Bridge over ocean
1 September 2015 CFA Institute Journal Review

Improving Investment Decisions with Simulated Experience (Digest Summary)

  1. Marc L. Ross, CFA

An experiment can permit investors to make investment decisions both without and with simulated experience. The authors discover that the latter leads to greater assumption of risk but without any loss of satisfaction in the event of unsatisfactory results.

What’s Inside?

Simulating investment experience educates investors about product risk and decision making more effectively than completing a risk tolerance questionnaire. This innovative approach to investor education leads investors to make greater risk-seeking investment choices without an increase in decision regret.

How Is This Research Useful to Practitioners?

The common practice among advisers of using questionnaires to educate prospective investors on the trade-off between risk and return and to link responses to investment recommendations is necessarily a less direct approach than having them undergo a simulated investment experience. But questionnaires fail to give the investor a true feel for the trade-off. The authors use a simulated investment experience to communicate the risk and opportunities of various investment choices. Critical insights from behavioral finance literature suggest that such an experience creates a better understanding of risk and return.

The authors conduct an experiment to determine the impact of simulated experience on investment decisions. A group of subjects had to invest in a group of financial products two times. The group included products with guaranteed returns (risk free), index products with some protection from losses, and fully indexed products with no downside protection. Subjects made their first decision after receiving verbal information and sometimes a supporting graphical illustration about the products’ return distribution. Before the second decision, subjects “experienced” return distributions via random sampling. This experience presented risk and return in a more relevant and observable manner. The authors then evaluate how the simulated experience influenced individual investment selection.

The authors improve on existing research because they apply a within-subject experimental approach that enables them to analyze the degree to which investors’ behavior changes in response to their experience. Additionally, they address potential sampling bias by having the subjects experience the same number of random returns to avoid a description–experience gap that has plagued previous experiments. Finally, the authors focus on selection of principal protection products on an individual basis rather than in the context of an asset allocation decision.

They find that simulated investor experience influences product selection. A significantly larger number of the subjects switched to a riskier product from the first to the second decision than switched to a less risky product. Financial planners and investment advisers should find the authors’ conclusion highly relevant to their investment practice. Simulated investment experience can permit investors to assume more risk but not to be as dissatisfied in the event of an unfavorable outcome.

How Did the Authors Conduct This Research?

The authors conduct their experiment with 535 students ranging in age from 18 to 45 years and from different academic tracks at the University of Zurich between 2011 and 2014. There are two phases to their experiment: a multipart base exercise and then a series of robustness checks.

The experiment itself has four phases. The first entails responses to questions on general and financial risk. Two binary lotteries regarding loss and risk aversion follow, which carry real monetary incentives. The next phase presents a verbal description of the underlying return index and then descriptions of five capital protection products in progressive degrees of risk–return trade-off measured against the S&P 500 Index. At this point, the subject selects one of the products to invest in. The subjects gain simulated investment experience in the third phase by sampling a fixed number of random one-year returns of the return distribution both for the index and the product selected. The final phase concludes with a demographic questionnaire and free response questions.

The subjects reconsidered their investment decisions significantly after undergoing the simulated experience. They tended to take greater risks that stemmed from a more direct alignment of product choice with risk tolerance and did not express decision regret after the fact. The test results hold up to numerous robustness checks for such phenomena as experimenter demand, order effects, recency effects, sampling bias, and information asymmetry.

Abstractor’s Viewpoint

Educating investors about the consequences of their investment decisions has been a longstanding challenge for financial educators and advisers. The authors’ attempt to bridge theory with practice and make the investment experience more comprehensible and relevant to the end user appears to be a watershed effort. Investors can make and experience informed decisions. How this methodology would hold up in different investment cultures could be an interesting topic for future research. Developing a program to make this approach an integral tool of the financial planning process would be a great leap forward in the practice of individual investment management.

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