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E v o l u t i o n a r iy a n c es o f t e nd e s c r i b e a s a b r a n c h f b e h a v f n i d o ioral finance, but University ZurichProfessor of Thorsten H e n si n s i s t s h a t e v o l u t i o n a rfyn a n c e t a n d s l o n e ." l f y o u t i s a " t h i n l <n t h r e ed i m e n s i o n s ,h e s a y s , t h e n t h e r ea r et h r e e i " t h i n g s : r a d i t i o n afIi n a n c eb e h a v i o r a iIn a n c ea n de v o l u t i o n t , f , ary finance." E v o l u t i o n a r yn a n c e s e se v o l u t i o n a rd y n a m i c ss,u c h fi u y as mutationand selection, study how tradingstrategies to and financialinnovations evolve. Why doesit get lessattent i o n t h a n b e h a v i o r a i n a n c e ? o ro n et h i n g ,i t ' sf a i r l yn e w fl F

and probablyfewerthan 5o peopleare worl<ing the fietd. in Foranother, math is extremely the sophisticated. A l t h o u g h t a l l m a ys o u n dt o o t h e o r e t i c a H e n sh a s i l, appliedhis behavioral and evolutionary research private to b a n k i n g n da s s e tm a n a g e m e n tn dc l a i m s x c e l l e nrte s u l t s . a a e But there'sno chancehe'l[ be going solo as a hedge f u n d m a n a g ea n y t i m e o o n :" l d o n ' td o t h e d a y - t o - d ab u s i r s y nessbecause not my sl<ill," says.But he certainly it's he r e l i s h e s i s r o l ea s a c o n s u l t a nitn E u r o p ea n d H e n ss e e m s h , to be mal<ing difference. a
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Critics have complained behavioral that finance to sinfails gleoutmarket inefficienciesadvance, providing in only after-the-fact explanations. ls there workin progress any thatmight change this?
I hope so, but one should never forget that the so,called null hlpothesis - the thing that has to be beaten - is thar you cannot predict the market in any way. Given that, I think there is some progress, because there are specific things that actually do work. There are some behavioral hedge funds, for example, that play very specific strategies,and they generate excess returns. For example, at Fuller & Thaler Asset Management they play on the earnings,surprise effect, in which the market reacts more to negative surprises than to positive surprises. There are other very specific things. A colleague of mine, Bill Ziemba in Canada, is playing on what is cailed probability weighting - that people care more about small probabilities relative to what they should. So he plays on what is called the favorite long-shot bias on stock options, and he does it verv successfullv What are some additional practicalapplicationsof behavioralfinance? I think one should make a distinction between asset management and private banking. Asset management has to do with understanding the market as a complex system, which I do in evolutionary finance. Behavioral finance is more tailored to the intuitive mistakes that you make when investing, and the most interesting area of application is private banking. Switzerland is a big place for private banking, righr? So a lot of people in the world give their money to banks in Switzerland. Then they have to find a way to allocate the money, not in the Swiss market but in the world market. Typical mistakes are that they don't want ro do a iot of planning. This is matched by the behavioral concept of hyperbolic discounting, where you always think it's better to start your diet tomorrow, so you keep postponing and postponing. People don't want to face the initial cost of the wealth management process. That is the first major mistake. The second mistake is there is a lot of misframing of the situation. Here, behavioral finance is useful because it can use balance sheets and personal asset4iability management to r e v e a lt o c l i e n t st h e m i s f r a m i n g . The third thing is diversification. There are so many mistakes that you make when you are naive and you try to diversify, and behavioral finance helps to point our those mistakes. Finally, people have difficulty holding to a srraregy. They change their mind every day or every week, and they basically go south in the market because they don't follow a strategy that has been proven to suit their risk ability and their risk preferences.

They point out the common pitfalls and show clients how to avoid them. Its quite a successstory, especialiy for Credit Suisse.In private banking in Switzerland alone, Credit Suissehas something like 100,000 clients, so you need a strucrured process; otherwise, it is totally arbitrary and the customers wonder what they are paying for. Where does evolutionary finance fall within the spectrum of behavioral finance? My point of view is you should distinguish between traditional, behavioral, and evolutionary finance. Maybe I am too stdct on this, but behavioral finance is tailored to individual mistakes and not so much to the markets. Evolutionary finance, on the other hand, is useful for assetmanagement because it takes an i.ntegratedview of interactions of strategies,not only individuals but also institutions - hedge funds and delegatedassetmanagement. Evolutionary finance looks at lnteracting strategies and not at individuals.

Whydoes evolutionary finance focus individual not on investors?

Becausethe logic of the market is that individual investors don't matter. Its psychologically difficult because you wanr ro see yourself in the model, but for the market, it only matters which strategy is followed by how much capital. If you look at the models, what you uncover pretty soon is that asset prices are not derermined by individuals; they are determined by cash flow between the strategies. ln the Darwinian view, what is going on in the forest is not determined by the individual fox and the rabbit but by the relarive proportion of foxes and rabbits.

Can evolutionary finance used complement be to traditional asset managementdoes takeits place? or it
It's a question of what you think traditional asset management is. If you think traditional asset management is doing mean-variance calculus and looking at risk factors, as in the capital asset pricing model, I'm pretty sure ir will take its place because the CAPM and mean-variance theory are based on cross-sectionsof returns. But evolutionary finance is based on time ss1is5- it's based on dynamical systems. lf you want to invest, in order to get returns, you have to understand the dynamical system you are acring in.

There a lot of information was about behavioral finance in theliterature, notmuch but about evolutionary finance. Whyisthat?
The main reason is because people think there is traditional fi.nanceand then there is "something else." People don't understand the difference between evolutionary flnance and behavioral finance because they already have difficulty understanding the distinction between traditional and behavioral. So, many of the results from evolutionary finance get sucked up in behavioral finance. My second guess is that the mathematics are not only new but they are also hard. I'm not a mathematician myself.

What yourrolein all of this? is

We have helped Swiss banks like Credit Suisseand Deutsche Bank Asset Management do a structured wealth management process, which is based on behavioral finance. They go through the process with clients from one step to the next.

I work with highly trained co-authors: a Russian mathematician and another mathematician based in England. So you n e e ds o m e i n v e s t m e nrt n t o i t . Would you expect that more people will begin to follorrv evolutionary finance as it becomes better known? I'm pretty sure about this. When we invited Daniel Kahnneman. winner of the 2002 Nobel Prize for behavioral finance, to give a presentation here at the University of Zurich, a student asked him about evolutionary finance, and he said that it is the future. And I'm pretty sure that he knows. The rest of us have to do something else, becausewe all want the Nobel Prize [aughs] and this does seem to be the future for asset management. How does evolutionary finance apply to asset management? First, you need to identify the set of strategies I was talking about. That's pretty easy because if you are an investment banker or a hedge fund manager, you may have tried many such strategies.So you make a list of such strategies:active and passive, distinguished by time hori.zons.

What were conclusionsyourresearch? the of

It does not naively depend on return. That was the first guess - that when a strategy has a high return, everybody jumps on the high return. But it depends more on the rank. When a strategy is ranked first, it gets more inflows. Ultimately, investors want to divide their money across various of those strategies, and then they take the best-ranked strategy. The first-ranked strategy will get more money next period. And if you understand what the fund is doing - and this is known because if they want to attract money, then they have to disclose in a sense what they are doing - then you can make predictions on a medium-term horizon. Back to the forest analogy: if we have so many foxes and suddenly the rabbits die out, we can do sort of a prediction. So last year was a good year for the Swiss market, not so much for the US market, and then you can imagine where the flows go this year. When you see the interaction of the strategies,you can guess lt. Of course, you need a lot of econometrics in order to find the correct values, but you can make some educated guesses. There are some successstories. The Duke of Liechtenstein

has a bank called LGT (Liechtenstein Global Tiust). We Then what's more difficult is you have to get some numhelped create a fund for him based on these evolutionary bers for the relative importance of those strategies.Fortunateprinciples. For five years now it has worked great. ly, we have some good data now from State Street on which trades have been done by which investors, so we can classify . Hpw does evolutionary finance relate to genetic algorithms? the strategiesby the investors and the wealth. Then, you try to calibrate the model so that it fits to . A genetic algorithm is one strategy to solve complicated optimization problems. There has been some strand of the literawhat you have observed. Finally, the more difficult step is to ture - Holland and others at the Santa Fe Institute - who period ahead - to look at the next week or the next go one thought maybe the mean-variance calculus is too simple and good results on a monthly basis but not so month. We have much on a weekly basis. So you have strategies,you have the wealth at any point in time, and then you have to figure out what you call the wealth-flow function: when does a certain strategy attract we should do some more sophisticated things, like genetic algorithms, in order to frnd the best investment strategies. But the problem with this is, as with traditional or behavioral j finance, it's only a partial view; it's only focusing on one class

of strategies now generated by genetic algorithms. more wealth than some other strategy? Evolutionary finance takes into account those strategies, This is quite well known, and its quite robust, actually. and they don't always do very well. They do better than We can observe this with hedge funds or mutual funds, for example. We have some nice criteria to see when one strategy . mean-variance, which we can observe and also prove mathematically, but it's only one ingredient in a pool of strategies of a hedge fund attracts wealth and when a certain strategy i n t e r a c itn g w i t h o t h e r s l r a t e g i e s . dries out. We did it in the laboratory as well to look at other flow functions - they look quite similar, pointing at a : "uni.versallaw" almost like those known in physics.



perspective, Working anevolutionary from MIT's Andrew hassaid Lo that"innovationthekevto survival." is you Would agree?
I think it depends a bit on the time horizon. lf you are a hedge fund manager - if you want to generate return over a shortterm horizon - you have to be verf innovative because it may just happen that your strategv is covered by others so that everybody jumps on it and ther-rthe excessreturns go away. But you should also keep in mind that if you are a different animal, you can do ven- clifferent strategies and they will always work. For example. \\hrren Buffett is doing simple things, and they alu,avs s orli. This is again similar to evolutionary biology Did lou knon that scorpions have been the way they are for more tl-ran-iOtl million years? They never change; thev are jr,rst goocl at ri'hat they do. Why has the role of delegatedinvestinglargely been i g n o r e di n f i n a n c e ? In the standard theor1,,there is onl,v one person who decides on evervthing as a representatir,eagent. It cannot build in delegated asset management, because you need at least one

How do found often anomalies in thelaboratory up end being exploitablereal-life in markets?

I onLy know the two or three successful behavioral hedge funds mentioned earlier. I know others who have tried to go directly from the laboratory to the market, but they basically wasted their mone1..The strength of laboratory research is that )rou can isolate the aspectsyou are interested in. But a real market is just too complex compared with what you are doing in the laboratory. I would be wary of betting my money on a partial aspect found in a laboratory experiment, because there may be a dozen other aspectsgoing exactly the other way around. I'm saying this even though I know my colleagueswill hate me for saying it, becauselt's so nice to say, "Look, we have found this in the laboratory, and now we'll go to Wall Street." flaughsl / Christina Grotheer is a contnbuting editor and an editorial consultant to CFA Masazine.

who delegatesand one who does the management. I think this methodology is total nonsense. becauseyou have to study the interactions of various decisions that are taken. A single representative agent just doesn't fit. If you look at what people in phl,srcs or biology are "moddoing, they would say what we are dorng are not really els." They would say it's a Mickey Mouse thing. Here at the University of Zurich, they have 20 researcherswith various backgrounds doing one model to study a very specific type of cancer that you get in your belly In flnance, we do a model on our ou'n and we maybe have two students helpi.ng us, so it's not a coordinated effort as in the natural sciences. I think n'e har.e to improve on this. We need to do more observations and computer simulatlons in order to get good models. The Iinancral market is even more complex than a cancer,though the rnathematicsis the same.That's why I met with colleagues{rom the cancer research,becausethey are also using random dynarnical s\'sterns- in this case. describing the relative speed of grorvth of healthy and cancerous ceils.

Whyfocus onefieldwhenyoucando two?Thorsten on Hens, professor the Institute Empirical a at for Research in Economics the University Zurich, at of is currently pursuing research bothbehavioral evolutionary in and (3o finance papers counting). and professor the Hens alsoserves an adjunct in as Norwegian Business School's department finance of in Bergen, Norway. the National At Center Competence of in Research, is thescientific he director Financial of (FlNRISK), Valuation Risk Management and works a as Center Economic for Policy Research fellow, collaboand project. rates a European on Science Foundation Having earned PhD his fromBonn University (Germany) r9gz, in Hens heldpositions several has at universities Germany, addition workin Paris in in to andat Stanford University.


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