OK, we’ll be far outnumbered by our North American colleagues, but there will be a small British contingent at the Evidence-Based Investing Conference in New York City on November 15th. Among them is Clare Flynn Levy, whose firm Essentia Analytics uses machine learning technology to help professional investors to identify behavioural patterns which are likely to have a detrimental on their returns.
Behavioural finance is a fascinating subject. Understanding the intricately complex connection between behaviour and returns and, crucially, applying the lessons learned, are in my view a very important part of the evidence-based approach to investing. In this interview, Clare explains how technology can help all investors — professional and otherwise — to achieve better outcomes.
What are you going to be speaking about at the conference?
I‘ll be speaking about the extent to which technology can help investors stop being their own worst enemies.
For those who aren’t aware of Essentia Analytics, what exactly does it do?
Essentia uses machine learning technology to identify behavioural patterns in a given investor’s trade history and translate them into intelligible, actionable insights. Our technology then “nudges” the investor when it thinks he or she may be repeating the same detrimental patterns.
When we talk about behavioural bias, we’re normally thinking of retail investors. But your experience is that professional investors can be just as prone to those same biases, right?
Yes, that’s right. There’s no reason to believe that behavioural bias only affects retail investors — it affects all humans, to a greater or lesser extent. In professional investors, whether they be fund managers or indeed investment advisers, bias has a direct cost that undermines the fees that are being charged.
Of course active funds have been having a very difficult time outperforming their benchmarks. How big a part do you think manager behaviour has played in that? And what’s the answer?
The only thing that a manager can control is his or her own behaviour. So if you believe that there is any skill at all involved in investing (and I do), then a manager who wants to outperform the benchmark must focus on maximising skill. That requires maximising returns to the investment process, and minimising the impact of behavioural bias. The average fund manager simply hasn’t been doing that — they (like everyone else in the industry) have been caught up in chasing the outcome, rather than focusing on the process. I believe that there is scope for a smaller number of highly-skilled, process-oriented managers to outperform benchmarks.
You recently said that the fund industry needs to go into “centaur” mode — combining the strengths of man and machine. What does that look like in practice?
“Centaur” mode means recognising what computers do best — crunching vast quantities of numbers — and letting computers do that. It also means recognising what humans do better than computers: making judgement calls. If you use technology to tee up decisions to be made, and let the human actually focus on making the decisions, you get the best of both worlds. What Essentia does is use technology to tee up decisions to be made based on our understanding of how and in what contexts you make your best and worst decisions.
Can technology also help ordinary investors to be more disciplined?
Yes, although that is harder because they typically make fewer decisions, those decisions are often driven by things other than market values, and they tend to have less rigorous processes for making them. An intermediate step might be to help investment advisers to be more disciplined — after all, the academic research shows that they commit most of the same errors with their own money that retail investors commit on their own.
Finally, what would your advice be to ordinary investors when they feel their emotions starting to get the better of them?
The best practice is to spend time crafting a plan, before making any investment, that says what you will do if a variety of different scenarios occur. Then, when emotions inevitably do arise, acknowledge them for what they are. One of the worst mistakes that any investor can make is to think that he or she is immune to emotional decision-making. But rather than acting on the emotion, refer to the plan. What did you say you would do in this situation? Your emotions are providing you with useful information that it’s worth noting down, but the key to success is sticking to the plan.
Why not join Clare and other industry thought leaders like him at the Evidence-Based Investing Conference in NYC on November 15th? To register, follow this link.
In the meantime, here are interviews with some of the other speakers and panellists: