researching some of their portfolio holdings may become overly attached to some holdings and only bring up information favorable to the holding.

8

Define - Representativeness (Cognitive Bias)

the tendency, when considering choices when making a decision, to recall a past experience similar to the present decision-making situation and assume one is like the other. The new information can be misunderstood if it is classified based on a superficial resemblance to the past or a classification.

9

Define - Mental accounting (also known as money jar mentality) (Cognitive Bias)

involves the tendency of individuals to mentally put their money into separate accounts (or money jars) based on the purpose of these accounts. For example, amounts of money may be earmarked separately for savings, debt reduction, and a future vacation. In this case, setting aside money for a vacation while carrying a considerable amount of debt is, in general, poor money management.

10

Define - Cognitive Dissonance (Cognitive Bias)

When newly acquired information conflicts with pre-existing understanding, people often experience mental discomfort, also known as cognitive dissonance. When in a state of cognitive dissonance, individuals will often change some of their attitudes, beliefs, or behaviors to reduce their discomfort; maintain psychological stability; and feel more balanced. Unfortunately, attempts to achieve cognitive harmony are not always rationally in the best self-interest of the individual.

11

Define - Self-Attribution Bias (Cognitive Bias)

One ego defense mechanism is the self-attribution bias. Individuals take credit for their successes and either blame others or external influences for failures. Self-attribution bias is an ego defense mechanism because analysts use it to avoid the cognitive dissonance associated with having to admit to making a mistake.

12

Define - Anchoring (Cognitive Bias)

involves individuals making irrational decisions based on information that should have no influence on the decisions at hand. Anchoring is especially risky when people know little about the product being purchased, the service being delivered, or the investment being made.

13

Define - Outcome bias (Cognitive Bias)

the tendency for individuals to take a course of action based on the outcomes of prior events. An investor may choose a particular stock because that stock had superior performance over the past three years. However, this same investor would be ignoring the current conditions that may be applicable to the stock’s performance in the future.

14

Define - Framing bias (Cognitive Bias)

asserts that people are given a frame of reference—a set of beliefs or values that they use to interpret facts or conditions—as they make decisions. This bias leads individuals to process and respond to information based on the manner in which it is presented. It may impact how investors perceive investment performance. Under this concept, individuals often choose a guaranteed positive outcome (while avoiding a chance of greater gain that also carries the possibility of no gain at all), but they will take a chance to avoid a negative outcome (rather than taking a certain smaller loss).

15

Define - Recency Bias (Cognitive Bias)

In the recency bias, new information, which is more recent, is considered more important and valuable than less current information. Related is the concept of herding, which is when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available. Herding sometimes makes investors feel more comfortable because they are trading with the consensus of a group. In the context of herding, the recent data or trend becomes the investor’s forecast.

16

In contrast to cognitive errors, emotional biases.....

...are not related to conscious thought and stem from feelings, impulses, or intuition. As such, they are more difficult to overcome and may have to be accommodated.

17

When trying to overcome or mitigate biases (errors) that are both emotional and cognitive, success is more likely to be achieved by focusing on:

cognitive issues

18

Define - Loss aversion theory (Emotional Bias)

involves clients fearing losses much more than they value gains, and prefer avoiding losses to acquiring the same amount in gains. Loss aversion, which is related to fear of regret, explains why many investors will not sell anything at a loss.

19

Define - Overconfidence (Emotional Bias)

leads clients to believe they can control random events merely by acquiring more knowledge and consider their abilities to be much better than they are. They take credit for any financial decisions that have positive results.

20

Define - Self-control bias (Emotional Bias)

occurs when individuals lack self-discipline and favor immediate gratification over long-term goals. Consequences and implications of self-control bias may include insufficient savings accumulation to fund retirement needs and taking excessive risk in a portfolio to try and compensate for insufficient savings accumulation. Self-control bias might be overcome by establishing an appropriate investment plan and budgeting to achieve sufficient savings.

21

Define - Status quo bias (Emotional Bias)

occurs when comfort with an existing situation leads to an unwillingness to make changes, even though the change is likely beneficial. If investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out, status quo choices become more likely.

22

Define - Endowment bias (Emotional Bias)

occurs when an asset is felt to be special and more valuable simply because it is already owned. In other words, once individuals own assets, they irrationally overvalue them, regardless of the assets’ actual value.

23

Define - Regret aversion bias (Emotional Bias)

occurs when individuals do nothing out of excess fear that decisions or actions could be wrong. They attach undue weight to actions of commission (doing something) and do not consider actions of omission (doing nothing). There is more regret associated with taking an action that turns out poorly than with not taking an action that would have benefited the investor.

24

Define - Affinity bias (Emotional Bias)

refers to the tendency to make decisions based on how individuals believe the outcomes will represent their interests and values. This bias can lead to irrational decisions because investors perceive a product or investment opportunity to be a reflection of themselves. Ethnic, religious, or alumni affiliations can be the source of affinity bias.

25

What do the following three mean:

-Risk tolerance
-Risk perception
-Risk capacity

- Risk tolerance is the tradeoff that clients are willing to make between potential risks and rewards.
- Risk perception is the client’s assessment of the magnitude of the risks being traded off.
- Risk capacity is the degree to which a client’s financial resources can cushion risks.

26

What are the three types of learning styles?

(1) Visual learning styles - tend to respond to visual objects, such as graphs, charts, pictures, and reading information. Including visuals in data collection software programs or presentations are beneficial for clients with visual learning styles. Visual learners will express themselves through facial expressions and often have interests such as movies and spectator sports.

(2) Auditory learning styles - retain information by hearing or speaking. The financial planning process will be most effective if clients’ needs, priorities, and goals are discussed before being reduced to writing. Auditory learners express themselves through words and often enjoy music and conversation.

(3) Kinesthetic learning styles - understand concepts better using a hands-on approach. For example, writing goals and objectives with bullet points as they are formulated engages clients with this type of learning style. Kinesthetic learners often express themselves through body language and tend to enjoy physical activities.

27

Which of the following statements regarding learning styles is CORRECT?
I. Financial planning for an auditory learner would be most effective if the financial planner has frequent informative discussions.
II. A printed outline of the financial planning process would be most effective with the client who has a kinesthetic learning style.
III. Many changes in facial expression indicate that a prospective client most likely has a visual learning style.
IV. A client with a kinesthetic learning style often enjoys participating in sports.

I, III, & IV

28

Which of the following statements regarding learning styles is CORRECT?
I. Financial planning for an auditory learner would be most effective if the financial planner has frequent informative discussions.
II. A printed outline of the financial planning process would be most effective with the client who has a kinesthetic learning style.
III. Many changes in facial expression indicate that a prospective client most likely has a visual learning style.
IV. A client with a kinesthetic learning style often enjoys participating in sports.

I, III, & IV

29

Financial counseling - Economic and resource approach

Clients are assumed to be rational and will change to the most favorable behavior if given the appropriate counseling. In this approach, the financial planner is the agent of change. The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and debt.

30

Financial counseling -„ Classical economics approach

Clients choose among alternatives based on objectively defined cost-benefit and risk-return tradeoffs. The belief in this approach is that increasing financial resources or reducing financial expenditures results in improved financial outcomes.

31

„Financial counseling - Strategic management approach

A client’s goals and values drive the client-planner relationship. Conducting a SWOT analysis (identifying strengths, weaknesses, opportunities, and threats) is done early in the financial planning process. Here, the financial planner serves as a consultant.

32

Financial counseling - Cognitive-behavioral approach

Clients’ attitudes, beliefs, and values influence their behavior. Planners using this approach attempt to substitute negative beliefs that lead to poor financial decisions with positive attitudes, which should result in better financial results.

33

Financial counseling - Psychoanalytic approach

Based on the use of psychoanalytic theory such as Freudian or Gestalt theory, this approach is not widely used by planners. Few studies have been conducted to address its practical applications to financial planning

34

Which of the following statements regarding counseling theory is CORRECT?

I. The cognitive-behavioral approach to financial counseling asserts that clients’ attitudes, beliefs, and values influence their behavior.
II. Financial counseling is a process in which the planner helps a client change poor financial behavior by making recommendations to improve financial status.
III. Planners using the economic and resource approach assume clients are rational and will change to the most favorable behavior if given the appropriate counseling.
IV. In the classical economics approach to financial counseling, it is believed that improved financial outcomes can result from increased financial resources or reduced financial expenditures.

I, III, & IV

35

Lewis and Frederica have asked you to help them with their financial plan. During the initial meeting, you asked various open-ended questions to elicit their feelings, goals, and objectives. Based on the conversation, you believe a consultative approach should be used that specifically identifies their strengths and weaknesses, among other factors. Which of the following techniques is most closely aligned with your planning approach in this case?

A. Economic and resource approach
B. Classical economics approach
C. Strategic management approach
D. Cognitive-behavioral approach

C.

36

Lewis and Frederica have asked you to help them with their financial plan. During the initial meeting, you asked various open-ended questions to elicit their feelings, goals, and objectives. Based on the conversation, you believe a consultative approach should be used that specifically identifies their strengths and weaknesses, among other factors. Which of the following techniques is most closely aligned with your planning approach in this case?

A. Economic and resource approach
B. Classical economics approach
C. Strategic management approach
D. Cognitive-behavioral approach

C. Strategic management approach

37

Your client, Martha, often makes irrational financial decisions because she bases her decisions on information that should have no influence on the decision at hand. Martha's behavior is known as:

A) herding.
B) anchoring.
C) confirmation bias.
D) mental accounting.

B. Anchoring

The answer is anchoring. Making irrational decisions based on information that should have no influence on the decision at hand is known as anchoring. Herding is the tendency to follow the actions of a larger group, whether rational or not. Confirmation bias is the tendency to pay attention to information that supports one's preconceived opinions while disregarding accurate, unsupportive information. Mental accounting involves the tendency of individuals to put their money into separate "accounts" based on the function of these accounts.

38

Caroline considers her investment skills to be much greater than they actually are. She takes credit for any investment decisions that have positive returns but blames the economy when her portfolio does poorly. Caroline's behavior is an example of

A) confirmation bias.
B) overconfidence.
C) anchoring.
D) mental accounting.

B. Overconfidence

The answer is overconfidence. Caroline's behavior is an example of overconfidence. Confirmation bias is paying attention to information that supports a preconceived opinion and poorly made decision, while disregarding accurate, unsupportive information. Anchoring is making irrational decisions based on information that should have no influence on the decision at hand. Mental accounting is putting money into separate "accounts" based on the function of these accounts.

39

Which of the following statements best describes representativeness?

A) People believe the past will persist and will classify new information based on past experience or classification.
B) People often consider their investment abilities to be much better than they actually are.
C) People often make irrational decisions based on information that should have no influence on the decision at hand.
D) People tend to follow the actions of a larger group, whether rational or not in a particular case.

A) People believe the past will persist and will classify new information based on past experience or classification.

The prospect theory of behavioral finance states that people tend to fear losses much more than they value gains. Making irrational decisions based on information that should have no influence on the decision at hand is anchoring. Following the actions of a larger group, whether rational or not, is herding. Considering one's abilities to be much better than they actually are is overconfidence.

40

Which of the following may be affected by a client's risk tolerance and risk perception?

I. Investment decisions
II. Decisions concerning insurance coverage
III. Decisions concerning types and amount of mortgages
IV. Decisions concerning pension payout options

I, II, III, & IV

41

Which of the following statements regarding people who have a kinesthetic learning style is CORRECT?

I. They retain information by hearing or speaking.
II. They express themselves through facial expressions.
III. They tend to respond to graphs, charts, pictures, and reading information.
IV. They prefer their goals and objectives to be presented as a to-do-list in bullet form.

IV only

42

Which of the following statements regarding the classical economics approach to financial counseling is CORRECT?

I. Clients choose among alternatives based on objectively defined cost-benefit and risk-return tradeoffs.
II. This approach is based on the use of psychoanalytic theory such as Freudian or Gestalt theory.
III. This approach believes that increasing financial resources or reducing financial expenditures results in improved financial outcomes.
IV. This approach features the use of a SWOT analysis.

I & III

Statement II is incorrect; the financial counseling approach that is based on the use of psychoanalytic theory such as Freudian or Gestalt theory is the psychoanalytic approach. Statement IV is incorrect, the strategic management approach features the use of a SWOT analysis.

43

Which of the following statements regarding the economic and resource approach to financial counseling is CORRECT?

I. Clients are assumed to be rational.
II. The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and liabilities.
III. In this approach, the client is the agent of change.
IV. Individuals will change to the most favorable behavior if given the appropriate counseling.

I, II, & IV

Using the economic and resource approach, clients are assumed to be rational and will change to the most favorable behavior if given the appropriate counseling. In this approach, the financial planner, not the client, is the agent of change. The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and liabilities.

44

Which of the following statements regarding verbal mirroring is CORRECT?

I The use of verbal mirroring can improve rapport with clients.
II. In verbal mirroring, the planner imitates the client's word use, tone of voice, and communication method.
III. In verbal mirroring, the planner uses the client's body language.
IV. Verbal mirroring includes the inflection of voice or emphasis on certain words.

I & II

The answer is I and II. Statement III is incorrect because the use of the client's body language is physical mirroring. Statement IV is incorrect because voice tone is the inflection of voice or emphasis on certain words.