Module 2 - Behavioral Finance

Question 1

What is the definition of risk tolerance?

Answer 1

the trade off clients are willing to make between potential risks and rewards with some probability of negative outcomes.

Question 2

What is the definition of risk preference?

Answer 2

Attitude client has toward financial risks - constant personality trait

Question 3

What is the definition of risk perception?

Answer 3

Subjective judgement clients make when asked to describe or evaluate the risk of financial decisions

Question 4

What is risk capacity?

Answer 4

The degree to which a client’s financial resources can mitigate risk

Question 5

What is risk literacy?

Answer 5

The ability of the client to comprehend and act on information related to financial risks

Question 6

What factors contribute to a risk assessment?

Answer 6

Risk perception, risk preference, risk tolerance, risk capacity and risk literacy

Question 7

How would you explain a Psychological Profile?

Answer 7

This is the client’s risk assessment and personality traits that combine to form their opinions and attitude relates to finances.

Question 8

What is the difference between perception and judgement?

Answer 8

Perception is how to observe and your awareness of people, events, or ideas - Judgement is the conclusions you make about the perceptions

Question 9

What are the three types of learning styles?

Answer 9

Visual - seeing things
Auditory - hearing things
Kinesthetic - touch/doing things

Question 10

Visual learners prefer what type of financial data and have what personality traits?

Answer 10

Charts, graphs, pictures, and reading materials - they are facially expressive and enjoy movies and sports

Question 11

Auditory learners prefer what type of financial data and have what personality traits?

Answer 11

Goal setting, value setting, needs and priorities assessed and readdressed - they express themselves with words and enjoy conversation and music.

Question 12

Kinesthetic learners prefer what type of financial data and have what personality traits?

Answer 12

Bullet points (from the study material) and being involved in the process - they use lots of body language and enjoy physical activities

Question 13

What is the difference between an attitude and a belief?

Answer 13

Attitudes are a person’s opinions, values and wants. A belief is an attitude specific to an aspect of the person’s life.

Question 14

What two things make a value?

Answer 14

Attitudes and beliefs that are held strongly and believed to be right.

Question 15

Context is important for the financial planner to consider because:

Answer 15

It includes the past history and current conditions the client is in and these are affected by their personal circumstances: religion, culture, family, age, lifestyle, life cycle stage, etc.

Question 16

Do the planner’s attitudes and beliefs play a part in the planning process

Answer 16

Absolutely - they affect how we present, what data we present, and our expectations for client responses - we must temper our own attitudes and beliefs so we can meet the client where they are

Question 17

What is illusion of control bias? What is the impact of this cognitive error?

Answer 17

This occurs when a client believes they have influence or control over outcomes that they cannot control. (Like believing they will be able to time the market)
Genereally, these clients perform more poorly than those without it - they tend to trade more, neglect opportunities outside of their limited opinion, and fail to adequately diversify.

Question 18

What is the money illusion bias? What is the impact of this cognitive error?

Answer 18

Money illusion is when clients fail to understand the difference between nominal rates/prices and real (inflation adjusted) rates/prices.
For example - a 2% interest rate with 0% inflation is the same as a 6% interest rate with 4% inflation, but many only focus on the interest rate.

Question 19

What is conservatism bias and how does this cognitive error affect clients?

Answer 19

Occurs when client initially had a rational view but they are unable/unwilling to accept new information and update their opinion (especially if that new information is difficult to understand.)
Generally these clients hold on to investments too long, or are slow to update and make changes.

Question 20

What is hindsight bias and how does this cognitive error affect clients?

Answer 20

Hindsight bias occurs when people have selective memory about past actions and events. They tend to over overestimate their correctness and knowledge.
these clients can be very critical of analysis or performance of others and overestimate the rate of their own correctness - leads to overconfidence bias.

Question 21

What is confirmation bias and what are the possible consequences for clients with this cognitive error?

Answer 21

Confirmation bias means you look at new information/events trying to prove an already held belief or view.
This can lead to clients under diversifying, ignore negative information, set up data screens improperly, suffer from overconfidence bias.

Question 22

What is Representativeness bias and what are its possible affects on clients who suffer from this cognitive error?

Answer 22

This is when a decision maker uses a past experience to equate information and make a decision rather than relying on current data.
Clients with representativeness may be overly negative or overly positive about specific stocks/investments based on past personal experience/small sample size.

Question 23

What are the two types of Representativeness Bias?

Answer 23

Base rate neglect - this occurs when the probability (or base rate) is not adequately considered.
Sample-size neglect - this occurs when the initial classification of information is based on too small or unrealistic sample of data.

Question 24

Mental accounting is a cognitive error, what does this look like and how can it negatively impact clients?

Answer 24

This occurs when clients mentally categorize their money into separate accounts based on their intended purpose with the money. Rather than $15k in savings, they think: $3k for investing, $5k for new flooring, and $7k in my emergency fund. They may make poor decisions because they have their money categorized in such a way that they use it poorly. (Taking money from a retirement account rather than money earmarked for a vacation.)

Question 25

Another cognitive error is called "cognitive dissonance." What does this look like and how can it affect clients?

Answer 25

Cognitive dissonance is when new information causes mental discomfort, so the individual may have to alter a belief, attitude, or behavior in order to relieve that discomfort. Can cause clients to continue to fund a bad investment or refuse to act on an opportunity

Question 26

Cognitive dissonance can be categorized into two types, what are they and how are they difference?

Answer 26

1. Selective perception - this is when the individual only recognizes information that supports previous decisions (ties to confirmation bias) 2. Selective decision-making - this is when the commitment to the decided upon course is really high - they may continue to make decisions despite new information in order to stay on their desired route. (Investing in a losing investment so as not to waste the money they already spent.)

Question 27

What is self-attribution bias and how can this affect clients?

Answer 27

This cognitive bias is an ego defense mechanism. This occurs when clients take credit for all successes and blame others or external factors for losses. These are very difficult clients because they don't recognize help/advice given and pass lots of blame when there are losses.

Question 28

What is anchoring and how can it affect clients?

Answer 28

Anchoring is when individuals make irrational decisions based off information unrelated to the decision at hand. "The housing market is down, so I should sell all my stocks" "tech stocks always rise, so I should continue to invest in tech."

Question 29

What is outcome bias and how can it affect clients?

Answer 29

This occurs when clients make decisions based on past performance rather than current information.

Question 30

What is framing bias and how does this affect clients?

Answer 30

Framing bias is when decisions are made based on how the questions are asked and not the actual information - for example: Client is given $1000, they can choose between $500 or the chance to double their money by flipping a coin. Or they can be given $2000 and lose $500 or flip a coin and potentially losing $1000. Someone with framing bias would choose differently based on the option to win or lose money.

Question 31

Recency Bias is what, and how does it affect clients?

Answer 31

Recency bias is when clients rely on the newest piece of information, rather than a collective picture of a scenario.

Question 32

Availability bias

Answer 32

When someone overemphasizes information that is easiest to remember/reference and deemphasizes harder to recall information.

Question 33

What is herding?

Answer 33

Herding is when a group of investors trade in the same direction - it can cause a sense of false comfort because others are making the same decision.

Question 34

What is an emotional bias and how does it differ from a cognitive bias/error?

Answer 34

Emotional biases are not tied in rational thought but stem from feelings, impulses, or intuition. These are harder to identify and combat as they are more subjective.

Question 35

What is loss aversion theory and how can it affect clients?

Answer 35

Loss aversion is when an individual cares more about not losing than they do about gaining - they may not sell stock at a loss (even if indications presume continued failure rate or a long time to success) rather than cutting losses and investing somewhere else.

Question 36

What is overconfidence and how can it affect clients?

Answer 36

Overconfidence is when a client may believe they have more knowledge or control over events than they do. This leads to self-attribution bias and can also cause them to take action against advice/without enough information

Question 37

What is self-control bias?

Answer 37

This really should be called lack of self-control bias. This is when an individual does not take needed action and then attempts to make up for it by utilizing riskier methods. (Doesn't save enough for retirement so they have an overly aggressive portfolio for their age.)

Question 38

What is status quo bias?

Answer 38

Status quo is when comfort with the known outweighs the information or urgency suggesting another method or action. Essentially, this is when a client won't take action because the action is scary or because if they do nothing, nothing will change positively or negatively.

Question 39

What is endowment bias?

Answer 39

This is the belief that because you own something, it is worth more than it actually is. Valuing your antique rug at $20k but only being willing to buy a similar one for $15k is a classic example

Question 40

Regret Aversion bias is defined as what? What are some possible outcomes of this bias?

Answer 40

The inaction due to the fear of the decision or action being wrong. This assumes that changing will lead to worsening the situation without realizing that not changing could be worse in the long run. Excess conservatism, underperformance, and herding behavior are all examples of this emotional bias

Question 41

What is affinity bias and how can it affect clients?

Answer 41

This is when a client believes the outcomes will represent their interest and values. "I like costco, so everyone must like costco, so their stock will go up."

Question 42

What are money scripts or money beliefs?

Answer 42

These are the unconscious attitudes we have related to money as a result of childhood experiences that affect our adult perceptions and behaviors

Question 43

What is a financial comfort zone?

Answer 43

Everyone has a comfort zone between too little and too much wealth. There are pros and cons to having too little and too much wealth for most people.

Question 44

What are some examples of money scripts that result in pathological money problems?

Answer 44

1.Gambling disorder 2. Compulsive buying 3. Financial dependence aka "affluenza" 4. Financial enabling 5. Hoarding disorder

Question 45

What is the definition of financial well-being?

Answer 45

The ability to meet current and future financial obligations while having the financial freedom to live and maintain the desired lifestyle.

Question 46

Integrated financial planning involves two distinct types of finance - what are they and what is the difference?

Answer 46

Exterior - these are traditional financial matters Interior - these are feelings and emotional relationships with money

Question 47

What is Financial Therapy and at what point should a client be referred to a licensed professional?

Answer 47

Financial therapy is performed by a certified and licensed mental health professional - it is specific and involves treatment to cope with interior finance. Most financial planners do not provide this - so referring when necessary is important

Question 48

What is something that promotes honesty and trust in relationships? Why do people avoid this sometimes?

Answer 48

Financial transparency (but really, just transparency) Lack of transparency can occur when couples are avoiding conflict, or are trying to hide spending habits. This is going to sabotage goal achievement and future planning

Question 49

What are some sources of financial conflict?

Answer 49

* Family of origin - different ways growing up with money * Inadequate communication - taboo topic that is hard to talk about * Different risk tolerance levels * Adult children and how to help/how much to help * Blended families * Cultural differences * Inheritances - comparisons, lack of communication

Question 50

What should you compare when couples have differing risk tolerances?

Answer 50

Compare amounts in each client's portfolios - if they are about the same, then it's okay to leave it. If they are different, then they need to get on the same page so that one client isn't jeopardizing the other either way.

Question 51

What is goal incongruence? What should a financial planner do when this occurs?

Answer 51

This is when clients cannot or will not agree to a common goal and objective What to do: - "this is common" - help clients find common ground - encouraging sharing the why to help build understanding

Question 52

What are some ways money can be used as undue influence?

Answer 52

Financial manipulation can occur when one person is using money to wield power/influence over another - financial control, usually happens when one is more financially literate than the other, but can be mean - financial enabling or financial enmeshment can happen when someone is overly dependent on another even to the other's detriment - financial abuse involved the specific and systematic control and restriction of money so someone is reliant on the other.

Question 53

What is the economic and resource approach to financial counseling?

Answer 53

This theory assumes that clients are rational and will change to the most favorable behavior if given appropriate advise and counsel

Question 54

What is the classical economics approach?

Answer 54

This theory is that clients will choose based on objectively defined cost-benefit and risk-return tradeoffs when making financial decisions.

Question 55

What is the strategic management approach?

Answer 55

This is when the client's goals and objectives drive the financial planning agreement (we should always strive for this!)

Question 56

What is the cognitive-behavioral approach?

Answer 56

Client's attitudes, beliefs, and values influence their behavior and planners use this approach to help replace negative or harmful beliefs with positive ones.

Question 57

What is the Psychoanalytic Approach?

Answer 57

This is related to the field of psychoanalysis and is not widely used by planners

Question 58

Why is it important for CFP professionals to be culturally competent and show cultural humility?

Answer 58

Understanding various cultures and their belief systems regarding money and retirement is important so as to be respectful of the clients and allow for the strategic management approach. Cultural humility means that you will review and revise your assumptions and learning regularly to continue to build competence.

Question 59

What are two important things to consider regarding vocal/verbal communication?

Answer 59

Tone - inflection or emphasis of certain words - shows attitude regarding words being said Pitch - sound quality of highness or lowness - helps us understand emotion behind the words. High usually means uncertainty, lower generally means confident.

Question 60

What are some non-verbal communication cues?

Answer 60

Body language: - Facial Expressions - Eye Contact - Spatial communication - physical distancing/positioning during conversation

Question 61

How can one demonstrate active listening?

Answer 61

Paying attention, mirroring/reflecting what was said, asking leading questions to get more information

Question 62

What are some ways one can use mirroring to build rapport with clients?

Answer 62

Physical mirroring - matching body language, spatial communication, etc. can help set the client at ease Verbal mirroring - use similar or the same words as the client to set them at ease

Question 63

What is social penetration theory?

Answer 63

4 stages 1. Orientation - goal is to determine if there is value in continued relationship - usually starts before the meeting through marketing 2. Exploration - beginning of discussions related to money and details. Client should begin being more open to sharing feelings and concerns 3. Affective Exchange - planner and client relationship has significant trust and clients can share feelings, questions, concerns without reservation. Open disclosure, transparency, and sincerity are essential 4. Stable exchange - this occurs after consistent and established patterns have been established and maintained. Open, uninhibited, friendly, and meaningful conversations

Question 64

What is the money jar mentality?

Answer 64

Also known as the mental accounting cognitive bias