Behavioral finance - CFP Psychology of Financial Planning

Behavioral finance

Named cognitive and emotional biases such as loss aversion, anchoring, overconfidence, mental accounting, recency, herding, confirmation and status quo bias, and the framing and nudging techniques a planner uses to counter them. Items name the bias behind a client's decision.

Prospect theoryBehavioral biases

Practice question for this objective

Free samplePsychology of Financial Planningmedium

Margaret, aged 84 and widowed, is the planner's client and has full mental capacity. She holds 700,000 dollars of savings and now needs live-in care costing about 90,000 dollars a year. Her son Declan lives nearby, provides the daily care himself and wants the best package money can buy. Her daughter Fiona lives overseas, argues that a cheaper package at 55,000 dollars a year would do, and says openly that she is worried about how much will be left to inherit. The two of them are barely speaking. How should the planner proceed?

AEstablish with Margaret what she wants her money to achieve for her own care and for her legacy, model how long each package would last, and offer to explain her decision to Declan and Fiona with her consent Correct
BModel both care packages against Margaret's life expectancy and present the two projections to Declan and Fiona, inviting the pair of them to agree between themselves which package the family will fund
CRecommend the cheaper package on longevity grounds, since spending 90,000 dollars a year would exhaust the savings in under eight years and leave Margaret exposed if she needed care for longer than that
DDecline to discuss the inheritance question at all and advise Margaret to buy an immediate annuity large enough to meet the care fee for life, so that the argument about what remains no longer arises

The client is the person being advised, so the planner works to that client's own goals and helps her explain the decision to her adult children. Conflict between adult children over an ageing parent's care almost always mixes two questions that need separating: how the parent should be cared for, and what will be left over afterwards. Declan and Fiona each hold a real position, one grounded in the burden of daily caring and one in an expected inheritance, and neither of them is the client. Margaret has capacity, so the decision is hers and the planner's obligation runs to her. The useful sequence is therefore to establish her goals for care and for legacy, then quantify the trade-off so she can see that 90,000 dollars a year runs the fund down in about eight years while 55,000 dollars a year stretches it to roughly thirteen, before any recommendation is made. Offering to explain the reasoning to both children, with Margaret's consent, is the process move that lowers the temperature, because it converts what would otherwise look like one sibling winning into a decision the parent made with the figures in front of her.

Why A is correct: This keeps the decision with the capable client whose money it is, gives her the figures she needs to make it, and offers the planner as a neutral explainer so the children hear a reasoned choice rather than an accusation.

Why B is wrong: Modelling both packages is the right analysis and involving the children looks even handed, but handing the choice to them displaces the client from her own decision and makes the planner referee of a dispute that is not hers to settle.

Why C is wrong: The longevity risk is real and the arithmetic is correct, which makes this the most plausible of the wrong answers, but it adopts Fiona's position without anyone having asked Margaret what she wants her own money to buy.

Why D is wrong: An annuity can be a sound way to secure a care fee for life, but reaching for the product first skips the goals conversation, and refusing to discuss the legacy leaves the family conflict sitting intact behind the purchase.

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Exam traps in Psychology of Financial Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

He has reset his reference point to the current value of 180,000 dollars, which places him in the domain of gains, where the prospect theory value function predicts risk aversion rather than the gamble he proposes
Why it is wrong: The mechanism described is a correct statement of behaviour in the gain domain, which makes it read as textbook, but Daniel's own words fix his reference point at the purchase price, so he is not evaluating from the current value at all.
Submit the annuity application while she is certain of what she wants, because acting promptly on a clearly stated instruction respects her autonomy and lifts the burden of further decisions from her
Why it is wrong: Client autonomy is real and a clearly stated instruction does deserve respect, which is what makes this tempting, but annuitisation is irreversible and a preference formed in the first days of acute grief is not a stable statement of her long-term objectives.
Loss aversion, because a loss of a given size causes her roughly twice the pain that a gain of the same size causes her pleasure, and that asymmetry is what she has described to her planner
Why it is wrong: Loss aversion is the underlying preference that drives the behaviour, so naming it feels right, but it describes how she values gains and losses rather than the specific trading pattern of selling winners quickly while holding losers.

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