CFP Curriculum Recaps

Fundamentals Chapter 2 Recap: “Interpersonal Communication & Behavioral Finance”

Chapter Recaps: my notes to chapters of the financial planning coursework material through New York University’s CFP® Program (in conjunction with Dalton Education).

Chapter 2: Interpersonal Communication & Behavioral Finance

Note: Three main sections: Counseling Theories and Schools of Thought, Communication Tools & Techniques, and Behavioral Finance

  1. Counseling Theories and Schools of Thought
    1. Relevance:
      1. These 3 schools of thought can be a guide in identifying a style that fits the financial counselor best in order to make a more effective counselor. Depending on client’s style, may need to use a different school of thought or a combination.
    2. “Developmental” School of Thought:
      1. Theory: human development occurs in stages over time. Early life relationships become a template for those in adulthood.
      2. Origins: Freudian psychoanalytic theory.
      3. Goal: is to recount or correct earlier disrupted development to foster change in the client or client’s behavior.
      4. In-practice: questions should be used in moderation.
    3. “Humanistic” School of Thought:
      1. Theory: for a client to grow, the relationship needs a transparent and genuine counselor. Advisor needs to believe humankind is good and people can direct themselves and grow under the right environment. Majority of the Humanistic theories view clients as experts on themselves.
      2. Origins: much influenced by Freudian psychoanalytic theory.
      3. Goal: creating congruence and acceptance of personal responsibility.
      4. In-practice: treatment emphasizes experience of the present moment, freedom of choice, and keeping in touch with oneself. Questions likely more on process and feelings versus details or content. Counselor would help clients determine for themselves the questions they have.
        1. Advisor may spend a lot of time determining goals (to achieve congruence) and determine client’s feelings towards money and cognitive biases tendencies.
    4. “Cognitive-Behavioral” School of Thought:
      1. Theory: humans are subject to same learning principles established in animal research. Principles of classical conditioning (Pavlov’s dog) and operant conditioning (reinforcing or not punishment) are assumed to drive individual behavior and understanding.
      2. In-practice: counselor must conduct an evaluation of how reinforcers are maintaining problematic self-talk and behaviors. Questioning process is much more directive than “Developmental” and “Humanistic.” Basically looking for client information to design an intervention or plan consistent with cognitive-behavioral theory. Advisor will cover more on positive results to reinforce client belief in process, the client’s behavior, and trust in advisor.
  2. Communication Tools and Techniques
    1. Elements of Communication
      1. System of signs – word, object, gesture, tone, quality, image, substance or other reference pertaining to a code of shared meaning.
      2. Nonverbal – gestures, actions, or other expressions that are not verbal, but can substitute or reinforce verbal.
      3. Context is very important. Establishing rapport with a client may help recognize and understand client’s message
    2. Nonverbal behavior or “Body Language”
      1. Can communicate feelings and attitudes.
      2. Mainly communication from body (position & movement) and voice (tone and pitch).
      3. When indicators give mixed signals, advisor should ask more questions.
    3. Active Listening versus Passive Listening
      1. Passive listening = subconsciously listening. Often thinking about one’s response to what client is saying versus listening.
      2. Active listening = undivided attention and concentration on what speaker is saying and body language.
        1. May show interest with nodding and affirmative responses (“I understand”). This shouldn’t interrupt the speaker.
    4. Using Open and Closed Questions
      1. Open question = usually one that will result in a lengthy response. Usually begin with how, what, when, where, who and why.
      2. Closed question = usually a very targeted question answered with a 1 or 2 word response. Usually begin with is, are, do, did, could, would, have, or “is it not true that…”
      3. Implementation: advisor must recognize when each question type is warranted. A “why” question can put client in a defensive state.
    5. Clarifying or Restating a Client’s Statement
      1. If client’s message isn’t clear or mixed verbal/nonverbal communication, advisor should clarify.
        1. Restate = repeating a key word or phrase.
        2. Paraphrase = summarize in advisor’s own words.
        3. Question = ask what trying to communicate.
      2. Best time to clarify is before leaving the topic at hand.
    6. Client Data Collection
      1. Data is more than just quantitative (net worth, etc.) Includes values, attitudes, expectations, and priorities.
      2. Avoid long questionnaires initially, as client may feel their belongings or balance sheet is more important than the person and their goals.
  3. Behavioral Finance
    1. Introduction
      1. Traditional Finance, aka Modern Portfolio theory, developed in 50s and 60s with an objective and scientific view of economics and financial markets.
    2. Assumptions and Building Blocks of Traditional Finance
      1. The Rational Investor
        1. Preferred more wealth versus less and never confused by form of wealth received.
      2. Efficient Markets
        1. Share price reflects all relevant information, aka, no mispricings. Thus, impossible to outperform the market and investors have to acquire riskier investments to earn higher returns.
      3. The Mean-Variance Portfolio Theory Governs
        1. Given the rational investor assumption, investors constantly create their portfolios to comply with the Mean-Variance portfolio.
      4. Risk Yields Expected Returns
        1. Risk is measured by Beta from the Capital Asset Pricing Model (CAPM) developed by William Sharpe in 1964, a calculation depicting the volatility of an asset price in relation to the overall market volatility.
      5. Issues and Questions Unanswered by Traditional Finance
        1. October 1987 stock market crash shed doubt on Traditional Finance’s assumptions (rational investors and efficient markets).
    3. Behavioral Finance
      1. Intro:
        1. Relatively new and evolving part of finance. Four main assumptions directly below.
      2. Investors are “Normal”
        1. A person with emotions and cognitive biases. May commit cognitive errors and can be misled by emotions.
      3. Markets are Not Efficient
        1. Prices can stray from fundamental value, though markets can still be tough to beat. Reason is because the market is a collection of normal investors.
      4. The Behavioral Portfolio Theory Governs
        1. A goal-based theory where investors compartmentalize, aka, engage in mental accounting, to accomplish different goals based on risk. This is different than the mean-variance perspective where rational investors view their portfolio as a whole at all times.
          1. If a normal investor has only one mental account, then portfolio analysis is the same as in mean-variance theory. An investor with one mental account is referred to as “BPT-SA” (SA = Single account) where normal investors with several mental accounts are referred to as “BPT-MA” (MA – multiple accounts.
          2. The issue with not looking at the portfolio as one portfolio is the investor may not be considering the covariant effects (diversification).
      5. Risk Alone Does Not Determine Returns
        1. The Behavioral Asset Pricing Model considers a whole host of subjective factors including investor’s likes or dislikes about the stock or company, social responsibility factors, status factors, etc., in addition to Beta, book-to-market ratios, stock “momentum,” and market cap ratios.
    4. What Makes Investors Normal Instead of Rational: Cognitive Biases, Errors and Being Human
      1. Intro:
        1. Difference between a Rational Investor and a Normal Investor is the latter can make cognitive mistakes due to their beliefs or cognitive biases.
      2. Heuristics:
        1. Affect Heuristic (heuristic = rule of thumb) – judging whether something is good or bad.
        2. Availability Heuristic – relying on readily-available knowledge rather than looking at all information and/or options.
        3. Similarity Heuristic – using a similar situation to make a decision even though the situation is not identical.
      3. Mindset of Losing versus taking losses
        1. Keeping losing stocks because selling would admit defeat though rationally the value is lost when the stock price goes down even though the sale is not made.
      4. Patterns and Types of Cognitive Biases (most-common):
        1. Anchoring – attaching/anchoring one’s thoughts to a reference point which may not have any logical relevance.
        2. Confirmation Bias – filtering information and focusing information supporting one’s own opinions (versus seeking out dis-confirming information.)
        3. Gambler’s Fallacy – thinking an outcome is “due” because of past outcomes.
          1. In other words, if an outcome has repeatedly occurred recently (coin coming up tails), then a different outcome is due (heads).
        4. Herding – individuals mimicking the actions or decisions of a larger group, despite that the individual may not have made the same choice on his or her own.
        5. Hindsight Bias – looking back after the fact is known. Outcomes can seem obvious in hindsight. Can lead to overconfidence
        6. Overconfidence Bias – overestimation of one’s abilities.
          1. One of the most common behavioral biases and can be detrimental to LT investment performance. Can lead to excessive trading.
        7. Overreaction – overreaction, or Representativeness, is over-weighting sample information.
        8. Prospect Theory – given two equal investments in terms of odds of gains and losses, people would prefer the choice expressed in terms of gains versus losses.
        9. The Disposition Effect
          1. Reluctance of an investor to realize a loss from “faulty framing” where investors don’t mark to market the loss in value of a declined stock until sold, but only mark to their purchase price.
      5. Note on Limits to Arbitrage
        1. These behavioral biases only have a sustained effect on asset prices if there are limits to arbitrage. There is some evidence of arbitrage limits. Short-selling may be difficult, expensive, or impossible. Other limits include margin calls and exacerbated mis-pricings from uninformed investors.
    5. Behavioral Finance Conclusion
      1. Understanding behavioral biases can help create an optimal investment policy and plan for a client; an understanding can also help the investor of advisor be aware of or take advantage of common mistakes made by normal investors.

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