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.
Selective Perception (cognitive dissonance)
This is when individuals only register information that appears to affirm an already chosen decision. This ties into rationalization or confirmation bias.
Selective decision-making (cognitive dissonance)
This usually occurs when commitment to an original decision course is high. Selective decision-making rationalizes actions that enable a person to adhere to the original course.
Sunk cost
Already comitted cost that should not have an impact on future decision making but can during cognitive dissonance.
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.
self-enhancing bias
tendency to claim an irrational degree of credit for successes.
Self-protecting bias
irrational denial of responsibility for failure.
Anchoring
individuals making irrational decisions based on information that should have no influence on the decisions at hand.
Outcome bias
the tendency for individuals to take a course of action based on the outcomes of prior events
Framing 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.
recency bias
new information, which is more recent, is considered more important and valuable than less current information
herding
when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available
Emotional biases
not related to conscious thought (like cognitive biases) and stem from feelings, impulses, or intuition.
Since they are “deeper” feelings, they are more difficult to overcome and may have to be accommodated.
Loss aversion theory
clients fearing losses much more than they value gains, and prefer avoiding losses to acquiring the same amount in gains.
Overconfidence
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.
Self-control bias
occurs when individuals lack self-discipline and favor immediate gratification over long-term goals
Status quo bias
occurs when comfort with an existing situation leads to an unwillingness to make changes, even though the change is likely beneficial.
Endowment bias
occurs when an asset is felt to be special and more valuable simply because it is already owned. Overvaluing assets merely because you own them.
Regret aversion bias
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.
Affinity bias
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.
Money scripts or money beliefs
unconscious attitudes regarding money, often a result of childhood experiences, which affect adult perceptions and behaviors.
the influence of adults’, typically parents’, financial behaviors, on their children’s beliefs about saving, borrowing, and other financial decision-making.
financial comfort zones
represent financial circumstances in which people are content and unconcerned about their financial wellbeing. Too little wealth, and clients may feel anxious about meeting expenses and maintaining their current lifestyles.
Gambling disorder
the uncontrollable urge to continue gambling despite adverse financial consequences
Compulsive buying
addictive shopping or spending behavior that results in financial difficulties
Financial dependence, or “affluenza”
dependence on others for income not related to employment, most often creating a fear that the person(s) providing the support will stop the cash flow at any time.
Financial enabling
an individual agrees to provide financial assistance to another even though it may put the individual’s own financial wellbeing at risk.
Hoarding disorder
material goods are purchased and retained beyond their useful lives and the owner has difficulty disposing of them
financial well-being
ability to meet current and future financial obligations and the financial freedom of choice to maintain a desired lifestyle.
Integrated financial planning
involves exterior finance (relating to clients’ traditional financial matters) and interior finance (clients’ emotional relationships with money)
Financial therapy
Addresses financial wellbeing at a deeper level. According to the Financial Therapy Association, it is a “process informed by both therapeutic and financial expertise that helps clients think, feel and behave differently with money to improve overall wellbeing.”
financial transparency
promotes honesty and trust in relationships. For financial wellbeing among spouses and in families, those involved must be clear and unambiguous about income, spending, assets, and liabilities.
Goal incongruence
overall financial goals do not match across a couple. Results from conflicting goals or indecision when establishing them
Financial manipulation
individuals in relationships can use money to exercise power over partners, parents, grandparents, and others. They often play on others’ emotions to convince them to give the manipulators money, credit, or other assets, even though there is initially hesitation.
3 forms of financial manipulation
- financial control - – inequality among partners in setting financial goals or making decisions regarding money.
- Financial enabling, or financial enmeshment – most often involves supporting an adult who should not need to be dependent on the enabler.
- Financial abuse – controlling an individual’s ability to use, obtain, or possess financial resources.
culturally competent
focusing on knowledge that can be learned about clients from other cultures.
Cultural humility
involves a lifelong self-evaluation in which planners critically consider their beliefs and how they influence their interactions with clients. Here, planners honestly make an effort to understand clients’ identities related to ethnicity, gender, sexual orientation, education, and socioeconomic status.
active listening
key to effective communication. Planners should practice active listening by paying full attention to what their clients are saying, and by responding with paraphrasing the clients’ comments.
leading responses
Planners can also give leading responses that guide clients to give more details, causing a meeting of the minds.
emotional intelligence
includes the ability to recognize emotional expressions in themselves and their clients
Social penetration theory
originally created by Irwin Altman and Dalmas Taylor, outlines the four stages in which relationships, such as those between clients and their planners, develop and progress.
- orientation - marketing messages/initial communication
- Exploration - discuss financial planning process in more detail
- Affective exchange - planner-client relationship becomes one of significant trust
- Stable Exchange - have developed a consistent and established pattern together
