CXO: Dealing with behavioral bias

About Essentia Analytics

Essentia's is a software platform that uses behavioral analytics to improve the investment decision-making process. By combining an investor's actual trade data history with data on the context in which investments were made, their technology identifies a fund manager's strongest skills and where he/she is prone to behavioral biases. With this feedback, as well as automated alerts when old patterns are resurfacing, the software helps professional investors refine their investment decision making processes, enabling them to optimize performance.

The global investment management industry faces many challenges. In this recurrent CXO Corner relay column, we ask top executives to point the way ahead, sharing their views and best practices for meeting the challenges.

Journal: Thank you for taking over the CXO relay from David Eckert, Managing Director and CIO, Neuberger Berman. To begin, tell us about your professional background before founding Essentia Analytics.

Clare Flynn Levy: I'm an American who ended up in London 20 years ago, starting off as a fund manager for the first ten years of my career. I was a tech specialist from day one, really just by virtue of being the first generation of kid to grow up with a computer in their room.

I ended up going native into the tech side when I took the role of president at Beauchamp Financial Technology. I learned quite a bit about the front-to-back office systems environment while I was there, and after we sold Beauchamp to Linedata, I spent some time on the business management side of Tisbury Capital, a European event-driven fund, then started working on Essentia, which is effectively the software I wish I had when I was a fund manager, and the software I wish our portfolio managers and analysts had at Tisbury.

Journal: That was a jump – from fund manager to entrepreneur – has it been challenging?

Clare Flynn Levy: It's been a roller coaster, but I wouldn’t change it for anything. I mean, in my opinion, in the finance sector and financial technology space as well, there are a lot of companies that don't put enough emphasis on company culture. Starting my own company has been an opportunity to run things the way I always wanted to, including creating a culture that operates around mutual respect, authenticity, excellence, and empowering people to do their best work.

Journal: Moving on to Essentia that you started up in 2013, can you tell a bit about the services you offer and why there is a market for these?

Clare Flynn Levy: Well, when I say that Essentia offers the software that I wish I had had when I was a fund manager, it’s because anybody who makes investment decisions for a living wrestles with trying to figure out how to do more of what they’re good at and less of what they’re not. I suppose we all struggle with that, but an investment decision-maker’s job is to turn information into decisions, and in a situation where you have limited hours in the day and unlimited information, it's crucial that you get that right, or as right as you possibly can.

Using a data-driven feedback loop to continuously improve performance isn’t a new concept in many industries, but in investment management, it’s taken the shift of assets from active into passive vehicles, among other things, to threaten the viability of human-driven fund management altogether and drive the industry to raise its game.

In my opinion, as an investment manager looking forward even on a 5 year view, you have two choices:  either pack up, go home and let computers make all the investment decisions, or try and do something about maximizing your competitive advantage as a human, by leveraging technology. People are starting to realize that technology is our friend in the investment process, not only when it comes to idea generation, but also when it comes to each step after that.

It’s this sort of technology that Essentia offers.  Our Essentia Insights product takes trade data and market data, then reveals patterns in a given investor’s historical behavior, quantifies their impact on performance, and alerts them when damaging behaviors are reappearing.  Our Essentia Note investment journal helps investors maximize the efficiency of their investment process and get into the habit of reflecting on the “why” behind their decisions.

Journal: In light of these efficiency gains created by machines, is there a future for human fund managers?

Clare Flynn Levy:  Absolutely. There are still aspects of investment decision-making that humans do better than computers, and although Artificial Intelligence is progressing, it’s nowhere near the point of replacing those aspects of humans.

There are still aspects of investment decision-making that humans do better than computers, and although Artificial Intelligence is progressing, it’s nowhere near the point of replacing those aspects of humans.

That said, there are plenty of aspects of investment decision-making, such as data gathering and pattern detection that computers can do faster and more effectively, so human fund managers who want to compete going forward are going to have to operate at a different level, and focus their energy where they have an actual competitive advantage, such as the judgment calls and decision-making.

Journal: You’re particularly interested in behavioral bias among fund managers. Where do they have these biases, and what are they doing about it?

Clare Flynn Levy: There is an increasing awareness of the concept of behavioral bias in popular culture, including in the investment industry. A lot of fund managers have either read something or been to a conference where it’s been a topic of discussion and they are intrigued, but they haven’t necessarily seen any direct way to apply the concepts to their daily existence until now.

Some make the assumption that behavioral bias is more of a problem for retail investors, and that professional fund managers are somehow exempt or less susceptible. The reality is that we are all hard-wired with bias, and while experience can lead us to be less likely to act on it, you can fast-track the gaining of that experience, and increase its precision, by using a data-driven feedback loop.

The biases we see most commonly amongst professional investors are to do with loss aversion, including the Disposition Effect (cutting winning positions too soon and running losers too long), the Snake Bite Effect (avoiding a given stock based on having recently “been burnt” by it) and the Endowment Effect (not constantly reviewing your portfolio with a clean sheet of paper).

Fund managers who are motivated to capture additional alpha by avoiding acting on bias haven't had many options beyond reading about it. Some firms have constructed investment processes that include bias mitigation factors, such as making a ‘devil's advocate’ view a mandatory step to avoid Confirmation Bias.

Journal: Or forcing them to sleep on the decision for a night?

Clare Flynn Levy: Yes, exactly. There are different steps you can build in, but doing so without actually measuring the efficiency of that process, iterating on it, and being able to prove that it yields superior results misses a major trick.

Journal: Interesting, so you've developed some ways that portfolio managers can deal with behavioral bias, but even if they find it exists, do they accept it or do they want to get rid of it?

Clare Flynn Levy: The first question they ask is “how much does it matter to my performance?”  You’ve got to choose your battles - especially when those battles are with yourself!  The next question is, “Is there something easy I can do to mitigate it?”  These people are too busy to remember to act differently of their own volition, so what we do is send them proactive prompts to capture their thoughts, and proactive alerts to call their attention to positions where familiar habits may be arising.

These people are too busy to remember to act differently of their own volition, so what we do is send them proactive prompts to capture their thoughts, and proactive alerts to call their attention to positions where familiar habits may be arising.

Journal: How much is mitigating behavioral bias typically worth to your clients?

Clare Flynn Levy: To date, we’ve been able to help each of our clients unlock at least an additional 50bps – and sometimes far more.

Journal: It sounds like there are more gains to be made here than from chasing new alpha.

Clare Flynn Levy: Absolutely. If you were given the choice between the potential of 50 basis points trying to predict what the herd is going to do next, or 50 basis points to look in the mirror and understand your own behavior so that you could tweak some processes ever so slightly to do a better job yourself, which makes more sense as a risk/return proposition? The rational answer is to work on yourself, first.

Of course, we know that people do not always act rationally – including fund managers. Our natural tendency is to focus on other people's behavior, not our own. Since the dawn of software, there have been behavioral analysis applications out there that look at market data and try to predict what the herd is going to do next. In my mind, there is lower-hanging fruit available:  You can't control what the herd does, but you can control what you do.  Taking an honest look in the mirror can be scary, but by improving your self-awareness and gaining more control over your own behavior, you can actually develop your investment skill, whether you’re already a star performer, or you’re just starting your career.

But the fear factor is real, and it’s something we have to confront.  At Essentia, everything we do is coming from a place of empathy, not judgment and not monitoring. I have been a fund manager myself and a lot of my team are ex-fund managers and practitioners from the buy-side – we understand our customers at a much deeper level than you normally find in financial technology. We see our job as helping human investors be the best versions of themselves.

Journal: Is it even possible to change some fund manager's behaviors?

Clare Flynn Levy: Of course, but they have to want to change their behavior. There are plenty out there who say, “I've been doing it this way for 30 years and I'm not going to change now." And if you think you've only got five more years left of running money professionally, or if you’re in a situation where you don’t really need to compete, then I can understand why you wouldn't want to mess with the formula.

But there are plenty of investors out there who actively want to be better at their jobs, and who recognize that the key to consistently strong performance is getting the process right.  For them, it's about identifying small, incremental changes, then having Essentia prompt them with a reminder or a bit of workflow that makes it easy for them to incorporate the change. We’ve found, for example, that it’s really important when you contact a fund manager, if you want him or her to act on something. If you let the user personalize the timing of messages, they do act on them. And gradually, they do start to change their behavior.

Journal: Social media analytics is another interesting trend in the industry. Can such data be used to learn more about behavioral biases?

Clare Flynn Levy: Sure – it’s a good way to show how biases manifest in decision-making across the market. Again, the natural instinct is to try to use social media analytics to “outsmart the market,” but that assumes that the person using the social media data isn’t susceptible to bias him or herself – and we know that’s a flawed assumption.

What I think is interesting is using this sort of data to reflect on how you behave when the rest of the market is behaving in a certain way.  The herd mentality is a powerful thing – you can use social media data to identify it in yourself, and resist it more effectively.

Journal: Thank you for your insights. To continue the dialogue, whom would you like to hand over the relay to in the next CXO Corner?

Clare Flynn Levy: I would like to hand over the word to Michel Bois, Chief Information Officer, member of the Executive Committee at CNP Assurances in Paris, whom I’m sure with his considerable professional experience will have some interesting things to say about what he views as the biggest challenges and opportunities facing the industry going forward.