October 2, 2019
Studying the properties and composition that make up the FinTech ecosystem
Welcome to this week’s industry analysis with the FinTech Chemist. A wise man once said, “What makes us strong as human beings makes us weak money managers.” That wise man happens to be Dr. Daniel Crosby, a behavioral finance expert. After years of research, teaming up with Brinker Capital, and financial advisors clamoring for a behavioral finance technology platform, he’s delivering Tulip. So, let’s find out what’s blooming in behavioral finance.
FinTech Chemist: Daniel, it’s always a pleasure speaking with you. I find this area of the industry fascinating. In layman’s terms, what is behavioral finance and ultimately, what's the case for saying that humans ultimately make weak money managers?
Dr. Crosby: So behavioral finance, my favorite sort of colloquial definition of behavioral finance, is finance that accounts for the messiness of human behavior. So many standard econometric and financial assumptions are modeled on humans that maximize utility – humans that always make the right choice. That's just simply not the case. And so behavioral finance is just sort of finance that accounts for the messiness of human behavior in terms of what's the evidence that people don't make great money managers. The most popular and probably the most controversial study out there is the Dalbar study. It's controversial because it shows the largest effect size. It effectively says that people leave half of the available returns on the table. Other estimates are smaller, but it's generally somewhere between 2 and 4%. I mean, every study that's ever looked at it shows that there's a delta between what the market gives us and what people actually take home. And the biggest contributor to that is human psychology.
FinTech Chemist: And what are some of the biases studied in behavioral finance? What are some that stand out to you which have helped you in your practice?
Dr. Crosby: Out of 177 biases in the space, I boiled it down to four in my latest book. And so those are ego, which is this tendency to be overconfident; emotion, which is the tendency to let our heart run away with our head, if you will, let our emotions run away with our logic. There's attention, which is the tendency for us to think something is more or less probable based on how salient it is rather than how mathematically probable it is. So salience is this psychological term, which means basically how easy it is to recall or imagine something. My favorite example is shark attacks and selfies: 50 times more people die every year taking selfies compared to shark attacks, and yet people are scared of sharks and not scared of taking selfies because it's easier to imagine Jaws than it is for you to imagine drinking too much and stumbling into the road trying to take a selfie, right? Jaws is more salient than you just being a doofus. And so that's an example of attention or salience. And then the last one is conservatism, which is just this broad tendency to be loss averse, risk-averse, and have a preference for the status quo – not wanting to rock the boat, not wanting to lose, and not wanting to get outside of your comfort zone. So ego, emotion, attention, and conservatism are the big four that I've pinpointed.
FinTech Chemist: That’s a great analogy! Shifting it back to the financial advisor, I'm sure folks come up to you all the time asking for advice on how to manage unpredictable clients. How do you help and coach advisors to adapt and utilize these behavioral finance principles? Where does the advisor ultimately fit into all of this?
Dr. Crosby: An advisor really needs to do three things if they have any shot at changing behavior, and it's three Es. The first one is education. We need to make the clients aware of what the right behavior is. We need to teach them some sort of basic, simple truths about capital markets. My favorite example of this: in 1993, we started putting nutrition labels on all of our food. And since that time, America's gotten twice as fat. And so if education were enough, we would just pick up the Pop-Tarts and go, "Oh, nevermind. These aren't good for me," but we don't. Education is not enough.
The second thing we need is the right environment. Your environment is actually a much better predictor of how you're going to behave than your education is, so we need the right environment, which in the case of a client is the right portfolio, right? We need a portfolio that we can live with, and behavioral finance would teach you that the right portfolio is not necessarily the one that's mean variants optimized. The right portfolio is the one where the client can take the ride. There's this great study about the best performing mutual fund of the 2000s got like 18.5% a year, and the average client in that mutual fund had a negative real return because they couldn't take the ride. It would shoot up. Everyone would hear about it; they would pile in, it would go back down, everyone would freak out and jump off; they'd sort of rinse and repeat, so you need the right environment. Your portfolio is only as good as your ability to stick with it.
And then the third thing is the encouragement – just-in-time encouragement, so that when your education fails, when the portfolio is still freaking you out, despite your advisor's best efforts, you need someone to stand between you and your money and say, "Listen, I'm not going to let you blow yourself up." So education, environment, and encouragement I think are the three jobs of an advisor.
FinTech Chemist: And then what about technology? How is technology ultimately aiding in this movement to better understand behavioral finance?
Dr. Crosby: Well, I would say it hasn't done much! The survey I cited at Wealth/Stack was from the financial planning tech survey in 2017. They asked advisors, "What are the top technologies that will impact advisors?" and the number one answer, about 30%, was behavioral finance software. And then they asked advisors what tools were they using today, and 0% said behavioral finance software. So it's been very much this thing that we've been anticipating but haven't had access to. And so the one thing I will say is that simple things like auto withdrawal, right – like auto-withdrawal and auto-escalation – the simplest technology in the world, has a huge behavioral benefit because it lets you take that natural tendency towards status quo, propensity towards status quo and laziness and just kind of lock them in for your benefit, so little stuff like that can have a huge impact. But in terms of proper behavioral finance technology, we haven't really had it.
Ironically, a lot of the things that technology has enabled makes people worse investors. We can now trade now with ease: it's cheap, it's easy, we have tons of liquidity, we have tons of visibility, and we can see what our stocks are doing tick by tick every moment on our iPhones – and none of that is good for investors. It's one of those things that everyone wants, and no one needs. Things that are ostensibly good, like the ease of transacting business and transparency & liquidity, can actually be quite bad for people because: research. Meir Statman did research in 19 different countries, and he found that in every single country he studied, the more active people were where their accounts, the worse their performance was. And so all of this, clients are happy to have it, and they shouldn't, so it's tricky. I think tech has inadvertently made us worse behavioral investors in a weird way.
FinTech Chemist: That's really interesting. So that brings us to Tulip. What is it? How are you hoping the industry will use it? What are you hoping to accomplish ultimately?
Dr. Crosby: It's a gamified simulation of markets that gives deep behavioral analytics about the client's behavior. We start at the very beginning by just basically asking people to live through 30 years of real market history. They enter their account information, how much money they have to invest, we ask them a couple of questions about their risk preferences so we can allocate that relative to their risk preferences, but then they lived through 30 years of market history that includes everything from news updates about political headlines to comparing their portfolio to the S&P, which everyone does, unfortunately, to living through the highs and lows of a market and along that way, they make decisions about what to do with their portfolio, and we get a lot of great behavioral analytics on this. The reason we do this is surprisingly simple. One of the first things you learn as a psychologist is that people are really horrible, and I mean horrible predictors of their own behavior. You ask someone, "What are you likely to do in the event of a 20% market drawdown?" People will tell you, "Oh, well," they'll tell you the socially desirable thing, which is, "Well, I know that I should be buying them, right? I know that I should be staying the course. I know that that's a buying opportunity in the long-term." Well, what they tell you and what they actually do when their money's on the line are very different things. So what Tulip does is it doesn't ask people what they're going to do. It just puts them in that simulation. It puts them in that situation rather, and then just observes what they actually do. This self-reported preferences versus revealed preferences is by itself a big step forward for measuring client behavior. I read a study this week that talked about observing classroom behavior, and they asked teachers to report on how much young boys and girls had contributed to the class. And the teachers on average said the girls had contributed slightly more than the boys. The actual classroom interactions had been observed and a physical tally of every time a boy made a comment or a girl made a comment was kept, and the boys made three times more comments than the girls. We all just view the world in a biased way. We view our own behavior through the most biased lens of all, and so we believe in just putting people in the right situation instead of asking them how they'll respond in that situation.
FinTech Chemist: So what are your plans for Tulip as it starts to grow up? What does success look like to you for this platform?
Dr. Crosby: Success for us is going to be saving clients money by minimizing the behavior gap. We are actually working on a specific dollar figure now that we want to save clients. Because if you think that clients give up anywhere from 2% of their returns per year to 4% of their returns, if we can begin to shrink that gap with thousands of advisors times millions of dollars, that's a real benefit. That's really keeping dollars and cents in people's portfolios by managing their behavior. But they will then have to take a trip to see the grandkids or buy food or whatever. And so that's going to be our goal: minimizing this behavior gap and keeping real dollars in people's pockets that they would have otherwise sacrificed to fear and greed.
FinTech Chemist: What has the reception been like?
Dr. Crosby: The reception has been so dramatic. This is just an example of pent up demand really – pent up demand for something that the world has needed for a long time. Going back to those three Es, there's an educational component, so Tulip will educate your client about their own behavioral biases: their own propensity to make certain types of mistakes, their own strengths, for that matter. It solves the environment problem by telling them what's a portfolio that would fit that you can live with, that'll get you to where you want to go without bucking you off, as it were. But the coolest part is the encouragement piece: when we encounter market conditions in realtime that are analogous to the ones that gave a client a problem in the game, we send the advisor an alert that says, "Hey, you might want to call Mr. Smith and check on him because this type of volatility. This type of drawdown, this type of whatever, tends to give him a hard time and this is a time when you can add value by encouraging him, and this is what you ought to say." Going back to those three Es, I think that Tulip sort of solves this problem holistically. But for me, the coolest part is that encouragement piece, because I don't know if you ever saw Minority Report, but it's like this concept of pre-crime, right? We're going to head you off at the pass for making a mistake before you make it. And that to me is super cool.
FinTech Chemist: That's incredible! Where should I send people to sign up if they want to be part of the beta program?
Dr. Crosby: www.TulipAdvisor.com.
People aren’t always rational, but with Tulip, investors can now look before they leap. Now, onto my next scientific… I mean FinTech hypothesis adventure. And, as always, remember to take your vitamins!
Read the previous edition of The FinTech Chemist.