RICK BENSIGNOR: Most investors and even professional portfolio managers do not have tools at their disposal to help them get out of markets.
CLARE FLYNN LEVY: People that just trade on intuition are going to lose all their money. The best I've seen is people who start with intuition and do the research.
RICK BENSIGNOR: Today, I'm joined by two guests, Clare Flynn Levy, and Brett Whysel. Clare is a FinTech entrepreneur, and the founder and CEO of Essentia Analytics. She has a bachelor's degree from Barnard College and also spent some time at the London School of Economics. Brett Whysel is the founder of Decision Fish. We'll talk about what that company is, but it's very apropos to what we're going to be talking about today. He has a degree from Carnegie Mellon in Economics and if I'm not mistaken, French as well as a master's degree. As well as a master's degree from Columbia University, in- remind me.
BRETT WHYSEL: Philosophy.
RICK BENSIGNOR: Philosophy. Very good. It actually is what. Now, I'd known Brett for- I don't know- close to two years, I'd say.
BRETT WHYSEL: Feels longer.
RICK BENSIGNOR: Yeah, much longer. And what I was going to say is he has a wickedly good sense of humor, which you can start seeing already. So we should have a lot of fun as we discuss what. Well, today's a conversation about something that the three of us have a passion for, and in many ways, our lives and our professions revolve around it. It's the area of behavioral finance.
Now, this is a very hot topic, especially on Wall Street and academia. In the last 15-20 years, we've seen a bunch of Nobel Prize winners in the areas of Behavioral Sciences, specifically towards economics. Starting with Daniel Kahneman, in probably 2002-2003, I believe he was the first to win combining psychology into the field of financial decision making. And then followed by several years ago now, Robert Shiller from Yale, and most recently in 2017, Richard Taylor, from the University of Chicago.
So I want us to have a very relaxed conversation today, this is not going to be a formal interview, this will be the three of us talking about this subject matter. And the goal of having real viewers, Real Vision viewers, be able to get a better understanding of what this topic is, and why it's so frequently discussed now, especially on Wall Street. So before where we get into the depth of it, let me just give a little background on each one of you. Clare, you are CEO of this company called Essentia Analytics. What is that?
CLARE FLYNN LEVY: Essentia is a software company primarily, but what we do is help human investors make measurably better decisions. And by human investors, today, we mostly work with professional fund managers who make decisions day in and day out, usually as evidenced by trades. And so we analyze all that trade data as a starting point to understand patterns in decision making behavior. But actually, as our clients get deeper into the site, this process of a continuous data driven feedback loop on their decision making, we get into capturing their decisions not to trade as well, which sheds an entirely different light on how you spend your energy as a fund manager.
RICK BENSIGNOR: Brett, you yourself have been a banker on the street for many years. And then left banking, as you call it, you're a recovering banker who has shifted now towards both teaching and also starting your own company, Decision Fish. So tell me about where are you teaching now? What are the courses that you're teaching as they apply to this conversation?
BRETT WHYSEL: Well, I'm teaching at the Borough of Manhattan Community College. The classes I'm teaching coming this fall are Intro to Finance, Corporate Finance and Managerial Decision Making. Also, I am teaching at City College classes in Economics for Public Policy, as well as Service Design Thinking Capstone.
RICK BENSIGNOR: On issues, how many have you worked closely with portfolio managers, and I suspect that you get a decent amount of pushback from potential clients as you're talking to them about what Essentia does, to the point that they probably say, oh, I'm just fine at what I do, I don't need any help. I'm a very solid money maker each year. I don't need this stuff. And that almost itself is one of the biases if we think of confirmation bias, this is someone who themselves is just simply looking for information. So they're taking their own success, and saying, I don't need help.
And I've got to think that you run into this a fair amount that PMs have some sense of an ego, and they have this role that they're managing, whether it's small millions, or hundreds of millions, if not billions of dollars, where they go, like I don't want you to look into me, I'm just content the way I am. And yet, you probably can help them increase their returns if they would just open to the idea of being looked at and evaluated, that's probably very scary to them.
CLARE FLYNN LEVY: It is self-selecting. The people we work with, 30 different institutions around the world and it's not every single PM within any given institution. So usually about 20% I think, that's like finger in the wind. 20% of PMs on any given team who are up for this and buy up for it. In my experience, there's a certain type of person that's either a Fitbit wearing, continuous improving triathlon participants type of person who's just like, they have all the apps for their cycling, and they have all the gear for other parts of their life. And they totally believe that data analytics can help you perform better because they've seen it in that side of their life.
BRETT WHYSEL: The optimizers.
CLARE FLYNN LEVY: The optimizers. I call them the continuous improvers. And then there's the behavioral finance enthusiasts, who are usually CFAs. They're more the studious side of the equation. Sometimes it's the same person, by the way, but we hone-in on those people, because we know our hit rate is much, much higher with them than going around to every PM on the street and saying, would you be interested in this?
I make decisions on how to allocate my energy. And if I sense that you're the type of person who's just going to say, yeah, but, yeah, but- I'm very good at what I do, I'm not even going to go there. Because my view is, you may well be very good at what you do. I don't know, because I can't see the data. I don't doubt your institution has made you feel that you are very good at what you do. And hopefully, your performance has been what's caused them to do that. But I don't think you're going to be running money for much longer, which is a punchy thing to say. But this is where the world going.
Data analytics on everything is the way it's going. And data analytics on investment decision making- the investment management industry is leveling up in terms of professionalism in lots of different ways and responsibility towards clients and all of that. But the first responsibility is to be the best fund manager you can possibly be for your clients and make the best possible decisions you can. And so I think more and more firms are going to force that issue, this is going to be how they do things. And the people that don't want to do it, they might not get fired, but they'll age out of the system. The next generation of fund managers is already all over this. They think it's funny that those old guys don't want to do it.
RICK BENSIGNOR: Yeah. Look, I don't know, 30 years ago, there was no such thing as a behavioral finance course at a university. Now, more and more universities are teaching them. As I said, I taught at NYU for years. It is a growing field. So younger people who are recent grads have at least been exposed. I often do lectures, presentations, conferences, and I'll say to them, how many of you guys have been exposed to behavioral finance, you have some idea of what it is and have had some training in it? And it's a fair amount of hands compared to that same question even five years ago.
So it's definitely growing and younger people are being exposed to it. Most portfolio managers, I'd say probably on the mutual fund side of the industry, I'm guessing here, I don't know this, for sure. But I'd say there's probably a good chance there, at least, on average, 35 years old to 65 years old, and probably had no chance to have been exposed to this unless they took the initiative themselves to hear what's going on with Wall Street, and what is this hot topic everybody's talking about?
But in general, I think they've probably- it's much tougher to get somebody who's a 45-year-old, who's been doing this for 10 plus years, to say, okay, let's go through the last thousand trade ideas or investments have put on and analyze them with real analytics to tell me where are my mistakes and what do I keep doing wrong, because I think if I'm not mistaken, Essentia is probably the most successful firm on the street that does this. And it takes the portfolio manager or somebody above to say, hey, we want to do this. We want to make our PMs more successful. We'll put the investment into it, because it should pay off over time. If we can even increase returns by 50 basis points, that's huge. And a lot of people don't realize that. But when you're running money, that's significant amount of a change in performance.
CLARE FLYNN LEVY: And the crazy part is you can improve by 50 basis points. So there's low hanging fruit in a world where having an advantage for having better information or for being smarter than everyone else is pretty hard to do in this day and age. But you can have an advantage by knowing thyself better than the other guy and actually watching your game tapes and doing what an athlete would do. That's how they win. So as you're saying, I'm thinking, why would anyone not do that? It's so crazy. But that's the beauty. If you are willing to do it, you're in a minority and there's a massive advantage to be had.
RICK BENSIGNOR: So in the field of behavioral finance, there are dozens and dozens of well-known documented biases that people have. Let me start with you, Clare, what are the ones that you find in the portfolio management world? What would you say are the three or four most common ones that you come across that's just by and large, most PMs have?
CLARE FLYNN LEVY: Well, we're looking for behavioral patterns, and then we're connecting those to biases and a given pattern might connect to lots of different potential biases. And you know the literature as well as I do, there's a lot that's related to loss aversion, lots of sub-biases that are connected to loss aversion. And that loss aversion is the biggest one that we see evidenced of in people's behavior. And it's often about how they behave when a price is going against them, as opposed to whether the position is losing them money. It might be currently losing you money, but you might be still in the black.
But people have a tendency to hold on while price is sliding well beyond the point where rationally they should cut and run. And we do lots of back-testing to see what is that point for each individual, at least historically. Now, what we're not doing is saying to people, therefore going forward, you should always cut positions when they have fallen by this much, here's your stop loss. I'm all for stop losses. And if they want to play this, it's great, we can help them with that.
But really, all we're trying to do is say in the circumstances where price is on the slide and that might be going on for months, the slow bleed situation where you don't necessarily even realize that you're dying on the floor because it's been one drop, one drop, one drop. That goes on a lot. And if we can help your brain take the decision, or at least the review of that position from being a System 1 decision, we're not really thinking about it at all, you are implicitly making a decision to hold on by not doing anything. And turn that into a System 2 decision that's very deliberate, where you actually go through your investment process.
And so what we do is having held up the mirror and said to you look, you have a tendency to do this in these situations. Now going forward, we're going to ping you a little- we call them nudges, just a little email. A nudge. It's going to happen whenever one of your positions is doing that. And it's just going to ask you some questions. And those are going to be questions you told me you wanted to ask yourself at this point. So it's your voice, it's like your future self has your back as it were, and technology is what makes that possible.
And that is what gets people to earn the extra basis points. It's not showing them the analysis, because you can't show people analysis 'til it blew in the face. It's interesting, but they go back to their desk and do what they do. If you can nudge them at just the right point to follow their own investment process, not tell them what to do. Turns out, they are amenable to that and they will follow their investment process. And their investment process usually is pretty good. What we can measure what are the outcomes of the decisions they make when they have been nudged versus when they haven't been nudged. And it's markedly better in terms of hit rate and in terms of payoff.
So that's been very, very successful around loss aversion. Another one that we've just been doing some really interesting research around is alpha decay. You could call that endowment effect, maybe, but it's about holding on past the sell by date. And it's not that the stock is necessarily going down. And maybe it's still going up, but it's not going up as much. The alpha accumulation isn't as rapid anymore as it once was. And when we analyze all of the ideas you've ever had, we may find that your prime alpha generating time is the first 3 months of a position's life. But your tendency is to hold on for 9 months or 4 months, or whatever it is.
So again, we can nudge you and say here are the positions that are 3 months old. Again, here's some questions you said you wanted to ask yourself to help you decide what to do next. And maybe you double up or maybe you just sit tight, it's up to you. But historically, this is when that capital would be better used towards something else. So again, that one really does help to change behavior, because a portfolio manager is not thinking about how old is my idea, and other thoughts, something that people typically monitor.
RICK BENSIGNOR: So the nudge is to you have it like the kicker here, it's making a portfolio manager wait, or you've done this before, here's what's happened when you've done it before. Nudge, you may want to think about altering your behavior based upon past results.
CLARE FLYNN LEVY: Just like do your process. You intend to do your process, you say you do your process, but you're a human being. And we all know that under certain circumstances, we don't follow our process.
RICK BENSIGNOR: No, I myself right now, I have one position on that I know, really, it's much harder for me to justify why I'm still in it. And so at least having done this myself and coaching others, I'm conscious of it. And I'm very close to kicking it out. But I think the nudge is really important. And that makes me turn to you, Brett, and think about in the world you're dealing in both on the academic side and then the target audience in Decision Fish, you had written an article for Forbes, that-
BRETT WHYSEL: Forbes.com
RICK BENSIGNOR: Forbes.com, not the actual magazine, forbes.com. That talked about, essentially, all individual investors create negative alpha, and that it's our own mistakes. It's the frequency of trading that hurts us more. In fact, there was some study done- I don't remember who it was- that said the most successful accounts on Wall Street, individual accounts, are from people who virtually forgot that they had invested years ago into some mutual fund or something when they were at a company. And because it's just grown over time.
BRETT WHYSEL: Yeah, I think that was Fidelity. And I think the finding was that accounts whose owners were dead.
RICK BENSIGNOR: Well, that's probably what it was.
BRETT WHYSEL: We're talking retail accounts. And I put wasn't that everyone has negative alpha, of course, some must outperform. But yeah, there's certainly a lot of stimulus out there that can cause us- and biases in here that can cause us to trade poorly. And I think the point of my article is that most people just should not try, myself included.
RICK BENSIGNOR: Yeah. Look, I'm in Wall Street almost 40 years now. And many years, I was a pit trader back in the days that commodities markets actually had pits. I've been trading a long time. I managed some money now, too. And there's always the battle that you have between trading often or letting stuff ride or something that I've made money on, at what point do I kick it out and say, I've made enough and it's not likely going to continue generate at the same level it has, which is similar to what you've seen said, essentially, dwindling alpha return, and it still may be outperforming.
But is there something that I can go and switch it into, but you have a cost to sell, there's potential tax implications. And then to get into another investment, you have a cost, whether it's commission or whatever it is, to go into something else. So there's always the question of is overtrading a killer or is it something that people should be doing? Not overtrade, but let's say-
CLARE FLYNN LEVY: Trading a lot. One of the analyses we do is about do your adding and trimming decisions actually add value? And I have seen people for whom they do add value. They're in the minority. It's not that common to see but some people actually are very good at it. And most people are not very good at it and destroy a lot of value. And myself, I suspect included, I'm I don't have any of my past data, sadly. But I know that every summer, everyone else would go to Saint-Tropez, back when I was based in London, the entire hedge fund industry would pack up and go to France, and I'd sit in my office bored, nothing's really going on. I guess we'll trade, like eat your fingers, are a real thing. And a wasteful one.
RICK BENSIGNOR: Most investors and even professional portfolio managers do not have tools at their disposal to help them get out of markets. They're much