Anxiety levels can also guide investment decisions

“If a question is unclear or vague, respond in the way that best reflects your feelings.”

This is an instruction one might expect from a women’s magazine, or a therapist. But a private bank?

In fact, private banks are increasingly turning to behavioural finance to understand clients’ attitudes to risk. Put simply, behavioural finance assumes investors are not rational. The easiest way of seeing this is through the psychology of buying and selling. Investors tend to buy when the market is high and sell when it is low.

The investment industry has long been aware that clients make irrational decisions. But a breakthrough came in 2002, when Daniel Kahneman won the Nobel Prize in economic science for his work on how people make decisions in uncertain conditions, combining the fields of economics and psychology.

Behavioural finance can help understand why clients make investment decisions. For example, wealth consultants noticed a trend among some clients in 2008 to move assets into one industry or sector – against advice to diversify. When they discovered these clients had made money as entrepreneurs in the sector into which they had moved their money, this impulse to ‘return to what you know’ was easier to understand.

Barclays Wealth, in whose “financial personality” questionnaire the opening line appears, considers itself a pioneer in the area. It asks new clients basic psychological questions such as whether they are easily stressed, and whether uncertainty makes them anxious – rather than just asking how much money they could stand to lose.

The bank appointed a head of behavioural finance at the end of 2006, and rolled out the technique at the beginning of 2008. It has been extended this year to clients in the US, the Middle East and Asia.

“What using only risk tolerance tends to ignore is that when we invest we’re not robots. I could give you the best possible risk-return portfolio, but if along the journey you respond emotionally to ups and downs you might be harming your own performance and swamping any benefits we’ve given you,” argues Greg Davies, head of behavioural finance at Barclays Wealth, who holds a PhD in behavioural decision theory from Cambridge University.

For example, two clients may have the same degree of risk tolerance – but one is more prone to stress than the other. This person is likely to monitor their portfolio regularly and perhaps make decisions during market swings. The other client may be more inclined to sit it out.

This influences what sorts of investments they should be in, says Mr Davies. The stressed client should be in more liquid investments, while the laid-back client can be in less liquid, more volatile investments.

Most private banks insist they use behavioural finance techniques, arguing risk questionnaires contain an element of psychology. But others claim the tools used are not rigorous enough.

“By and large they’re paying lip service to the term as it’s a nice buzzword,” argues Mr Davies.

This view is backed up by an independent wealth management consultant, who says: “Private banks have never really engaged with behavioural finance – there are very few that adopt it systematically and even fewer that invest in it.”

Most private banks in the UK stick to the categorisation approach – slotting clients into risk profiles of high, medium and low. They tend to focus on clients’ tolerance to risk, asking how they would feel about different levels of risk, as well as how much they would feel comfortable losing.

Other countries tend to branch out more. “The Americans tend to be way ahead of us in measuring risk,” says Richard McCourt, who leads the investment policy group at Fortis Private Bank. “When a new client is signed up in the US they get a risk tolerance questionnaire that touches on behavioural finance.”

The leader in its field is US wealth manager Guggenheim Investment Advisors – which boasts Mr Kahneman as a senior adviser.

There are a number of reasons why UK private banks may not implement full behavioural finance methods. Some fear the potential for complaints should two clients with the same risk profiles be given different portfolios.

Others may question how much clients value the method.

But Scorpio Partnership, the wealth management consultancy, has done research among ultra high net worth clients finding behavioural finance is valued very highly. “It’s a foundation in a long-term relationship,” says Graham Harvey, a director.

Some private banks argue they do not rely on risk questionnaires alone. “People say one thing when they’re filling in a questionnaire but in reality, when experiencing market declines, they feel something very different,” says Rupert Robinson, chief executive of Schroders Private Bank. “That’s what we try to work out.”