Over the past two weeks, I’ve explained how automated investment services, or “robo-advisors,” are generally wired.
Today, I’m tackling what the real problems are with robo-advisory services – who should use them, and how not to get crushed when they go haywire.
Depending on what theories and math robo-advisors are wired for, they construct a “personalized” portfolio based on forms you fill out online, and they automatically rebalance your portfolio when threshold weightings of positions in your portfolio get out of balance.
And that’s precisely where the issues begin…
Ghosts in the Machine
The first problem with these services starts there, in their construction of portfolios.
They are personalized- but only to the degree that you fit into a model that fits thousands or hundreds of thousands of other hopeful investors. So, don’t count on your portfolio being different to the point where you believe it’s immune from what anyone (or everyone) else might suffer through if markets blow up.
Generally, you’re put into “passive” low-cost indexed ETFs. Investors plowing in larger sums at some services, like Wealthfront, can have a combination of individual securities and one or two “completion ETFs” to track an index.
If you’re investing 100% in U.S. equities and expect robots to diversify you, they will… but they won’t.
The bottom line is, no matter how robots break up your funds- whether they put you in several big index ETFs tracking the likes of the S&P 500, the Dow Jones Industrials, or the Nasdaq- you’re essentially correlated to the market.
Robots can put you into large-cap ETFs, small-cap ETFs, growth ETFs, value-oriented ETFs, into ETFs indexed to divided sectors or industries, or smaller subsets of equities based on fundamentals, dividends, almost any subset of stocks based on almost any theme. There are lots of indexed “products.”
But you’re still correlated to the market.
It may matter what indexes you’re in on the upside, in the short run. It won’t really matter in the long run if you’re well diversified across all these indexes and groups. You’re being indexed enough, diversified enough, to essentially just follow the general market.
On the downside it matters, because correlation is what it is: a phenomenon, whereby most equities breakdown when faced with widespread selling by individuals, hedge funds, and mutual funds. It matters especially in the short-run, regardless of how “uncorrelated” to each other these equities are supposed to be.
Then there are the ETFs. That’s what you’re mostly invested in with robo-advisory services.
If you don’t remember what happened to ETFs last August, you need to be reminded here and never forget.
Because ETFs are composed of actual stocks, or futures, other assets, or derivatives for that matter, they are priced based on the sum of their parts. Last August, before markets opened, futures prices were down sharply. Everyone knew stocks would likely selloff hard at the open. And… they did.
The problem with ETFs suddenly surfaced. How can you open trading in a security if the price of that security (an ETF), is based on other stocks that aren’t open, or opening, and have no prices? You can’t really. If you do, you’re just guessing.
So while lots of ETFs weren’t opened for trading, the constituent stocks that they’re made of were going down.
What happens to your portfolio if your robots can’t sell your ETFs while the stocks that make them up are going down?
You could be devastated.
The Faults in Correlation
Now, we’re back to correlation. If stocks are going down and some investors can’t sell what they want to sell, they’ll sell whatever they have to, including other asset classes.
That’s cross-asset correlation. Everything gets sold and sometimes there are no safe harbors. Usually when there’s panic selling, the Treasury bond market becomes a safe harbor and prices of bonds rise.
Maybe your robot will have you in a small T-bond position. You’ll at least have that.
Robo-advisor advocates would argue it would be unlikely an investor would be 100% in just U.S. equities based on their models. But their models are based on investor inputs. And if an investor wants all equities, and all-American equities, they’ll get that.
As far as cross-asset diversification, especially achieved by mean-variance analysis (a favorite of most robo-advisors), Mark Broadie, Professor of Business at Columbia University, has demonstrated through simulations that “the error maximization property of mean-variance analysis becomes more pronounced as the number of asset classes increases.”
In other words, you’re more prone to larger standard deviation moves on both the upside and downside the more diversified you are in different asset classes.
And, you know now that matters more on the downside, because that’s when the big moves – the “fat tails” wreck all normal distribution-based models… which all of the robo-advisors are based on.
You don’t have to worry about much on the upside. Your robo-service will make you money, but being as indexed as you’ll be, don’t expect to outperform the market.
On the downside… good luck. You’ll get creamed along with everyone else when markets tank, maybe worse if the ETF market implodes from structural issues.
That’s in the short-term. If you’re a long-term investor you’ll be told to sit back and let the markets come back and lift you up when the correction or panic passes.
While this is historically true, what if you need to take money out in the short-term? What if you don’t have a long investing horizon? What if you were just trying to maximize your investment portfolio before moving more into bonds?
Portfolio construction is a problem, diversification is a problem, ETFs are a problem, correlation is a problem, the normal distribution math used is a problem – there are lots of problems with robo-advisory services.
If you’re an investing beginner and having a portfolio automatically constructed and rebalanced for you gets you into the market, I’m all for it. Go with it.
But, understand the pitfalls in blindly expecting a robot to understand you, the markets, and protect you from serious harm in the short-term, or the long-term. I only advise you use a robo-advisor if you manage that account and plan your contingent moves into the future and be ready to execute them when you have to.
Everyone was surprised to see how quickly the markets rallied after the election, and it’s even more surprising that we’re still riding that high. During his recent appearance on Making Money, Shah outlined how Trump can keep the skies looking blue.
To see Shah’s take on Trump’s first 100 days and the coming holiday season, click below…
Now that Dow 20,000 is right on the horizon, Varney & Co. host Stuart Varney asked Shah what it would take to get even further. Considering the trillions of dollars on the sidelines, the lack of resistance to the upside, and how a Trump presidency will affect the economy… Shah says 21k is attainable.
He also talked about Twitter’s “internal mistake” and how it will impact the stock, and Apple’s desperate return to Black Friday.
To see the full video, just click the link below…
There are so many things we can learn about investing from automated investment services, otherwise known as robo-advisors, that it staggers the mind.
After all, they’re computer-driven platforms imbued with advanced Sharpe, mean variance, and Modern Portfolio Theory that produce “efficient frontier” portfolios, and whose proprietary algorithms rebalance your portfolio based on threshold continuums and your personal dreams and goals.
Oh yeah, they’re complicated.
But there’s one lesson (one you were never taught) you can learn from taking a good, long look at how these robo-advisory services construct and rebalance your personal portfolio.
Because as we’re driven toward a future programmed by algorithms and dominated by Fintech innovations, it’s important to stop and take stock of some of the basic assumptions that will inform that future.
As you’ll see, there’s one fundamental assumption – upon which millions of portfolios have been built – that’s simply dead wrong.
Here it is…
Automated investment services – more commonly known as robo-advisory accounts – are relatively simple to understand, on the surface at least.
We talked about this last week – robo-advisories were created by millennials in response to the dot-com collapse, the financial crisis, and traditional fee-based advisory services.
But all is not what it seems. And if you dare dig into how they actually work, you’d be surprised how complex they are.
Today, I want to show you how these services actually automate portfolio selection and perform rebalancing acts, and help you understand some of the complex portfolio management theories providers have to use.
Because what you don’t know can really hurt you – and you should know how your money is being managed.
Let me break it down for you…
I’ve been telling you for most of 2016 that financial technology, or Fintech, is changing the investing and trading landscape.
One of the most profound Fintech disruptors is the creation of automated investment services, more commonly known as “robo-advisors.”
The idea of automating investment services was the brainchild of a handful of millennial-focused Fintech entrepreneurs, most of whom are millennials themselves.
With their general aversion to traditional fee-based advisory services, their experience of living through the tech-wreck of 2000 and the 2008 market shellacking, their comfort and trust in computers and technology, millennials (the generation born or coming of age between 1982 and 2000) were presumed to be the perfect audience for robo-advisory services.
Sure enough, assets under management by robots (and their human helpers) exploded into the billions this year.
But millennials aren’t the only group who are enamored with these low cost, automated investment services. They’re catching on with lots of investors.
If you’re not one of those investors, today, I’m going show you how robo-advisors work and what they cost, as well as the pitfalls associated with this newfangled investing horizon.
Let’s get started…
I’ve been telling you for weeks that hedge funds have been sucking wind, partly due to too often plowing into the same trades then exiting them too late.
But I’ve also been telling you that they’re ready for a comeback…
And the election of Donald Trump just proved it. You see, many hedge funds actually played the election close to perfection.
Whether they’re able to continue their recent burst of positive performance doesn’t matter to us, unless of course you’re in any of those floundering funds.
What matters to us is what positions they’re into now and when they’ll unwind them.
Because knowing what we know about their positions we can front-run their exiting strategies by putting on smart risk/reward reversal trades.
Here’s what they did, what they’re going to do, and how to front-run them before they rush for the exit doors.
Just a few weeks ago, 19,000 on the Dow seemed impossible – but the market continues to surprise post-election.
Speaking on a recent episode of Varney & Co.,Shah told viewers that 19k that is well within reach – and it could come sooner than many think…
Shah also shared his thoughts on a newly proposed plan to break up “Too Big to Fail” banks.
Minnesota Fed President Neel Kashkari’s plan involves increasing the financial stability requirements that would naturally lead to smaller banks with less risky balance sheets.
To hear what Shah has to say about the plan, along with a host of other topics, click below.
President Calvin Coolidge famously said, “The chief business of the American people is business.”
Thank goodness we’re getting back to that.
President-elect Donald Trump, a successful businessman himself, says rebuilding America’s infrastructure is his number one business priority.
That’s great for America… and great for investors betting on infrastructure businesses.
Over the past three days infrastructure stocks have been on a tear.
They’ve been bought up at a furious pace, propelling indexes higher and pushing the Dow Jones Industrials Average to all-time record highs.
And it’s not too late to get in on the action…
The stock market was supposed to have a major beef with Donald Trump’s election.
Now that Mr. Trump is the president-elect, everyone’s asking “Where’s the beef?”
That famous quip comes from a 1984 Wendy’s commercial assailing claims that Big Macs and Whoppers had meatier patties. That same year, Walter Mondale used it to mock Gary Hart’s proposed agenda, and later used it against Ronald Reagan, who eventually won a second term.
The answer today, as far as stocks are concerned, is there looks to be a lot of red meat in the economic future president-elect Trump’s proposing.
And as U.S. investors start to get it, they’re rotating into select stocks instead of shedding positions as everyone expected.
It’s too early to tell what investors are or aren’t going to fully embrace, since we don’t know who president-elect Trump will surround himself with and what exactly his agenda will be.
But that doesn’t mean investors should stand by with their wait-and-see glasses on.
There’s one opportunity in our future that’s a no-brainer – because it’s the central pillar of Donald Trump’s economic plan.
Here’s what I’m talking about…