LFPE5800 – Financial Planning Environment

Unit 5
BEHAVIOURAL FINANCE
The units have been updated using the South African Financial
Planning Handbook 2023 version.
Students are recommended to have the latest version (2024) of this
textbook.

Learning outcomes for this unit

On the successful completion of this module you will be able to:
1. Understand Behavioural Finance and the key concepts: The psychology of the
investor and the psychology of the markets; Standard Finance and Behavioural
Finance; Normal Investors and Rational Investors.
2. Differentiate between the two ways of thinking and deciding – intuition and
reasoning. Define the different investor biases and understand the differences
between cognitive and emotional biases.
3. Illustrate how strategies can assist financial advisors and clients to control biased
decision behaviour during the planning and investment process.
4. Outline how decision-making changes in the context of living in retirement
(compared to saving for retirement).
5. Understand how the application of behavioural finance knowledge in the financial
planning process can contribute to regulatory compliance.
6. Define risk tolerance as a psychological construct and explain how it differs from
risk capacity and risk required as financial constructs, referring also to how each
fits into the advice process.
7. Apply the insights gained from behavioural finance when constructing asset
allocation portfolios to gain client commitment, trust and informed consent.
In order to gain the most benefit from this module you are advised to work through
chapter seventeen of the SAFPH first. In this module of the study guide the same
structure is followed as in chapter seventeen and you will be easily able to link the
questions in the study guide to the content of the SAFPH.

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Introduction
Insight from behavioural finance regarding investor decision-making should not be
viewed as a separate approach to the financial planning process, or as information
that is nice to have, but not vital to a successful advisor/client relationship. Research
and survey findings globally suggest that behaviouralising the financial planning
process will be the key differential in the way a successful financial planner delivers
trusted advice in the future. A behavioural finance planner approaches clients with
their motivations and expectations at the centre of the financial planning process.
Behavioural finance finds application in all stages of the financial planning process as
well as through all of your client’s life stages.
In order to effectively implement a financial planning process, we often forget that the
process actually depends on sound decision-making. Behavioural finance will assist
you to better understand the psychology and emotions underlying your client’s
decision behaviour during the financial and investment planning process. With this
focus on the person in the process, we hope to enable the financial planner as well as
the client to make better financial decisions.

1. UNDERSTAND BEHAVIOURAL FINANCE AND THE KEY CONCEPTS

Behavioural finance explains the psychology of financial decisions. It is a multi-

disciplinary field using insights from various subject fields including finance,
economics, psychology and neuroscience amongst others. For the purpose of
financial planning, we can view behavioural finance as the study of two separate fields,
the psychology of the investor and the psychology of the markets. According to
Standard Finance theory, investors take all relevant information into account, use it
optimally and always make rational decisions. According to Behavioural Finance
theory, investors are normal and often make decision mistakes. In the words of Meir
Statman: “Sometimes we are normal-smart and sometimes we are normal-stupid”
when we make decisions. You will find a description of behavioural finance and the
key concepts in chapter seventeen of the SAFPH.

1.1 Tasks 1:

1.1.1 Define behavioural finance in your own words referring to the origin and fields
of application.
Your answer should include the following elements:
Behavioural finance borrows insight from various disciplines to explain how
the financial planner as well as his/her client makes decisions during the
planning process. For many years the approach was that both can apply their
minds and make rational decisions by using all available information optimally.
We know now that this is not possible and we are prone to decision mistakes
as we make reasoning errors and our emotions get in the way. Most of what
we need to know about the way we make financial decisions is described by
the psychology of the investor. The psychology of the markets describes the
anomalies in the Efficient Market Hypothesis. The mistakes tend to be (a)
irrational (normal), we are often (b) unaware of them, and the mistakes tend
to repeat themselves in a (c) systematic fashion.
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1.1.2 Discuss what is meant by irrational and systematic mistakes in a behavioural
finance context.
The mistakes we make when making investment decisions tend to be (a)
irrational (normal), we are often (b) unaware of them, and the mistakes tend
to repeat themselves in a (c) systematic fashion. By describing the mistakes
as irrational, we mean that the mistakes are clouded by emotions and this is
contrary to good reasoning. In describing the mistakes as systematic, we imply
that the mistakes crop up in patterns and that they will repeat themselves if
we do not intervene and rectify our thinking and decision making.

1.1.3 In understanding the historical context of behavioural finance, it is important

to keep the contrast of the client as Homo economicus (rational) versus Homo
sapiens (normal) in mind. Outline the essence of the two expressions.
Your answer should include the following aspects:
The term Homo economicus or “Economic man” implies that man is endowed
with high rationality and that investment and financial decisions are always
based on a logical reasoning process. It further implies that any investor will
set goals that will be to his/her greatest advantage and that the investor will
continually seek with the least possible costs, to fulfil these predetermined
goals. Working within the Homo economicus model, we accept that the
financial planner and the client will seek all available information about
opportunities and risks and that all of the information is accounted for in the
decisions they make.
In contrast to the view of the client as Homo economicus, there is the
alternative view of the investor as Homo sapiens meaning that the investor is
seen as a total normal human being: complex, often irrational, sometimes
operating with good intentions, but on the other hand unpredictable and
contradictory. Although the rational side of the investor is recognized, it is
acknowledged that he/she is also strongly driven by his/her emotions, and not
by logic.

2. DIFFERENTIATE BETWEEN THE TWO WAYS OF THINKING AND DECIDING

– INTUITION AND REASONING

The distinction between our two minds, intuition and reasoning, was first labelled by
Kahneman and Tversky. Exploring the differences between automatic responses by
our intuitive mind and responses as a result of deliberate reasoning, was part of their
earlier research. When working with clients it is important for the financial planner to
understand the errors made by our intuitive mind (sometimes referred to as our
emotional/feeling mind), and the errors made by our reasoning mind (sometimes
referred to as our reflective mind). Some people think that the reasoning mind never
allows for mistakes, but this is simply not true. When we have incorrect or incomplete
information, the product of the reasoning mind is imperfect.
Intuition is fast, automatic, effortless, sometimes emotionally charged, and a product
of habit. Most of our thoughts are intuitive and, in many instances, powerful and
accurate, but always with the possibility of error. Reasoning, on the other hand, is
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deliberate, an analytic process governed by rules and requires effort. Effort is the main
difference between the two minds. For the financial planner and his client, the
challenge is to engage the reasoning mind when making decisions important for
financial wellbeing. It is important to remind ourselves that both minds allow for error,
be it biases or mental shortcuts.

2.1 Tasks:

2.1.1 To test your cognitive self-monitoring, give a quick answer to the following
question and give an explanation in your own words of what is meant by
cognitive self-monitoring:
“There is a patch of lily pads in a lake. Every day, the patch doubles in size. It
takes 48 days to for the patch to cover the entire lake, how long would it take
for the patch to cover half the lake?”
You probably answered 24 days but the correct answer is 47 days. Cognitive
self-monitoring is the ability of your reasoning mind to monitor the output of
your intuitive mind without deliberately thinking hard. Click this link for an
explanation to the test.

2.1.2 Discuss and list two instances during the financial planning process when you
and your client are most prone to falling back on the intuitive mind to assist
you to reach a solution? Keep in mind that your brain operates with a lot of
emotions when uncertainty is involved.
Almost every situation encountered by you and your client during the financial
planning process is subject to intuitive thinking. Your answer should touch on
two or more of the following scenarios mentioned by James Montier in “The
Little Book of Behavioural Investing”:
(i) When you are struggling to define the client’s goals clearly; or when the
goals are constantly changing, or different goals are competing with each
other.
(ii) When you are working with incomplete information, or information that is
constantly changing. Also, when information is ambiguous and conflicting.
(iii) When you do not have a lot of time to reach decisions.
(iv) When there is a lot of uncertainty surrounding the decisions.
(v) When you need to make decisions when you are under stress.
(vi) When decisions involve interaction with other people and may sometimes
depend on actions by them.
(vii) When decisions involve complex scenarios.

2.1.3 Recommend and discuss strategies to make sure you, as well as your client,
use reasoning when discussing and implementing a financial plan.
It is important to be aware that you and your client rely on intuitive thinking
most of the time in your day-to-day activities and therefore also whilst
engaging in financial planning. To use a specific step by step process with
checks and balances will assist in engaging your reasoning mind. Educating
yourself and your client regarding the possible decision mistakes (referred to
as biases you may both be inclined to make), will assist you to recognize this
faulty thinking and adopt strategies to change this decision behaviour. New
behaviour must be practiced/exercised to replace faulty behaviour.
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3. DEFINE THE DIFFERENT INVESTOR BIASES AND UNDERSTAND THE
DIFFERENCES BETWEEN COGNITIVE AND EMOTIONAL BIASES

Most of the decision mistakes made by financial planners and their clients are made
in patterns and are therefore predictable and systematic. They are influenced by our
emotions, social environment, intelligences, preferences and more. These less logical
and often irrational decision patterns are also referred to as biases. The ability of a
financial planner to recognise the decision biases in his/her own behaviour and clients’
behaviour can greatly enhance the trusted relationship between a financial planner
and his/her client.
Prominent behavioural finance practitioners adopted a framework for making a
distinction between biases with a cognitive or an emotional origin. This distinction is
based on the premise that cognitive biases originate mainly as a result of faulty
reasoning, and emotional biases originate from intuition, impulse and feelings.
Behavioural finance research also found that individuals are prepared to accept help
from financial advisors as they realize that they have limitations. It is therefore vital for
the financial advisor to study cognitive and emotional behavioural biases to enable
him to assist his clients in making better decisions.

4. UNDERSTAND THE CONNECTION BETWEEN INVESTOR BIASES AND THE

CHALLENGES FACED BY THE FINANCIAL ADVISOR IN THE PLANNING
AND INVESTMENT PROCESS

The challenge for behavioural finance practitioners is to translate the academic theory
into practical application for financial planners and their clients. These efforts gained
momentum in the aftermath of the recent global economic meltdown which exposed
inadequacies in the client engagement models used by financial planners and financial
institutions. Key research documents by the likes of Price Waterhouse Coopers and
Merrill Lynch Wealth Management indicated that a deepened understanding of
behavioural finance is needed to deliver wealth management in the new era. MetLife
observed that the Information Age with the assistance of the personal computer in
communicating to clients the facts in a highly analytical way through spreadsheets,
illustrations and loads of information, shifted the focus. In all this, financial planners
ignored the role of emotions and language, and did not connect with clients in a
comfortable and meaningful way any longer. We will focus on three typical challenges
financial planners face with their clients during the planning process: procrastination,
the need for self-control and gaining trust.

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4.1 Tasks:

4.1.1 Procrastination is about our difficulty to start acting and taking action for the
benefit of our financial future. Discuss what you think the main reasons may
be for what is also known as investor paralysis. List the behavioural biases
you think underlying this phenomenon are, and suggest appropriate actions
to overcome it.
There are many reasons why your clients may procrastinate. In recent years
it may well be the money they lost on investing into products in recent times
linked to the financial markets or even property. Another reason may be
because people just hate being wrong and making the wrong choices,
therefore they just end up doing nothing. Big and complex decisions also scare
people into inaction.
The behavioural biases responsible are:
Regret Aversion – people avoid taking decisive actions because they fear that,
in hindsight, whatever course they select will prove less than optimal.
Loss Aversion – people have an intense fear of losing money, the thought of
losing that becomes unbearable resulting in them doing nothing.
Status Quo Bias – the current situation is favourable because if things change
things will become less certain.
Immediate Gratification – people choose what is nice today over what is best
for the future.
To eliminate procrastination, take the following actions:
• Ask the client to commit to a specific date in the future when they will start
with an action. Setting a specific date is already halfway there. Pre-
commitment to begin with a strategy at a specific time in the future does not
trigger the intuitive mind’s aversion to do what is right today.
• Ask the client to state exactly what he commits to do on that specific date.
For instance, how much money he will start to put away on that date?
Remind him/her what the timing might cost in terms of lost opportunity.
• Another strategy is to tell the client to start with a smaller purchase
immediately whilst deciding which amount, they want to put away. It is a way
to start working towards the goal immediately. This will slowly make the
client used to the change.
• Remind the client that doing nothing is also a decision.

4.1.2 List the behavioural biases underlying the lack of self-control to resist
impulsive behaviour in investing and outline different strategies which
investors can use to assist with this lack of discipline.
Overconfidence – most people believe that their ability is above average and
that their information is superior to those of others enabling them to make
better investment choices.
Availability – People do not have the time or expertise to rationally analyse
every bit of information and tend to fall back to information readily available in
the media and that is easy to remember. This can be anything from product
launches to advertising campaigns.

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 Familiarity – People tend to invest in companies and currencies they know, as
well as invest in their own country, as this is their comfort zone. This leads to
a lack of diversification and increase of risk exposure.
One strategy is to decide on a process with specific built-in rules and
deadlines. We cannot control uncertainty, but we can control a process
designed to eliminate impulsive behaviour. Another strategy is delegate
financial decisions to professionals with good reputations and the necessary
skills and qualifications to assist us in making the right decisions and reaching
our goals. Some experts suggest investors should stick to a long-term strategy
which limits the amount of investment options. They also suggest avoiding
looking at information about your investment all the time. It is important to
remember that different strategies work for different people.

4.1.3 Discuss how to gain and maintain your client’s trust in an environment where:
• Financial planners are increasingly being portrayed as less than honest, and
• Clients lost money and question your ability to make a contribution to their
financial wellbeing.
The answer to gain clients’ trust and maintain it consists of two components.
The first component is competence as a financial planner and the second
component is being able to show empathy - to connect with a client on an
emotional level.
Although clients know that financial planners have to be registered at the
Financial Sector Conduct Authority (FSCA), that they have to adhere to
specific codes of conduct, that they have to write regulatory exams and, in
many instances, have professional qualifications such as the CFP
designation, they must constantly be reminded about your competence. The
financial planner must display qualifications, must be open and honest and
acknowledge shortcomings, and not take credit for instances of luck, such as
good performance results in bull markets when everyone is doing well.
The basic principle for showing empathy is to stay in frequent contact with
clients in good and bad times. Ask for feedback about service levels and
appropriateness, about how the client experienced the financial planner and
his/her staff in good and bad times. This will enable the financial planner to
identify problems areas and pro-actively address them. It is vital to never
embarrass the client by exposing their ignorance in financial matters. Trust is
enhanced when the financial planner is able to deliver advice in a way that is
easily understood by the client without the client feeling incompetent. The
financial planner must not shy away from talking to the client about his
emotions and feelings about money. Part of managing clients’ financial
matters is managing clients’ emotions about money. When financial planners
ignore this, they will never gain full trust of their clients.

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5. OUTLINE HOW DECISION-MAKING CHANGES IN THE CONTEXT OF LIVING
IN RETIREMENT (COMPARED TO SAVING FOR RETIREMENT)

Behavioural finance research in recent years brought dynamic new insight to how
people think and make decisions after retirement.
These insights highlight the need for financial planners working with clients who reach
retirement, or are already in retirement, to change their approaches toward them.
Where the focus with clients was on accumulating wealth for the pre-retirement years,
it must change in post-retirement to get the same clients to pay themselves an income.
All the knowledge and experience clients gained during pre-retirement years were
about saving for retirement. A new set of skills and a different mind-set are required
for the post-retirement years both for financial planners and their clients. Even more
importantly, is the realization of how people change emotionally and cognitively as
they age. They become more sensitive to losses, some suffer from cognitive
impairment and show decline in mathematical numeracy, and fear losing control of
their money.
MetLife published research adding to the new post-retirement paradigm. Clients who
participated in a survey overwhelmingly ranked meaning more important than money,
medicine or place, with the importance of meaning increasing as participants’ age.
Meaning in this context can be described as how people feel about issues important
to them. This mind-set again highlights the importance of engaging with clients on an
emotional level when talking to them about their money in retirement, about the risks
they might face and the best strategy for their unique circumstances.
In the current global financial environment, it is also extremely important to keep the
unique risk faced by retirees into account. Foremost is the risk of outliving savings,
referred to as longevity risk. But inflation risk and sequence of returns risk, which is
the risk that market declines in the early years of retirement, coupled with ongoing
withdrawals, can significantly affect the longevity of a portfolio, and this also need
consideration.
Against the background of all the aspects mentioned, post-retirement planning and
decision making can be daunting for both financial planners and their clients. We need
to develop a new language to communicate more effectively with clients in their post-
retirement years.
References:
Jordan, J.W., Weinberger, D, Franks, J.L. 2011. Engaging Clients in a New Way.
MetLife.
Read:
Bernartzi, S. 2010. Behavioural Finance and the Post Retirement Crisis. Sponsored
and Submitted by Allianz America.

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5.1 Tasks:

5.1.1 Discuss the phenomenon of hyper loss aversion exhibited by elderly people
and argue how to address this in strategies for post-retirement planning.
Daniel Kahneman and Amos Tversky were the first to draw attention to the
fact that people experience the pain of a loss at least twice as acutely as the
pleasure of a gain. Recent studies revisited this phenomenon and tested how
retirees experience losses differently to the general public. The results were
somewhat shocking and showed that retirees are up to five times more loss
aversive than the average person, thus the phenomenon of hyper loss
aversion. Where most people are willing to gamble with the chance of 50% of
winning R100 and a chance of 50% of losing R50, most retired people won’t
gamble with the chance of 50% to win R100 and a chance of 50% of losing
R10.
Putting in place a solid financial plan that includes investing rules, before major
movements in the markets heightens emotions, is a key part of dealing with
hyper loss aversion bias. Another approach to control the hyper loss aversion
is to split the client’s portfolio into buckets for different goals, committing
certain amounts to short-term income, medium term income, and longer-term
growth. This is called the ‘time segmentation strategy’ or ‘bucket strategy’ and
it is a way for tackling the client’s tendency of selling out of the market during
periods of high volatility. This can help to calm the client, knowing that there is
enough cash to support the income needs regardless of how depressed the
market is over the next two to three years. It may also be important to invest
a portion of the client’s investments in a guaranteed annuity which will
guarantee a lifetime income to cover the client’s basic living expenses. This
will assure the client that there will always be a guaranteed lifetime income.
Educate the client on the difference between loss and volatility. Portfolio
values go up and down, but some retirees do not understand this and think
that when the portfolio’s value is declining, they may lose everything. They are
unable to differentiate between the volatility of an investment and the potential
of the investment to decline completely to zero. Upon receiving their monthly
investment statement in a period of high volatility, they may not see that their
portfolio is down R10 000, they see it as having lost R10 000. Such clients do
not understand that investments can, and do recover from such declines and
rather visualise their investments declining util there is nothing left.

5.1.2 Illustrate how you can frame solutions for the client when they retire, in terms
of the income they will need, and not in terms of return on investment that is
used as part of the saving for retirement framework.
When presenting a solution for the client, it is important to focus on the amount
of income the client can receive, the reliability of the income and the duration
this amount will be received for. When a solution is framed in terms of income
and duration most will choose what is really to their benefit, income for as long
as they live. Keep away from language referring to asset value and return on
investment which will focus the attention on asset preservation and growth,
reminding them that they want to retain control of when to access their money.

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5.1.3 Demonstrate how the mental accounting approach in planning can be a useful
tool to assist retirees in understanding how to meet their financial needs.
When we consider the research which indicates that it becomes increasingly
difficult for people to understand abstract concepts such as graphs and charts
explaining returns as they grow older, using basic concepts makes sense. One
of the more useful behavioural finance concepts is the concept of mental
accounting, putting money in separate mental buckets earmarked for different
needs. Many people use this concept unconsciously in their day-to-day
budgeting to cover needs such as money for groceries and money for
entertainment. The money for rent bucket will not be used for entertainment
purposes and the year-end bonus money must pay for the holiday.
This concept of different money buckets can assist in post-retirement planning
where the different buckets can mirror goals. The money that has to pay for
lifelong rent at a retirement village can be in a guarantee bucket to ensure that
there is no fear that a person will run out of money for this purpose. Another
bucket can be for visiting children overseas which can be in a growth-
orientated investment. This approach is easy to understand for people who
might be struggling with cognitive impairment and will provide peace of mind
knowing that basic needs are covered.

6. UNDERSTAND HOW THE APPLICATION OF BEHAVIOURAL FINANCE

KNOWLEDGE IN THE FINANCIAL PLANNING PROCESS CAN
CONTRIBUTE TO REGULATORY COMPLIANCE
It is important to have insight into how a person thinks and feels when making financial
decisions because of the implications of the new regulations that govern the
relationship between client and financial planner. The new regulations in the financial
services industry directly impact on the trusted relationship between the financial
planner and his client. The focus is on simplicity and transparency of products, quality,
objectivity and independence of advice aligned to the client’s risk tolerance profile,
preferences and goals; ensuring that financial planners are equipped with the
necessary training and skills to provide the required levels of advice; and that their
businesses are equipped with the required processes and tools to ensure delivery of
the desired levels of service. The desired outcome of the proposed and current
regulation hope to prove that the real differentiator between financial planners will
be: the depth of their skills and experience to elicit and understand their clients’ needs
and preferences; the suitability of their training and qualifications and the ability to
apply their knowledge appropriately; professionally developed and integrated tools
and processes ensuring smooth execution of advice, planning and feedback; and
effective risk management.
We may argue that the financial services industry is becoming over-regulated and as
a result new entry into the market is discouraged. This premise can be unpacked by
examining the drivers behind the new legislation: as long as investment scandals, tax
evasion schemes and incidents of clients being treated unfairly by financial planners
and insurance companies dominate reports in the media regarding the financial
services industry, and consumers continue with undisciplined lending and spending –
regulations will follow. Regulations in most instances are aimed at protecting
consumers against themselves and others. Consumers need protection against their

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own actions motivated by their own self-interest and desires. They also need
protection against actions of other players and interest groups in the financial services
industry (also motivated by self-interest and personal and communal desires). Some
of these players can include individual financial planners, banking institutions and
investment companies and their practices.
What remains mostly unanswered are the contribution of individuals’ own
psychological traits, cognitive and emotional biases to the occurrence of macro
financial crises and micro unlawful acts by individuals and institutions. On the macro
scale, actions by huge institutions can undermine confidence and trust in the financial
system as a whole. When individuals and institutions lose trust in a system, fear will
cloud all their future decisions and the system will stagnate until confidence in the
system is restored. To regain the confidence of the players that drive the markets may
require intervention from governments via regulations. Those in favour of regulation
want regulations they consider helpful and effective such as more disclosure of
information regarding financial structures behind a product, but not regulations that
are excessive resulting in prohibiting such products. There are also those that oppose
new regulations and advocate a free market system which they believe will always be
effective and productive, although they do not advocate free markets for everything.
Most people, however, do feel that the large proportion of business failures, huge
embezzlements of the public’s savings and the subsequent suicides that often follow,
should in some way be prevented.
On a micro level, self-interest of financial professionals and their temperaments can
incline them towards opposing increased regulation. Current regulation already
prescribes that the financial planner must ensure that any advice would be consistent
with the client’s financial situation, needs and level of understanding. The regulations
referred to are the Financial Advisors and Intermediary Services Act, (Act No 37 of
2002) (FAIS Act) and the General Code of Conduct for Authorised Financial Services
Providers and Representatives published under Section 15 of the FAIS Act, the
Financial Services Ombud Schemes Act (Act No 37 of 2004) (FSOS Act), the Long
Term Insurance Act (Act 52 of 1998) and the Pension Funds Act (Act 24 of 1956).
These regulations are not obsolete and new regulations are in the process of being
promulgated. (Students are advised to make use of the Compliance and Regulatory
Framework units to ensure an understanding of this.) From a behavioural perspective
we propose that whether advice is suitable should be considered objectively,
regardless of possible own greed from the financial planner and wishes expressed by
the client motivated by his own greed.
An understanding by a financial planner of his own behavioural biases (as identified
through research in the field of behavioural finance), and an understanding of his
client’s behavioural biases, may assist profoundly in complying with the regulations
referred to. This may especially be relevant to complying with the General Code of
Conduct for Authorised Financial Services Providers and Representatives. The
regulatory authorities might not have had any knowledge of behavioural finance when
they prescribed in the Code of Conduct how to disclose to a client, how to report to a
client and how to avoid confusion by the client, as most legislation still proposes the
existence of the rational man (Homo Economicus). The real world of the financial
planner and his client is the world of the normal man, the world of Homo Sapiens. We
propose that an understanding of behavioural concepts such as behavioural biases
and the ability to identify them may assist intermediaries and their clients to manage,
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and possibly control, the influence of these behavioural biases and other human
desires on decision making.
We should consider the six steps in the financial planning process believed to
represent “best practice” internationally in the financial services industry, within this
frame of mind (See SAFPH for a description of these steps). Within each step there is
the potential for some misunderstanding or less than optimal decisions as a result of
a cognitive or emotional bias such as framing, representativeness and mental
accounting not being observed and dealt with. For many financial advisors, the six-
step process may only be a way to reach the point where a sale can be made - nothing
more than window dressing. The financial advisor who is serious about his profession
and his relationships with clients will realize that financial planning calls for much more.
Best practice calls for the financial planner to address all the client’s financial needs –
from educating the client on financial matters to pure money management needs such
as monthly household budgeting and cash flow management.
Doing a single needs analysis may not address these aspects of financial planning
and of the advice process as described by the Financial Advisory and Intermediary
Services Act 37 of 2002 and the related Code of Conduct. (Both the FAIS Act and the
Code of Conduct can be viewed on the FSCA Website, www.fsca.co.za). Whilst a full
needs analysis requires a financial advisor to assist a client to prioritise their needs,
this does not happen during a single needs analysis. This may result in another more
significant need not being met. It is therefore wise for a financial advisor to warn clients
against a single needs analysis as even the purchase of a house or exit from a pension
fund, just to name a few so-called single needs, can result in change of financial
priorities. Without a high degree of financial literacy, the client will not be able to access
the impact of the above changes on his total financial position.
Statman (2009) writes in the Financial Analysts Journal that regulation can replace
trust when reputation slips. He continues by stating that we cannot be blind to the risk
that unwise behaviour by some of us could lead to disastrous consequences for all of
us. The question to answer is whether the financial services industry needs more
regulation than already prescribed by current legislation. We believe that more
regulation “might keep most of us economically healthy most of the time, but we need
the economic equivalent of mandatory immunization, to prevent the carelessness of
some from infecting all of us”, concludes Statman.

6.1 Tasks:

6.1.1 Discuss how the financial planner can use his knowledge of behavioural
finance to enhance his relationship with his client in each of the six steps
recommended for the financial planning process:
Step1: Establish and define relationship
Step 2: Gather client data – factual and personal
Step 3: Analyse information
Step 4: Prepare and present recommendations and solutions
Step 5: Implementation
Step 6: Reviewing and monitoring
• Establish and define the relationship: As this is in many cases the first
contact between the client and the financial advisor, the financial advisor

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 should take some time to establish the client’s values regarding money –
what their core beliefs are, what they want to do, what would give them
pleasure to do, how their parents made money decisions. It is about the way
they think and feel regarding money that matters. Such a discussion to get
to know your client might assist in avoiding assumptions by you that may
lead to misunderstandings later. Such a discussion will also assist to
establish your client’s level of knowledge and understanding of financial
matters. This is the first opportunity for the financial advisor to “connect” with
his client and to establish trust.
• Gathering client data – factual and personal: Apart from factual data
collection, the financial advisor should also gather information regarding the
client’s financial goals for the various stages and transitions in his life.
Getting the wrong information will lead to “inappropriate advice” later. The
financial advisor should start to uncover some of his client cognitive and
emotional biases and note them as part of information gathered. Ask as
many questions as possible to uncover biases. By finding out the client’s
history much information will become apparent. This is also where you
should use a proper psychometric risk tolerance questionnaire to uncover
the client’s feelings regarding taking financial risks.
• Analyse information: Focus on the process of financial planning. Take all
the different areas of financial planning into account to ensure that a
comprehensive needs analysis is done and not one where some vital
planning areas are left out. This will ensure that the financial planner gives
appropriate advice. Consider how you will address the client’s biases you
might have uncovered.
• Prepare and present recommendations and solutions: This is a critical part
of the financial planning process. The financial advisor needs to be aware
of his own biases and control them as well as the biases he identified in his
client’s psychological make-up. The financial planner should allow the client
to participate in deciding on an appropriate solution. This will contribute to
the client “feeling” the solution being appropriate for his/her unique
circumstances. Most complaints lodged against the financial planner later,
originate from the presentation of recommendations and solutions phase.
Complaints such as: clients did not understand the advice given; not all the
client’s uncertainty and confusion were dealt with and the information was
presented in a misleading way; recommendations did not take the client’s
risk profile into account. Most of this can be attributed to how the financial
advisor framed his solution to the client, in most instances not clarifying the
content and borders of the client’s frame of understanding.
• Implementation: It is vital for the financial advisor that he receive informed
consent from his client for implementation and that the client has a clear
understanding of each phase during the process of implementation. It is best
to adopt a disciplined process and to stick to the process by drawing up a
commitment memorandum between the financial planner and client. This
will serve as a roadmap for implementation. It will also help to resist
impulsive behaviour caused by outside noise. Make sure that the client
understands the reasons behind every decision and why implementation is
prioritized in a given way.

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 • Reviewing and monitoring: Financial planners need to bring mental
discipline to their clients, much the same as great coaches and great
athletes have mental discipline. Focus on the strategy decided on and not
on the component parts. Encourage clients to adopt a long-time horizon and
reinforce the message in all written material to the client. Ensure that the
strategy stays aligned with the client’s goals. Rebalance the investment
portfolio at predetermined times to stay aligned with the strategy. Add value
to the relationship with clients by educating them continuously regarding
psychological issues and ongoing financial developments that may impact
on their decision behaviour.

6.1.2 Argue why you do/do not agree that more regulation is the answer to
protecting clients from losing money as a result of inappropriate advice by
financial services professionals.
I do agree that more regulation is the answer to protect clients from losing
money as a result of inappropriate advice by some financial services
professionals. It is human nature to continuously keep looking for loopholes to
enhance income and exploit regulatory regimes. Greed, of both financial
planners and their client, work in sync to encourage financial planners to sell
inappropriate products for their own financial gain and for clients to seek
unrealistic benefits and proceeds. The regulator must protect individuals
against themselves and others by staying one step ahead with new regulation.
I do not agree that more regulation is the answer to protect clients from losing
money as a result of inappropriate advice by some financial services
professionals. Properly enforcing current regulation will be adequate to
prevent the consumer from being exploited by unscrupulous financial
advisors. The consumer is also not always an innocent victim as their own
greed, lack of self-control and biased decision behaviour lead them to ignore
appropriate advice given by financial professionals. The answers to control
this behaviour lie in educating the public regarding this harmful behaviour and
develop broad-based strategies to prevent this behaviour. These programmes
should start on school level and should reach all communities. Empowering
people with knowledge will serve a better purpose than more regulation.

6.1.3 Examine the concept of framing in the advice process and how it can be
misused by both the financial advisor and financial institutions to sell products
regardless of a client’s needs.
The problem regulators encounter when evaluating the industry (also true from
a behavioural finance perspective) is whether role players use their gained
knowledge to do the right thing or to do the wrong thing (for good or for bad).
Role players are clearly using it for both which touches on the ethical - a
regulation dilemma.
What do financial institutions do? Their priority is to get a sales force to sell as
many products with the highest profit margins as possible. The sales force is
paid commission and bonuses positively aligned to sales targets for these
products. The marketing material will most certainly frame the product in terms
of what you can gain by buying them, to add superficial benefits (such as cash
bonuses or loyalty cards) and frame them as essential or added benefits for
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 the clients. Only in the small print, if at all, you will find mention of steep annual
increases, which the product does not cover or guarantee.
What about financial planners? Time and again we hear about property
syndications or other products with high promised returns being sold. A quick
glance at the most recent determinations by the FAIS Ombud will render
numerous examples: classic framing in terms of high returns over short
periods, no mention of default probabilities or what will happen if the rental
cycles are down. The real motivation for the financial planner is not to best
serve the needs of the client but to find a way to frame a product as appropriate
because of the high commissions attached to it. In almost all of these cases
there are other products available to meet the client’s needs.
It is almost certainly not necessary to leverage behavioural finance gained
insights to create demands for products that are most certainly not in the
client’s best interest.

7. DEFINE RISK TOLERANCE AS A PSYCHOLOGICAL CONSTRUCT AND

EXPLAIN HOW IT DIFFERS FROM RISK CAPACITY AND RISK REQUIRED
AS FINANCIAL CONSTRUCTS, REFERRING ALSO TO HOW EACH FITS
INTO THE ADVICE PROCESS

Financial planners talk to their clients about risk issues all the time, and the compliance
departments of various companies and the legislature dedicate an enormous
percentage of their time to the risk-related aspects of advice. But with all this focus on
risk, many financial planners do not understand nor distinguish between the different
aspects of risk present during the advice process. Sloppy risk processes make
financial advisors vulnerable to compliance transgression and claims by unhappy
clients.
Because many financial advisors do not handle the conversation regarding the
different risk parameters well, clients do not understand the risk involved in their
portfolios. These are the clients that may just start complaining when losing money
during down cycles in the market. It can be all too easy for them to say: “The strategy
was too risky for me”, “My financial advisor should have known that”, “I didn’t
understand the risks because they were not explained to me properly” and “If I
understood the risks in the first place, I would never have agreed to the investment”.
Risk has three primary aspects:
1. Risk required: The risk associated with the return that would be required to achieve
the client’s goals. This risk has a financial characteristic. It is the level of risk a client
needs to take in order to reach financial goals. This risk is determined by taking
into account the client’s financial circumstances, his resources and goals.
2. Risk tolerance: The level of risk the client prefers to take. This risk is a
psychological attribute of the client. It is how an individual feels about taking risk. It
describes where a person strikes the emotional balance between seeking a
favourable outcome versus risking an unfavourable outcome. We know that risk
tolerance is stable and does not change during an economic downturn. We also
know that marriage, age and wealth can influence risk tolerance.

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3. Risk Capacity: The level of risk a client can afford to take given his financial
situation.
This risk is about how much your client can afford to lose without messing up
his/her present and future plans. This risk has a financial characteristic. Risk
capacity is the absolute measure and overrides the other two.
With the appropriate planning tools, financial advisors can identify the three
ingredients of risk and discuss their interaction with the client so that mismatches can
be resolved, and trade-offs be made. Trade-offs can involve reducing goals, delaying
goals and increasing savings. Ultimately, it is important that the client give his or her
properly informed consent to the riskiness of the investment portfolio recommended.

7.1 Tasks:

7.1.1 Outline the process of how to achieve the client’s informed consent to the level
of risk proposed for an investment plan recommendation. Give a step-by-step
explanation of the process.
Planning step 1: Assess the client’s, and his partner’s (if applicable), risk
tolerance with a proper scientific tool. Discuss the results with both and
highlight the differences and similarities.
Planning step 2: Evaluate the client’s, and his partner’s (if applicable), goals
and financial resources and calculate the risk (return) required. The risk
required determines the return required to achieve the goals (and vice versa).
The return required may be impossibly high in which case the goals need to
be reviewed to bring the returns down to a level that is achievable.
Planning step 3: It is now time to consider the client’s risk capacity for the
amount of risk proposed to reach the proposed goals. This step is about
testing the upside potential of the proposed plan versus the downside
potential. Risk capacity is determined by the client’s level of income, the term
of the investment and possible insurance cover.
Planning step 4: Discuss the outcomes of step 2 and 3 with your client and
make trade-off decisions where necessary. If the risk required is too high for
the client’s risk capacity, possible solutions are to ease the goals or increase
the resources if possible.
Planning step 5: Use the results achieved in step 1 and 4 and make trade-off
decisions between risk tolerance and risk required if necessary. If the risk
required is greater than the risk tolerance the client can endure, the answer is
to ease some of the goals, or increase resources or take more risks. If the risk
required is less than the risk tolerance you can raise goals, decrease
resources or take less risks.
Planning step 6: Now it is time for the client to make the decision and give
his/her commitment to the plan.
It is important to note that the financial advisor can use the trade-off decisions
the client has to make as an opportunity to educate the client and to ensure
that each element of risk is properly understood.

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7.1.2 Discuss why you think the perception that a person’s risk tolerance changes
during a market downturn exists.
We know that risk tolerance is a personality trait and remains unchanged
except for very traumatic experiences impacting this trait. What changes
during a market downturn is a person’s risk perception. Risk perception is what
a person views the risk in the market at a given time to be. It can be compared
to a professional race car driver who has a very high risk tolerance for driving
fast cars, but will be cautious when the track he has to race on is slippery and
wet in places. His perception is that the conditions are risky and that you
should slow down where the track is slippery and wet.

7.1.3 Defend or negate the statement: Getting an accurate measurement of your

client’s risk tolerance is key to provide appropriate advice.
Risk tolerance is a small but critical part of the financial planning process. It
consists of the client’s instructions to his/her financial planner about how much
risk they are comfortable with in their investments. In a volatile market or bear
market, risk becomes a reality for both the client and his/her advisor. If risk
tolerance was not measured accurately and discussed appropriately with the
client during the advice process, the circumstances can trigger a crisis in the
relationship with the financial planner. The client may start to question the
financial advisor’s competence and even lay an official complaint. Worst case
scenario for the client is that his/her risk aversion, which underlies the risk
tolerance, may kick in and the client could change their investment holdings
at the worst possible time. If risk tolerance was measured accurately and
discussed appropriately with the client during the advice process, the client
will be unhappy with the return but not the advice. You can take them back to
the decision-making process and your explanations of the various risk
parameters.

8. APPLY THE INSIGHTS GAINED FROM BEHAVIOURAL FINANCE WHEN

CONSTRUCTING ASSET ALLOCATION PORTFOLIOS TO GAIN CLIENT
COMMITMENT, TRUST AND INFORMED CONSENT.
To adopt a behavioural finance framework and develop a standardized structure within
this framework which financial advisors can use to design unique investment plans for
each of their clients, will contribute towards establishing trusted relationships with
clients. When clients experience a process where the financial advisor
• takes their unique financial circumstances into account to establish their goals.
• establishes their financial risk tolerance.
• takes their unique investor biases into account;
• discusses gaps between the client’s risk tolerance, risk required, risk capacity and
the influence of the behavioural biases on asset allocation, and only then
• proposes an investment plan.
If the above process is followed, the client will be inclined to accept the proposed
investment plan and also be less likely to waver from it. The financial advisor can feel
assured that he has gained his client’s commitment following a process designed to
reach informed consent.
With the explosion of technology and its application in the financial services
environment, financial advisors increasingly bombard their clients with technical
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information whilst hiding behind sophisticated technology applications to establish
financial solutions for their clients. The result, is sadly, that financial advisors are no
longer able to connect with their clients in a meaningful way. An analytical approach
to financial and investment planning delivers facts to clients but fails to connect with
the client on a personal level to discover their feelings about finances and investing.
The future lies in accommodating the whole person, with his emotional preferences,
in financial planning to deliver trusted advice. A good financial planning software
package and a myriad of technical qualifications on its own is just not good enough to
satisfy clients anymore. You need a behavioural approach to service clients more fully.

8.1 Tasks:

8.1.1 Outline under what conditions will you moderate or adapt your client’s
standard risk/reward asset allocation portfolio for client biases, and briefly
differentiate between cognitive and emotional biases.
The client’s level of wealth determines whether the financial planner should
moderate or adapt to a client’s behavioural biases during the asset allocation
process - more specifically, adapt to biases in wealthy clients and moderate
biases in less wealthy clients. A client outliving their assets is a far greater
problem than a client’s inability to become the richest citizen in South Africa.
In the first instance, the client’s standard of living may be jeopardized; in the
latter, the client’s standard of living will most probably remain in the 99.9th
socioeconomic percentile. Therefore, if bias is likely to endanger a client’s
standard of living, moderating is the best course of action. If only an unlikely
event, such as a market crash, for the most financially secure clients could
jeopardize the client’s standard of living, overcoming the impact of the bias on
portfolio return becomes a lesser consideration, and adapting may be the
more appropriate action.
The type of behavioural bias the client exhibits will determine whether to
moderate or adapt. More specifically, moderate for clients exhibiting cognitive
biases and adapt for those clients exhibiting emotional biases. Behavioural
biases could be categorized into two broad categories:
• Cognitive biases stem from faulty reasoning and therefore better information
and advice can often correct them. This includes heuristics such as
anchoring and adjustment, availability and representativeness biases. Other
cognitive biases include selective memory and overconfidence.
• Emotional biases originate from impulsive feelings or intuition, rather than
conscious reasoning, and are therefore difficult to correct. This includes
regret, lack of self-control, loss aversion, hindsight and denial.

8.1.2 Read the following scenario and

• discuss the effect the biases may have on a standard asset allocation
model; and
• discuss how you will moderate or adapt to these biases.
The Nel family is a financially well-informed couple, both aged 36, with two
children aged 6 and 10. They are financially sound but were not invested
during the bull market of the 1990s as many of their neighbours were. The
couple’s total income, R700 000, is, like the family itself, not expected to grow
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 significantly. They have saved R200 000, which they hope will be the financial
foundation from which they will send their children to university and retire
comfortably.
The Nel’s suffer from:
• Loss aversion
• Regret—the tendency to feel deep disappointment for having made
incorrect decisions
• Availability bias—the tendency to believe that what is easily recalled is more
likely
Further assume that it is 2012; capital markets are still off their highs (for
shares) and lows (for bonds) compared to 2008, but no longer at the extremes
of the recent down-market cycle. After you, the financial planner, administer a
risk tolerance questionnaire, and establish the risk they require to reach their
goals, the risk/reward asset allocation model indicates the following
allocations:
70 % equity, 25 % bonds, 5 % cash
Effect of biases – We are presented with biases that could lead us in different
directions. Because the Nel family’s portfolio has not kept pace with their
neighbours’, the Nel’s regret having made incorrect decisions in the past may
prompt them to take on more equity risk than may be appropriate. But because
they do not tolerate risk (loss aversion) and have shrunk from the latest
information about the skidding equity market (availability), they are more
comfortable with less exposure to equities. Again in this case, biases favouring
fixed income appear to outweigh those favouring equities—we need to
thoughtfully consider the situation further.
Moderate or adapt?
The Nel family’s biases are mainly emotional (loss aversion and regret). Thus,
your instinct is to adapt to a lower allocation to equities of 50 percent because
you believe that the Nels are likely to be comfortable with, and be able to
adhere to, such an allocation. But given their level of wealth, your financial
planning model suggests that a lower equity allocation would not provide a
secure retirement given their university expenses; that is, their standard of
living is at stake. You decide to compromise, and your recommendation is to
moderate and adapt, striking a balance between their investment goals and
biases.
This is the best practical allocation decision. The risk/reward recommended
allocation was 70 percent equity, 25 percent bonds and 5 percent cash. You
had contemplated dropping the equity allocation to 50 percent based on their
biases but realized that such an allocation would present a standard-of-living
risk. Thus you bring the equity allocation up to 60 percent, which results in a
compromise of 60 percent equity, 35 percent bonds, 5 percent cash allocation.

8.1.3 Examine your own approach to new clients, the process you use including fact
finding and analysis. Discuss how you can behaviouralise your own processes
to focus on your client’s feelings first and then move on to the hard facts as
you move along.

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 There is no hard and fast answer here. The idea is to get each candidate to
do introspection into their own way of doing business and come up with
suggestions on how and where to make changes.
What is important, is to understand that a standard fact-find and analyses
process, driven by software, is nothing but a sales-driven approach. Adding a
behavioural approach will change it to client-driven approach. You should
mention how and where you will question clients about their experiences from
childhood regarding money, savings, investments and their feelings about it.
Also how you will attempt to discuss your solutions and products proposed in
a way that will be easily understood by your client and experienced as
transparent? Important is to focus on:

All truths are easy to understand once they are discovered; the point is to discover
them.
Galileo

Financial planners should help people figure out how to live. What’s the role of
money, and how much is needed, in terms of life quality? If planners don’t help
clients think about the quality of their lives, I don’t think they can justify their fees.
But the real social value in financial planning, for those who are interested in that, is
in helping people who don’t have enough money. I try to help financial planners think
about how people think about money, and how they can help clients understand the
financial decisions they have to make, and how to better manage the trade-offs in
life.
Dan Ariely FPA Denver 2010

References:

Kahneman D (2002). Maps of bounded rationality: A perspective on intuitive judgment

and choice. Nobel Prizes 2002. Website: http://www-
psych.stanford.edu/~knutson/nec/
kahneman02.pdfhttp
Bernartzi, S (2011) Behavioural Finance in Action: Psychological challenges in the
financial advisor/client relationship, and strategies to solve them. Allianz Global
Investors.
Montier, J. 2010. The Little book of Behavioural Investing: How not to be your own
worst enemy. John Wiley and Sons. Inc New Jersey
Bernartzi, S. (2011) Behavioural Finance in Action. Allianz Global Investors Centre for
Behavioural Finance
Statman, M. 2009. Regulating Financial Markets: Protecting Us from Ourselves and
Others. Financial Analyst Journal, May 2009. www.cfapubs.org
Ariely, D. 2010. Irrationality and what to do with it.
www.FPAjournal.org/Home/PodcastPage.
Davey (2010) Managing the Risky Business of Advice. AICPA Planner Newsletter
Davey. (2011) The Five Proofs – the Route to Informed Consent. www.fa-mag.com
Du Plessis, C. (2011) Risk Tolerance Myths. IBF Website: www.ibfsa.co.za

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