Stephen Duneier and his new book "Alpha Brain." Stephen Duneier and his new book “AlphaBrain.”

If you want to profit from other people’s investing mistakes — and who doesn’t? — make a plan in advance. The brain is stuffed with cognitive biases — errors in thinking, like loss aversion — that undo investors but that, at the same time, create opportunities for others in the market, argues Stephen Duneier, CEO of Bija Advisors, in his book “AlphaBrain” (Wiley- February 2019).

The book provides a proven, systematic method for overcoming flawed, emotional decision-making that’s based on “gut instinct.” In chapters such as “Cerebral Junk Food” and “How to Stop Losing Money,” the veteran investment manager, 51, serves up his cognitive science-based approach with which Bija helps investors reach better outcomes.

ThinkAdvisor recently interviewed Bija senior advisor Jake Vincent, who edited “Alpha Brain” following a severe stroke that Duneier suffered in 2017.  He is continuing his recovery in rehabilitation.

Over a 30-year career, Deneier has scored kudos as a dynamic, popular public speaker. One of his motivational TED talks, “How to Achieve Your Most Ambitious Goals,” can be seen on YouTube.

Vincent, previously a hedge fund manager and sell-side strategist at Merrill Lynch and Credit Suisse, has a background in psychology and is a member of the British Psychological Society.

Duneier’s cardinal rule for investors: Don’t be reactive. Instead, be proactive by having a process and a trading plan set in advance, albeit one that’s subject to consistent re-analysis and is continually evolving, he writes.

Duneier started out as a broker with Drexel Burnham, then ran currency options trading at Bank of America and was managing director for emerging markets at AIG International.

Next, he developed a hedge fund into a $1.25 billion fund with average annualized returns of 20.3%. In 2012, he founded Bija consultancy, based in Santa Barbara, California.

The multi-faceted Duneier has raced cars, flown a helicopter, piloted planes acrobatically and is the artist known as YarnBomber, who has created large-scale installation knitted art on Santa Barbara mountain trails.

Here are excerpts of our interview with Vincent, who discussed the investing concepts and advice about which Duneier has written in “AlphaBrain: How a Group of Iconoclasts Are Using Cognitive Science to advance the Business of Alpha Generation”:

THINKADVISOR: Stephen Duneier writes: “We are prone to decision-making mistakes, and it’s those mistakes that make it possible for skill to exist in our industry. The only way to generate true alpha is to capitalize on the mistakes of others.” Please elaborate.

JAKE VINCENT: A lot of opportunity is created by relatively predictable behavior. As investors, we have to understand those mistakes and look for places where other market participants make them.

How can investors avoid making their own decision errors?

By having a plan for exactly how to make decisions, analyzing the outcomes and constantly improving the decision-making process, while taking out emotion and instinctive actions [generated] by the cognitive biases we all hold.

How do these biases — errors in thinking — impede investing success?

The idea is: How do you compensate for the flawed conceptions we make naturally, not thorough some error. It’s just how our brains work. How do we fight that? How do we make sure we don’t repeat them? The answer is: By making a process that constantly fights the errors our brain makes day to day.

How can financial advisors help clients overcome cognitive biases?

The most important message of the book is: Don’t be reactive because you’ll be even more prone to falling into natural cognitive biases. If you’re calm and logical and have a plan set in advance, that plan will be free of emotion.

How can that benefit FAs?

They’re able to say to clients who want to invest in [a certain company], for example: “[This firm] has been on the news a lot, but that doesn’t necessarily mean it’s a good investment. Those are two separate things.” If, say, the market is down 5% and people are calling their advisors: “Get me out!”, the advisor should be ready with a plan to help them. The point is to have a process for going about what kinds of trades you look for, which constantly evolves.

What’s an example?

You’ve analyzed the previous returns and have seen that you have a propensity to do a certain kind of bad trade on a Wednesday. So you put something in place that doesn’t let you trade on Wednesday morning. You’ll have an efficient, fact-checked and constantly re-analyzed process that gets you to constructive trades — and you’ll be disciplined about it.

“When real money is on the line, we are more likely to make worse decisions,” Mr. Duneier writes. Is that because we’re nervous at such times?

Yes. We make worse decisions under stress. One reason is that we’re more prone to cognitive biases then but don’t have time to check and double-check what we’re doing and think calmly. It’s all now, now, now! That elevates our fight-or-flight response, and we start making decisions for reasons that are different from investing. It becomes emotional.

What is Mr. Duneier’s and your view on short-term trading?

Very short-term trading is a gamble. You’re fighting people that have algorithms and automatic trading machines. You’ve got to think what your edge is trading short term. Our view is that there’s none currently unless you’re able to program algorithms.

Why is it so chancy to trade short term?

Some things have a very high probability of outcome in the end, but I can’t tell you what’s going to happen in the market over the next two weeks. Anyone who thinks they can is either a genius or a madman. But in the medium term, there are some things that become extremely likely if “X’ happens.

For instance?

You can set yourself up with a trading plan that says: If Trump gets impeached, there will be the following opportunity. You don’t need to predict that he’ll be impeached. You just say: If he is, these are the opportunities, and this is my trading plan. So you’re set and prepared.

Mr. Duneier writes that “the job of an investor is to predict the future, and predicting the future always involves uncertainties.” Please explain.

When you’re investing, you’re making a hypothesis on the future, which, by its very nature, can be wrong. So then it’s about what you need to do to be proven right, making sure you’re not trying to predict an unlikely future or one based on your cognitive biases, which are flawed.

For instance?

People tend to be at their very worst at predicting when they’re skewed by personal experience: Just because you use an Apple phone doesn’t mean you have insight into Apple or that it’s a good investment. Steve and I talk about using options to combat that [thinking] by maximizing the downside. The other thing is to trade less.

 

What’s one way to do that?

You’ve got to be aggressive when you find the right buy — such as structuring a trade that allows, for example, a five-to-one payout on a 50%/50% bet — but not get bored and tempted to chase whatever is exciting in the newspapers at the moment.

What’s the issue there?

It’s the struggle to separate the emotional from the rational. To use the Apple example again, someone may think, “I really like my phone. I want to believe in the company.” My view is that the danger isn’t that you invest in something you like; it’s that you’re irrationally attached to it. If you get to a point where you think you were wrong and should get out [of the investment] but your brain says, “Oh, but I still like the phone,” that’s impacting your trading decision, which shouldn’t be linked to emotion.

Speaking of technology, Mr. Duneier poses the question to readers: Will you be a victim of fintech — particularly AI — or will you be a beneficiary and able to capitalize on it to generate alpha? Please comment.

It’s not just having clever tools — it’s about how you use them and get them into your process. If you use fintech to help your process, we think it can be very helpful. But buying fintech because fintech exists is very dangerous, expensive and not likely to help at all. If you buy the wrong stuff, it won’t be helpful to how you’re planning to trade. If, however, you build it into the way you’re trying to create trading opportunities, it could allow you to, for instance, notice when bull markets do crazy things.

Do you foresee tech helping investors more with trading in the future?

Where fintech is dominant right now is in the really short time horizon, like today’s trading. Eventually, it will be [helpful] in the longer term as well, where the speed at which you enter a trade is far less important because you’re looking a year down the line vs. a week. But trying [right now] to fight AI and [other tech tools] that have faster processing speeds than you have, where speed really matters, puts you at a huge disadvantage.

How is Mr. Duneier’s recovery progressing?

It’s moving in the right direction, but these things take some time. If there’s anyone I’d bet money on to recover, it’s Steve.

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