The Psychology of Financial Planning

By Certified Financial Planner Board of Standards, Inc. (CFP)

Section 1: Client and Planner Attitudes, Values and Biases

Section 1 includes Chapters 1, 2 and 3, and provides an overview of client and planner attitudes, values, and biases. This section discusses the importance of understanding how a client's psychology, background, learning style and values can all impact the financial planning process. It also discusses the importance of the financial planner framing advice in a way that accounts for all those psychological characteristics, leading to a more effective client-planner relationship and a higher probability of success. Research has shown that when clients can see that financial planning recommendations are demonstrably connected to their personal values and goals, they are much more likely to act on those recommendations and achieve success.

Chapter 1: Framing Advice in Light of Client's Risk Tolerance (Swarn Chatterjee and Dave Yeske)

Chapter 2: Developing a Productive Client-planner Relationship That Addresses the Psychological Elements of Financial Planning (Megan McCoy and Neal Van Zutphen)

Chapter 3: Identifying and Responding to Client Values and Goals (Megan McCoy and Meghaan Lurtz)

Section 2: Behavioral Finance

Section 2 includes Chapters 4 and 5, and introduces key concepts from the area of behavioral finance. This section provides an understanding of the impact of cognitive biases and heuristics on people's financial decision-making and well-being, and discusses strategies for overcoming some of the common client psychology barriers in the financial planning process.

Chapter 4: Impact of Cognitive Biases and Heuristics on Financial Decision-making and Well-being (Ron Sages and Swarn Chatterjee)

Chapter 5: Client Psychology Barriers in the Financial Planning Process and Strategies for Overcoming Them (Ron Sages and Swarn Chatterjee)

Section 3: Sources of Money Conflict

Section 3 includes Chapters 6 through 10, and provides an overview of the major sources of money conflict. This section focuses on the harnessing of client's motivation for achieving their financial goals, examining couple and family financial transparency, and discusses strategies for mediating potential financial conflicts and facilitating goal congruence. This section also discusses counseling strategies that can be used for identifying when money is being used for purposes of manipulation.

Chapter 6: Building the Client's Motivation for Achieving Their Financial Goals (Rick Kahler)

Chapter 7: Examining Couple and Family Financial Transparency (Emily Koochel and Meghaan Lurtz)

Chapter 8: Mediating Financial Conflict (Sonya Lutter and Emily Koochel)

Chapter 9: Facilitating Goal Congruence (Rick Kahler)

Chapter 10: Identifying When Money Is Being Used as Manipulation (Saundra D. Davis, Meghaan Lurtz and Megan McCoy)

Section 4: Principles of Counseling

Section 4 includes Chapters 11 and 12, and introduces the principles of counseling. This section includes the application of counseling theory in the financial planning process, and discusses strategies for forging trusting client-planner relationships.

Chapter 11: Applying Financial Counseling Skills to the Financial Planning Process (Emily Koochel, Megan McCoy and Saundra D. Davis)

Chapter 12: Forging Trusting Relationships (Megan McCoy and Sonya Lutter)

Section 5: General principles of effective communication

Section 5 includes Chapter 13, and provides an overview of the general principles of effective communication. This topic is of great importance as effective communication has been shown to be the single largest predictor of client trust and relationship commitment, which in turn can lead to a greater propensity by clients to reveal personal and financial information, engage in effective conflict resolution, and act on financial planning recommendations.

Chapter 13: Multifaceted

• Language: English
• Publisher: The National Underwriter Company
• Release date: Apr 27, 2022
• ISBN: 9781954096462

Book preview

The Psychology of

Financial Planning

Certified Financial Planner Board of Standards, Inc.

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ISBN: 978-1-954096-45-5

Copyright © 2022 Certified Financial Planner Board of Standards, Inc.

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FOREWORD

Approximately every five years, CFP Board conducts a Practice Analysis Study to ensure the CFP® certification requirements reflect current practice. The results of this study — the largest research project in the U.S. related to the body of knowledge for financial planning — establish our Principal Knowledge Topics, which are the topics covered by our Registered Programs, assessed on the CFP® exam and accepted for continuing education credit.

Our 2021 Practice Analysis Study introduced a new Principal Knowledge Domain called the Psychology of Financial Planning. It covers critical skills that CFP® professionals can use to better serve their clients, from understanding attitudes, values and biases of both clients and planners to using effective communication techniques to build trust.

Starting in March 2022, the new domain is integrated into the CFP® exam. But the Psychology of Financial Planning is not only an essential area of study for candidates, but also for experienced CFP® professionals.

Over the years, leaders at firms that hire financial advisors have shared with me that they need more advisors who can effectively communicate to and relate with their customers. A financial planner can have all the technical financial knowledge in the world. But that knowledge has little value if they can’t effectively communicate that information to their client, and demonstrate understanding of how a recommended course of action meets the client’s unique needs and goals. An understanding of the Psychology of Financial Planning is key to the professional development of financial advisors.

The Psychology of Financial Planning sets out to provide the theoretical underpinnings and practical knowledge for each of the topics that make up the new domain. This pioneering resource will help candidates prepare for the CFP® exam, and it also will help current practitioners improve their competencies in these areas.

Such a resource takes significant time and effort to produce. But the book relies on the subject matter experts who have spent years doing research in the areas covered by the Psychology of Financial Planning domain and who graciously agreed to incorporate their expertise to develop this resource. The book’s esteemed Editorial Advisory Board — Swarn Chatterjee, Ph.D.; Sonya Lutter, Ph.D., CFP®, LMFT; and Dave Yeske, DBA, CFP® — steered the development of the book’s structure and text, both writing and editing chapters to ensure the book included theory and case studies to fully explore each Principal Knowledge Topic of the new domain. The Editorial Advisory Board brought on authors well versed in each of these areas to contribute to chapters. Contributors include: Saundra D. Davis, MSFP, APFC®, FBS®, CSC; Rick Kahler, MS, CFP®, CFT-I™, CeFT®; Emily Koochel, Ph.D., CFT-I™; Meghaan Lurtz, Ph.D.; Megan McCoy, Ph.D., LMFT; Lance Palmer, Ph.D., CFP®; Ron Sages, Ph.D., CFP®; and Neal Van Zutphen, CFP®, M.S.

Thank you to our Psychology of Financial Planning Advisory Group, including Elizabeth Cox, CFP®, CPA, CDFA™; Neal J. Solomon, CFP®, CLU, ChFC, CASL; Susan M. John, CFP®; Nathan Harness, Ph.D., CFP®; Malik S. Lee, CFP®, CAP®, APMA®; Melissa Sotudeh CFP®, AIF®; and Joseph V. Maugeri, CFP®, Managing Director, Corporate Relations.

Our internal advisory group, led by Chief Operating Officer Elizabeth M. Stewart, met regularly to integrate the new domain into our certification requirements and to develop the concept of this book. The cross-functional team providing their expertise and guidance throughout this book project included: John M. Loper, CFP®, Managing Director, Professional Practice; Ibi Layi-Ojo, Director, Examinations; Mary Kay Svedberg, Ph.D., Director, Education; Alex Torres, Director, Continuing Education and Experience; Rachel L. Sheedy, CFP®, Manager, Financial Planning Knowledge Center; Jason Gudenius, Director, Marketing; David Porter, CPA, Interim Controller; Tim Stifel, Director, Stakeholder Communications; Zach Gelnett, Manager, Data and Analytics; Eric Nepomuceno, Manager, Examinations; David Mazzulla, Director, Information Technology; Tim Fields, Education Analyst; and Morgan Graham, Registered Programs Administrator.

With the CFP® practitioner top of mind, the creation of the book’s content was managed by two of CFP Board’s in-house CFP® professionals: John M. Loper, CFP® and Rachel L. Sheedy, CFP®. John took the lead in assembling the book’s Editorial Advisory Board and content contributors, as well as providing additional practitioner perspective, while Rachel was instrumental in shepherding the manuscript through the editorial review process on its way to the publisher, ALM Media.

The collection of experts involved in creating this resource all had one focus: you, the CFP® practitioner. We hope you find this resource to be illuminating and thought-provoking, and also one that serves as a go-to guide that you can use in your everyday practice. In the end, we hope this resource not only sharpens your skills as a financial planner but also improves your relationships with your clients and ultimately their financial well-being.

Kevin R. Keller, CAE

Chief Executive Officer, CFP Board

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PREFACE

Swarn Chatterjee, Ph.D.

Sonya Lutter, Ph.D., CFP®, LMFT

Dave Yeske, DBA, CFP®

What Is Psychology of Financial Planning?

After years of research, CFP Board settled on a cohesive definition of psychology of financial planning: identifying and responding to attitudes, behaviors, and situations that impact decision-making, the client-planner relationship, and the client’s financial well-being. The psychology of financial planning goes beyond client psychology or the elements that prevent clients from making rational decisions and includes the broader system encompassing all aspects of the client-planner relationship. This broader system includes characteristics of the financial planner that influence client decision-making, it includes characteristics of the client that influence how the financial planner behaves, and it includes the cultural background of both financial planner and client.

In short, psychology of financial planning is not client psychology, and it is not behavioral finance. The psychology of financial planning is the interaction of planner characteristics with client characteristics. It is 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.

This book is structured around the Principal Knowledge Topics that make up the CFP Board’s Psychology of Financial Planning domain. The Principal Knowledge Topics included in this domain 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

Financial planners are expected to be proficient in each of these areas. As demonstrated by the case studies in each chapter, proficiency sometimes means awareness of an issue and knowing how to make a proper referral. Just as financial planners are not expected to also have a law degree and be licensed estate lawyers, neither are financial planners expected to be therapists. That does not mean, however, that it isn’t appropriate for financial planners to incorporate grounded theories and practices from the field of counseling psychology into how they interact with clients during all phases of the financial planning process.

This book provides an overview of the importance of the role of Principal Knowledge Topics included in the Psychology of Financial Planning domain that provide a better understanding of people’s financial decision-making, and provides insights that can be helpful in building and strengthening client-planner relationships.

Section 1 includes Chapters 1, 2 and 3, and provides an overview of client and planner attitudes, values, and biases. This section discusses the importance of understanding how a client’s psychology, background, learning style and values can all impact the financial planning process. It also discusses the importance of the financial planner framing advice in a way that accounts for all those psychological characteristics, leading to a more effective client-planner relationship and a higher probability of success. Research has shown that when clients can see that financial planning recommendations are demonstrably connected to their personal values and goals, they are much more likely to act on those recommendations and achieve success.

Section 2 includes Chapters 4 and 5, and introduces key concepts from the area of behavioral finance. This section provides an understanding of the impact of cognitive biases and heuristics on people’s financial decision-making and well-being, and discusses strategies for overcoming some of the common client psychology barriers in the financial planning process.

Section 3 includes Chapters 6 through 10, and provides an overview of the major sources of money conflict. This section focuses on the harnessing of client’s motivation for achieving their financial goals, examining couple and family financial transparency, and discusses strategies for mediating potential financial conflicts and facilitating goal congruence. This section also discusses counseling strategies that can be used for identifying when money is being used for purposes of manipulation.

Section 4 includes Chapters 11 and 12, and introduces the principles of counseling. This section includes the application of counseling theory in the financial planning process, and discusses strategies for forging trusting client-planner relationships.

Section 5 includes Chapter 13, and provides an overview of the general principles of effective communication. This topic is of great importance as effective communication has been shown to be the single largest predictor of client trust and relationship commitment, which in turn can lead to a greater propensity by clients to reveal personal and financial information, engage in effective conflict resolution, and act on financial planning recommendations.

Section 6 includes Chapters 14 and 15, and discusses strategies for helping clients who experienced crisis events with severe consequences. The strategies discussed in this section focus on helping clients navigate unanticipated personal and environmental crises, and the importance of empathy when working with clients who experienced such events. As is true across all topics in this book, self-awareness and self-development by the financial planner is as important as understanding the client’s psychology when helping them navigate difficult circumstances.

This book has been written for use by experienced financial planning practitioners, undergraduate and graduate students enrolled in CFP Board Registered Programs, and those planning to take the CERTIFIED FINANCIAL PLANNER™ exam. This book can also be used for advanced undergraduate and graduate level coursework across a number of academic disciplines including but not restricted to business, consumer science, economics, finance, financial planning, human development and psychology. In addition, the book provides information that will be of interest to a broader audience in the general public who want to better understand their financial behaviors and attitudes, and are looking for insights to improve their financial decision-making.

We hope the readers will find the information included in this book to be practical, useful, and informative in their work and practice.

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EDITORIAL ADVISORY BOARD

Swarn Chatterjee, Ph.D. is the Bluerock Professor Financial Planning at the University of Georgia. He currently serves as the head of the Department of Financial Planning, Housing and Consumer Economics. Dr. Chatterjee has previously served as the President of the Academy of Financial Services, and currently serves as the President-elect for the American Council on Consumer Interests.

His research interests include examining the financial decision making of households, studying the psychology of financial well-being, and evaluating performance across different stages of the financial planning process. He serves as an Associate Editor for the Journal of Financial Counseling and Planning, and also serves on the editorial review boards of the Financial Services Review, Journal of Family and Economic Issues, Journal of Financial Planning, and the Journal of Personal Finance. He has previously Dr. Chatterjee has contributed to CFP Board’s Client Psychology book and the Financial Planning Competency Handbook. He received his Ph.D. in Personal Financial Planning from Texas Tech University.

Sonya Lutter, Ph.D., CFP®, LMFT is the director of research and education at Herbers & Company. She remains on adjunct faculty at Kansas State University where she was previously an endowed professor and head of the Department of Applied Human Sciences. She holds degrees from Kansas State University and Texas Tech University in marriage and family therapy and financial planning. Her research has been featured in news outlets such as The New York Times and The Wall Street Journal.

Dr. Lutter won the Best Theoretical research paper award at the national Financial Planning Association meeting two years in a row with colleagues on topics related to Savers & Spenders and The Financial Implications of Cohabitation. Her developmental work in financial therapy is summarized in Financial Therapy: Theory, Research, and Practice with co-editors Dr. Brad Klontz and Dr. Kristy Archuleta.

Dr. Lutter has been active in promoting financial literacy and well-being on college campuses. She has worked with multidisciplinary teams to focus on finances within relationships, food insecurity, and financial behaviors of veterinary and pre-veterinary students. Lutter’s work at the financial counseling centers at Texas Tech and Kansas State have guided her financial counseling research agenda, which culminates with a co-edited book with Dr. Dorothy Durband, Student Financial Literacy: Campus-Based Program Development.

Dave Yeske, DBA, CFP® has been practicing financial planning for over 30 years and is the co-founder of Yeske Buie, a wealth management firm with offices in San Francisco, California and Vienna, Virginia. He is also the program director for Golden Gate University’s financial planning program, where he teaches Personal Investment Management and the capstone Cases in Financial Planning. Dr. Yeske served as national president of the Financial Planning Association and is a trustee and chair-elect of the Foundation for Financial Planning. He also served as chair of FPA’s Academic Advisory Council and was Practitioner Editor of the Journal of Financial Planning. In 2017, FPA honored Dave with the P. Kemp Fain, Jr. Award.

Dr. Yeske’s research has been published in the Journal of Financial Planning and he contributed 13 chapters to the CFP Board Financial Planning Competency Handbook. With co-author Elissa Buie he contributed chapters to both Investor Behavior: The Psychology of Financial Planning and Investing, published by Wiley Finance, and Financial Behavior: Players, Services, Products, and Markets, published by Oxford University Press. He holds a BS in Applied Economics and MA in Economics from the University of San Francisco and a doctorate in Finance from Golden Gate University.

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CONTRIBUTORS

Saundra M. Davis, MSFP, APFC®, FBS® is a U.S. Navy veteran and nationally recognized speaker, financial coach, educator and consultant. She is the founder and lead trainer of the Financial Fitness Coach (FFC®) certification program, which supports community-based providers and financial professionals to build the skills necessary to promote change in how individuals, families and communities think and talk about money.

Ms. Davis is the founder and Executive Director of Sage Financial Solutions, a San Francisco Bay Area based organization that develops comprehensive financial capability programs for low- and moderate-income communities throughout the United States. She is a Financial Behavior Specialist (FBS®), and her philosophy of the financial continuum of care is a framework to promote the highest standard for professional services for all people, irrespective of wealth and income. Her volunteer efforts as a founding member, past president and current board member of the Financial Therapy Association, and as a member of Financial Planning Association Diversity and Pro Bono committees, have served to shape a more inclusive profession.

A certified mindfulness teacher, Saundra holds a B.S. in Management and an M.S. in Financial Planning from Golden Gate University where she is currently a Distinguished Adjunct Professor in the Personal Financial Planning program.

Rick Kahler, MS, CFP®, CFT-I™, CeFT® is a pioneer in integrating financial planning and psychology. Mr. Kahler is a founder of financial therapy and recognized for his pioneering work in that field by InvestmentNews in 2019 with their annual Innovator Award and in 2018 by the Insiders Forum with their annual Iconoclast award. He is a founding board member and Past-Chair of the Financial Therapy Association. In 2020, he became one of the first Certified Financial Therapist-Level I (CFT-I™) and a Certified Internal Family Systems℠ Practitioner in 2021. In 2021, he also founded IFS Informed Financial Therapy™.

BusinessWeek named him one of the top 15 most experienced financial planners in the nation and Investopedia as one of the 100 most influential financial advisors. He is a Distinguished Adjunct Professor at Golden Gate University and a past chairman of the South Dakota Investment Council, managing $6 billion.

He has been cited in scores of periodicals and news outlets, including ABC News, NBC, CNBC, Fox Business, The Wall Street Journal, The Times of London and The New York Times. He writes a weekly column on personal finance, produces a weekly podcast, Financial Therapy — It’s not just about the money and is a co-author of four books, including Facilitating Financial Health.

Emily Koochel, Ph.D., AFC®, CFT-I™ is an experienced financial professional, academic and researcher. She currently serves as a leader for eMoney Advisor’s Financial Wellness and Financial Education initiatives in her role as the Senior Financial Planning Education Consultant. Prior to her career in FinTech, she served as an Assistant Professor teaching courses in personal financial planning and working in the financial planning field.

Dr. Koochel’s Ph.D. in Applied Family Science and Master’s in Financial Planning provide a multidisciplinary lens to inform her work where she focuses on the impact of financial behaviors and financial backgrounds. She serves as a subject matter expert in the field, reviewing and authoring peer-reviewed journal articles, book chapters and contributing to public scholarship. Most notably, she has been recognized for her research on financial transparency, awarded 2020 Outstanding Research Journal Article of the Year by the AFCPE, published in the Journal of Financial Counseling and Planning.

She holds the Certified Financial Therapist – I designation, awarded by the Financial Therapy Association, and is an Accredited Financial Counselor, conferred by the Association for Financial Counseling and Planning Education.

Meghaan Lurtz, Ph.D., FBS™ is a Professor of Practice at Kansas State University where she teaches courses for the Advanced Financial Planning Certificate Program, a lecturer at Columbia University where she teaches Financial Psychology, and an undergraduate adjunct professor through the University of Maryland system in their CFP Board Registered Program.

Dr. Lurtz is also a writer and Senior Research Associate with Kitces.com, a financial planning blog. She is a past president of the Financial Therapy Association.

Her research interests vary as she studies both practitioners of financial planning as well as financial planning and financial therapy practices and interventions. Her research and expertise have been featured in Journal of Financial Planning, Journal of Consumer Affairs, Financial Planning Review, The Wall Street Journal, BBC, Million Dollar Roundtable and New York Magazine. She has also contributed chapters to CFP Board’s textbook, Client Psychology.

Megan McCoy, Ph.D., LMFT, AFC®, CFT-I™ works in the Financial Planning Department in the College of Health and Human Sciences at Kansas State University where she serves as an Assistant Professor and the Program Director for the Financial Planning Master’s Program. She is a licensed Marriage and Family Therapist, an Accredited Financial Counselor® and a Certified Financial Therapist-I™.

Dr. McCoy holds a B.A. in Psychology from The University of North Carolina and a M.A. in Marriage and Family Therapy from Drexel University. Dr. McCoy also attended the University of Georgia, where she earned a Ph.D. in Human Development and Family Science with an emphasis in Marriage and Family Therapy and a specialization in financial counseling and financial therapy practices.

She volunteers on the Financial Therapy Association’s Board of Directors and is the Associate Editor of the Journal of Financial Therapy. Dr. McCoy’s research focuses on financial therapy, financial self-efficacy, as well as diversity, equity and inclusion within financial planning. Her work has been published in both mental health and financial academic journals.

Lance Palmer, Ph.D. pursues engaged scholarship as a Professor of Financial Planning at the University of Georgia. He has provided in-depth experiential learning opportunities to more than 900 students and overseen more than 40,000 hours of client-facing service learning. Dr. Palmer’s service-learning students have worked with more than 10,000 individuals in-person or virtually and have made a cumulative economic impact of more than $20 million in Athens and other Georgia communities.

Dr. Palmer’s research explores motivating financial behavior change through brief intervention strategies. He develops brief interventions that are informative and scalable, and can be integrated into a variety of contextual learning settings, such as the income tax preparation process. These brief interventions are founded in Solution Focused Coaching practices, self-regulation and self-efficacy theory, and they borrow some elements from behavioral economics. The goal is to help individuals become emotionally connected to their desired financial goals in a positive and supportive environment. Ultimately, individuals have a clearer vision of their financial future, are motivated to achieve that future and have acted in a positive way that prepares them for their future.

Dr. Palmer was a founding Steering Committee member for the Academic Research Colloquium hosted annually by CFP Board and is a past president of the Academy of Financial Services.

Ron Sages, Ph.D., AEP®, CFP®, CTFA, EA is an Adjunct Professor of Personal Financial Planning at the University of Georgia, Athens, where he teaches in the Master’s degree CFP Board Registered Program. Dr. Sages served as an Inaugural Lecturer in Wealth Management at Columbia University in New York City during the 2020-21 academic year.

Prior to joining both academic institutions, he was an Assistant Professor of Personal Financial Planning at Kansas State University from 2011 to 2019, where he was a 2016 recipient of the GPIDEA Faculty Excellence. In addition to his responsibilities in academia, Dr. Sages is a Senior Investment Officer and Director of Financial Planning for Eagle Ridge Investment Management, LLC, a wealth management firm, based in Stamford, Conn.

A former wealth management entrepreneur for 25 years, including an additional 20 years of Money Center Bank experience, Dr. Sages earned his doctorate in Personal Financial Planning from Kansas State University in 2012 and his MBA in Finance and Taxation from the University of Connecticut in 1979. His research interests are in behavioral finance, risk management and financial literacy.

Neal Van Zutphen, CFP®, M.S. has been a financial planning practitioner since 1987. He founded Intrinsic Wealth Counsel, Inc., a fee-only RIA, serving clients through financial life planning guided by research in humanistic psychology and behavioral finance. He has devoted his life’s work to elevating the financial planner as fiduciary professional, promoting the benefits of financial planning to the public, and to deepening the connection between financial planning and psychological sciences.

Mr. Van Zutphen has served as a CFP Board Ambassador and was past president of the Financial Planning Association of Greater Phoenix. In 2010, he was nominated for the Heart of Financial Planning Award by his local chapter. He has presented at local and national FPA conferences. His research has been published in the Journal of Financial Planning. In 2019, Neal participated in CFP Board’s Client Psychology, Theory & Practice Group meeting.

He is a member of the Financial Therapy Association and an associate member of the American Psychological Association. He holds a Master’s degree in personal financial planning, a certificate in Financial Therapy, and he is a Certified Financial Behavioral Specialist.

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

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Chapter 1

Framing Advice in Light of Client’s Risk Tolerance

Swarn Chatterjee, Ph.D.

Dave Yeske, DBA, CFP®

CFP® Certification Principal Knowledge Topic

Client and Planner Attitudes, Values, Biases

Objectives

Learning Objective

Analyze a client’s degree of risk tolerance and loss aversion and ensure recommendations are consistent with a client’s risk propensity, attitudes, composure (e.g., past behaviors during market corrections), capacity, knowledge and needs.

Chapter Objective

Identify and respond to gaps between perceived and actual risk tolerance.

Chapter Synopsis

This chapter discusses the assessment of risk tolerance and loss aversion, while taking into account the risk propensity, attitudes, composure, capacity, knowledge and needs of a client. This chapter also discusses the importance of identifying the gaps between perceived and actual risk tolerance, and explores the key determining factors affecting financial risk tolerance. The seminal theoretical works that provide the background to the assessment and measurement of individual financial risk tolerance are also discussed. The chapter translates the concept of financial risk tolerance to explain how financial planners can use it in practice. Accompanying case studies illustrate how the theory plays out in practice. The rest of the sections in this chapter include definitions, description of the concept of risk tolerance, assessment of risk tolerance, applications of risk tolerance in practice and cases that help readers synthesize the information included in this chapter.

1.1 RELEVANT TERMS

Risk is defined as a situation where the future outcome of an event cannot be determined with certainty (Chavas 2004). Financial risk tolerance is defined as an individual’s willingness to make financial decisions under uncertainty with a specific financial goal in mind, and with some probability of loss. Other definitions of risk tolerance have also been used in previous literature. Boyer and Byrnes (2009) define risk tolerance as engagement in behaviors that include some possibility of negative consequences. Financial risk tolerance can also be defined as the maximum amount of uncertainty that an individual is willing to accept when making financial decisions that involve a probability of loss (Grable 2016; Cordell and Woerheide 2003).

According to economist Burton Malkiel (1996), people’s risk tolerance is constrained by their financial situation. For example, individuals’ ability to make risky financial decisions may be constrained by their financial resources including wealth and uncertainty of income. This constraint is known as risk capacity. Risk capacity can be formally defined as the extent to which an individual may be able to withstand the outcome of a financial loss resulting from a financial decision made under uncertainty (Cordell and Woerheide 2003).

Furthermore, Malkiel (1996) conceptualized there to be two components of risk tolerance. These were subjective risk tolerance and objective risk tolerance. The first component, subjective risk tolerance, is estimated using the economic concept of perceived risk aversion; and the second component, objective risk tolerance, is measured using individuals’ financial resources and income. Weber et al. (2002) conceptualized the