FP511 Module 2 Flashcards
Behavioral finance
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.
It attempts to explain the presence and impact of people’s biases when making decisions regarding money.
Risk Assessment Process
During the data-gathering step of the financial planning process, planners should measure their clients’ psychological abilities to deal with uncertain outcomes. This is best done by collecting qualitative, or subjective, data.
Risk tolerance
Risk tolerance is the tradeoff that clients are willing to make between potential risks and rewards, with some probability of negative outcomes.
Risk Preference
Risk preference is the attitude a client has toward financial risks. This is a more constant personal trait
risk perception
risk perception is the subjective judgment that clients make when they are asked to describe and evaluate the risk of financial decisions. Not as constant of a trait
Risk capacity
Risk capacity, which also influences a client’s risk assessment, is the degree to which a client’s financial resources can mitigate risks.
risk literacy
risk literacy is the ability of a client to comprehend and act upon information regarding financial risks.
Perception
Perception is an individual’s personal awareness of things, people, events, or ideas.
Judgement
Judgment involves making conclusions about what has been perceived.
visual learning styles
Clients with 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 is beneficial for clients with visual learning styles.
auditory learning styles
Clients with 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.
kinesthetic learning styles
Clients with 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.
Attitudes
Attitudes reflect a person’s opinions, values, and wants.
Beliefs
Beliefs are a type of attitude because they reveal the understanding of some aspect of a person’s life.
Values
Attitudes and beliefs for which a person feels strongly are considered values, and represent what a person believes to be right.
Context
A client’s profile is largely influenced by context, which includes past history or any conditions that presently exist
Illusion of control bias
Illusion of control bias - exists when clients believe they can control or affect outcomes of, say, the market when they cannot. It is often associated with an overconfidence bias, which is emotional in nature.
Money illusion
Money illusion is 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.
Conservatism bias
Conservatism 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.
Hindsight bias
Hindsight bias is 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.
Confirmation Bias
Confirmation 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.
Representativeness bias
Representativeness bias is 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
Base rate neglect (Representativeness bias)
Base rate neglect is when the base rate (probability) of the initial classification is not adequately considered. Essentially, the classification is taken as being 100% correct with no consideration that it could be wrong.
A stock could be classified as a value stock, and new information about the stock is analyzed based on that classification. In reality, the stock may not be a value stock.
Sample-size neglect (representativeness bias)
Sample-size neglect makes the initial classification based on an overly small and potentially unrealistic sample of data. For example, the initial classification of the stock could be based on dividend yield without considering any of the other typical characteristics of a value stock.
Mental accounting (money jar mentality)
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.
Cognitive Dissonance
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.
