After the financial crisis of 2008, regulation has made the use of behavioral finance mandatory for large banks like Switzerland’s Credit Suisse and UBS. These and other institutions in Europe, together with many independent financial advisors, are employing the practical tools created by Zurich, Switzerland-based Behavioral Finance Solutions (BhFS).
Founded by three behavioral finance experts and professors at various universities in Switzerland — Thorsten Hens, Enrico De Giorgi and Dieter Niggeler – BhFS operates on the principle that the science of behavioral finance and its practical application in financial planning are inextricably linked in a continuing cycle.
“We use the income raised from the sale of our tools to feed our next lab experiments, which will in turn result in a new set of tools,” said Hens, who is the director of the Institute for Banking and Finance at the University of Zurich.
The result of that approach is a series of highly sophisticated tools based on in-depth and nuanced research in behavioral finance, which allows banks and financial advisors to understand their clients’ financial decisions in terms of a broad range of factors including gender and culture (Hens and his team studied the behavioral patterns and financial behavior of individuals in 52 different countries).
“Prior to the crisis, it seemed there was a belief that a customer in Switzerland is the same as a customer in China, but this is not at all the case for a number of reasons,” Hens said. “For global banks that continue to expand into new markets, it’s very important to understand the differences between different countries and cultures, as well as, of course, the differences between individuals.”
BhFS works closely with different institutions in Europe – and Hens is hoping that word will spread in the United States as well – to develop and implement a systematic investor profiling method that will enable them to create optimal asset allocation models for their clients.
The company offers three main tools: A diagnostic questionnaire that’s custom-made to fit a particular advisory process and is designed to identify the biases and preferences of individuals; a model that Hens likens to flight simulators used by pilots that figures out an investor’s definition of gains, losses and risks, and then builds a function that represents the investor’s decision-making process; and finally, a tool that determines a particular individual’s risk profile and allows for an advisor to create a portfolio that’s built for that person.
Behavioral finance identifies how investors see and evaluate their portfolios, Hens said. By applying those principles, it’s possible for advisors to build portfolios that give clients the most satisfaction. It’s important for investment advisors to clearly identify the risk aversion, risk preferences and risk perspective of their clients, and in this way, use a psychologically justified risk concept to meet investment goals. Finally, the investment strategy must be filled with concrete funds that investors can identify with to increase their commitment to the strategy – something that’s especially important during market downturns, Hens said.
Currently, his lab is working on a model that would allow financial advisors and investors to view risk in an interactive manner.
“Participants can push a button and a particular investment scenario is drawn and they’re given feedback on how they took their decisions,” Hens said. “We feel it’s much easier for people to visualize risk in an interactive way.”
Hens is also working closely with neuroscientists at the University of Zurich to see whether there may be biological reasons that make certain people more risk averse than others. This can be particularly useful for financial advisors, he said, “because if it’s revealed that risk aversion is biological and hard-wired into the brain, then there’s probably no way to change that person and make them view risk in a different way,” he said.
Hens got his Ph.D. at the University of Bonn, Germany, and he has held positions at the universities of Bielefeld, Germany and Paris, as well as at Stanford. He is also an adjunct professor in the finance department of the Norwegian Business School in Bergen, and he collaborates in the European Science Foundation project “Behavioral Models in Economics and Finance.”
Hens said he’s seeing a great deal of interest in BhFS’s methods (the firm also offers consulting services) and tools from banks in new markets like China and the United Arab Emirates.
“The younger an institution is, the better chance it has of using behavioral finance and really understanding its clients well,” he said.