The Psychology of Financial Planning: Practitioner Resource Guide

Practitioner

Resource Guide:

The Psychology of

Financial Planning

Certified Financial Planner Board of Standards, Inc.

Copyright & Terms of Use

Use of this electronic publication (eBook) from ALM Media Properties, LLC (ALM), is for the personal use of above buyer only and is subject to the following terms and conditions. All access to and use of this eBook is subject to U.S. copyright law. All intellectual property rights are reserved to the copyright holder. Redistribution or duplication of this eBook, including but not limited to any other electronic media or third party, is strictly prohibited. Under no circumstances may you redistribute this eBook by posting this eBook on an intranet, internet or SharePoint site or in any other manner. Any transfer of this eBook is strictly prohibited. Use of this eBook is also subject to the terms and conditions of use located at http://www.alm.com/about/terms-use.

This publication is designed to provide accurate and authoritative

information in regard to the subject matter covered. It is sold with the

understanding that the publisher is not engaged in rendering legal,

accounting, or other professional service. If legal or other expert assistance

is required, the services of a competent professional person should be

sought. – From a Declaration of Principles jointed adapted by a Committee

of The American Bar Association and a Committee of Publishers and

Associations.

ISBN: 978-1-954096-90-5

Copyright © 2023 Certified Financial Planner Board of Standards, Inc.

Certified Financial Planner Board of Standards, Inc.

1425 K Street NW #800

Washington, D.C. 20005

Printed in the United States of America

Cover art by Maria/Adobe Stock

PREFACE

Comprehensive, fiduciary financial planning is so much more than being competent at financial planning technical skills. You may be able to develop the most complex tax planning projections at your firm or develop detailed strategies to maximize income from the sale of stock options; these skills are valuable to your clients and are essential functions of being a CERTIFIED FINANCIAL PLANNER™ professional. But, in order to maximize your value to clients, you must also be able to communicate effectively and deliver recommendations in a way that moves client motivation forward through recommendation implementation (in addition to many other skills discussed in detail in this book).

The psychology of financial planning is CFP Board’s newest financial planning domain. CFP Board defines the Psychology of Financial Planning as "identifying and responding to attitudes, behaviors, and situations that impact decision-making, the client-planner relationship, and the client’s financial well-being. Within the Psychology of Financial Planning domain, client characteristics and financial planner characteristics intersect. It can be described as the the system within which clients planning for their financial goals and financial well-being are aided by financial planners who possess their own history, biases and values that must be recognized and sometimes subsumed in service to the client" (CFP Board, n.d.).

This book is written by financial planning practitioners for financial planning practitioners. It is intended to complement The Psychology of Financial Planning by providing CERTIFIED FINANCIAL PLANNER™ professionals with resources and tools to incorporate the psychology of financial planning into their practice. To put it another way, this book was written to provide financial planners with the resources to take the concepts and information described in The Psychology of Financial Planning and implement this information in work with clients. The Psychology of Financial Planning provides the what; this Practitioner’s Resource Guide provides the how. As such, this book addresses every Principal Knowledge Topic for the Psychology of Financial Planning domain and is laid out in 15 chapters parallel to The Psychology of Financial Planning. These Principal Knowledge Topics are:

Client and planner attitudes, values, and biases

Behavioral finance

Sources of money conflict

Principles of counseling

General principles of effective communication

Crisis events with severe consequences

In keeping the needs of practitioners at the forefront of this book’s design, this book is comprised of step-by-step guides, do’s and don’ts lists, exercises, assessments, examples and other helpful figures and lists to highlight what you need to know and how to apply the information.

The authors of this book recommend reading The Psychology of Financial Planning prior to reading this companion guide although the most salient points from each chapter from The Psychology of Financial Planning are briefly summarized to provide a foundation for the new content. Some readers may find it most useful to read the entirety of The Psychology of Financial Planning prior to reading this companion guide. Others may prefer to read Chapter 1 of this work directly after reading the first chapter of The Psychology of Financial Planning, and then proceeding on to the second chapters of each book.

One of the most valuable resources this book provides is the list of books, blog posts, research articles, and websites listed in the reference list of each chapter. The resources cited in this book were selected carefully, to be as useful and practical to financial planners as possible. This approach is truly what makes this book a Practitioner’s Resource Guide.

REFERENCES

CFP Board. (n.d.). The psychology of financial planning. https://www.cfp.net/knowledge/psychology-of-financial-planning.

Part I: Client and Planner Attitudes, Values, and Biases

Chapter 1

Framing Advice in Light of Client’s Risk Tolerance

1.1 INTRODUCTION

Risk tolerance is most widely defined as the maximum amount of uncertainty a person is willing to accept when making a financial decision (Grable, 2000). In other words, you can think of risk tolerance as a person’s willingness to take risk. However, risk tolerance is multifaceted, and can be conceptualized differently. For this reason, this chapter will define a number of different terms related to financial risk tolerance to illustrate the complexity of a client’s risk tolerance. Another contributing factor that can make risk tolerance difficult to account for is that risk tolerance is individual. If you are working with a couple or doing multigenerational planning, each person in the planning engagement has their own willingness to tolerate uncertainty. Planners must be able to address and account for the differences in risk tolerance. The larger the differences in each person’s risk tolerance, the more difficult this becomes. This chapter will provide you with a foundational understanding of what risk tolerance is and how you can measure it. You will also understand how your client’s risk tolerance may impact their behavior.

1.2 RISK TOLERANCE CONSIDERATIONS IN PRACTICE

In practice, risk tolerance is typically measured for compliance and regula­tory purposes and is used to choose a portfolio allocation for clients. The typical assumption is that clients with a higher risk tolerance are able to stomach more volatility in their portfolio. Theoretically, these clients will be able to take advantage of the higher potential for returns over the long-term by taking more risk with their investment mix. Of course, they will, in all likelihood, face more severe losses in their portfolios than clients who are invested more conservatively when the financial markets are in turmoil. These potential large portfolio losses can be very difficult to stomach. From a fiduciary perspective, it is essential to ensure that clients are not invested in portfolios that are too risky for their risk appetite that may result in greater losses than they can stomach. It is rarely in a client’s best interests to move to a more conservative portfolio or move all to cash in a down market.

Risk Tolerance

Risk tolerance is the maximum amount of uncertainty that a person is willing to accept when making a financial decision.

Although risk tolerance and investment recommendations will always be closely related, it is important for financial planning practitioners to understand that risk tolerance impacts clients’ other financial decisions and behaviors too. For example, your clients’ risk tolerance may impact their decisions related to debt payoff or annuitizing some of their assets. Clients with a low risk tolerance may strongly prefer to pay off a low interest mortgage with funds from their investment portfolio even when their investments have a higher long-term expected rate of return. The same clients may also strongly prefer to use the funds in their brokerage account to purchase an annuity given the perceived safety of a lifetime income stream over the volatility of the stock and bond market. You may have greater success with clients implementing recommendations if you understand how to frame your advice in light of a client’s risk tolerance.

The bullet points listed here summarize points from Chapter 1: Framing Advice in Light of Client’s Risk Tolerance in The Psychology of Financial Planning (Chatterjee and Yeske, 2022). This list highlights important concepts that are particularly relevant for financial planning practitioners to incorporate in their work with clients.

Risk tolerance is an important actor, not only for investment decisions, but also for many other types of financial decisions and preferences.

There are many ways to measure risk tolerance. The primary methods include professional judgement, heuristics, risk tolerance scales, and triangulation. Each method has its own pros and cons.

Your role as a financial planner is to help your clients arrive at decisions that correspond with their values but are also financially wise and consistent with their risk tolerance and good quality financial advice.

1.3 RISK TOLERANCE TERMS

Each of the important risk tolerance terms in this chapter are identified and defined below in Figure 1.1. Understand that risk tolerance is multifaceted and complex. Clients with a generally high risk tolerance may also have a risk preference or a risk attitude in a specific situation or in light of a certain goal that causes them to act inconsistently with someone generally comfortable with uncertainty. Additionally, many financial advisors have been frustrated by clients who have a large risk capacity but a low financial risk tolerance and want to be invested primarily in cash and bonds. Once you understand the various risk tolerance factors at play in a situation, you can work with your clients to help them increase their risk literacy and reach the optimal outcomes.

Figure 1.1. Risk Tolerance Terms

1.4 MEASURING RISK TOLERANCE

There are several different ways to measure subjective risk tolerance. Figure 1.2 includes a list of ways risk tolerance can be measured in practice. Bear in mind that none of these measures are perfect. There is a lack of consensus in the academic and practitioner communities regarding the best way to measure risk tolerance. Identifying and understanding how to measure risk tolerance most accurately and effectively in practice is an area where much work remains to be done.

Figure 1.2. Measuring Subjective Risk Tolerance

John Grable and Ruth Lytton (1999) developed a psychometrically validated risk tolerance scale that has been widely used in research. In all likelihood, your firm already has a preferred system in place for assessing risk tolerance. However, if you have not yet assessed your own risk tolerance, it is time to do so. The recommendations you make to your clients may be impacted by your own risk tolerance. In light of this, it is important to understand your own risk tolerance so that you can be aware of how it may impact your recommendations. You may wish to take multiple assessments to ensure the results are consistent. The questionnaire below could be a good starting point for understanding your own risk tolerance.

Grable-Lytton (GL) Risk-Tolerance Scale

In general, how would your best friend describe you as a risk taker?

A real gambler

Willing to take risks after completing adequate research

Cautious

A real risk avoider

You are on