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Oec Magazin (A1-b)

Simulated Experience and Investment Decisions Following emotional instincts during an investment journey and questioning decisions along the way can be very costly. Recently-published research co- authored by Professor Thorsten Hens, Chairman of UZH’s Department of Banking and Finance, corroborates evidence that «simulated experience» can considerably improve investment decisions. James O.H. Nason Professor Hens, what was the background to your team’s research? The background was the financial crisis which saw many people losing money after buying financial products which they didn’t really understand. Then came a lot of regulation in which regulators decreed that among other things financial advisors must check the risk tolerance of their clients, that is how much money they have and whether they can sustain losses without aborting their investment strat- egy. This all looked nice on paper, but nobody knew how to do it in practice. We decided to conduct some experiments to try to discover an effective way of establishing a client’s risk tolerance. What did you do? We devised a sequence of investment decisions for volunteer «clients» to take. One decision they had to take, for example, was whether to invest in a simple financial product where the risk and pos- sible financial returns were described on paper, as they are in an investment prospectus. In a second phase, we didn’t describe the product but our «cli- ents» could sample the distribution of financial returns over several periods by pressing a button and getting a display. This way they gained knowledge of the distribution of returns over time and could then decide whether to invest in that product or not. We then compared investment decisions resulting from the so-called «description design» which clients simply got from a piece of paper with the «simulated experience design». And what were the findings? The most interesting finding was that partici- pants who gained simulated experience from sampling distribution of returns were prepared to take on more risks and that these riskier deci- sions were not regretted in retrospect. It seems their initial perception was that the probability of losing was too high; but having gained sim- ulated experience they were able to learn about their own risk tolerance and how to cope with losses and this translated into an increased risk appetite. Can simulated experience ever substitute for actual experience? Actual experience is of course much better, but it can be costly. Firstly, you can lose a lot of money before discovering your own risk toler- ance. Secondly, it takes a lot of time. I’ve been investing in the stock market for over 30 years so I eventually discovered my own risk toler- ance but the price was quite a few losses! Do automated investment services, the so-called «robo-advisors», have a future in making invest- ment decisions for clients? At the moment this is what IT companies think is the future and they are attempting to do all this online without a banker. Automated invest- ment services have picked up on our research and are using experience-sampling. I know of several banks in Europe which want to set up a fully-automated investment advisory service – not because they think it’s better for the client, but because it’s much cheaper for the bank! But we end up where we started – with regulation. If a bank comes up with experience-sampling as their method of assessing the risk tolerance of a client they will need the regulator’s approval. And since this is leading-edge research it will take some time until it is accepted by the regulator and eventually becomes the industry standard. «I’ve been investing in the stock market for over 30 years so I eventually discov- ered my own risk tolerance but the price was quite a few losses!» Prof.Thorsten Hens Thorsten Hens is Professor of Financial Economics and Chairman of the Department of Banking and Finance. Oec. Juli 2015 19 Oec. Juli 201519