Updated: Nov 5, 2020
The last two decades have dramatically changed the world we live in. The internet, once a novel technological curiosity that was occasionally accessed after minutes of waiting through annoying dial-up noises, has penetrated every corner of our daily life. The resulting innovations in a relatively short period of time are astounding.
While still sluggishly ambling along behind many other sexier and innovative industries, the financial sector has witnessed some changes as well. Online DIY stock trading, the wide adoption of low-cost investment vehicles, the limitless flow of information (or disinformation) on financial markets at our fingertips, and the polarizing advent of crypto currency like Bitcoin have all caused disruptions and contributed to new innovations in the wide world of finance.
Despite the slew of new ideas, one area that has been notoriously digging in its heels is the investment advisory sub-industry. Investment advice has been around for quite some time, and it has become essentially a commodity. Everyone from your local bank, broker-dealers and investment banks, insurance companies, and tax preparation companies have all rushed to offer their two-cents on where you should be putting your money. Enter stage left a newcomer to the fray: the robo-advisor.
What Is a Robo-Advisor?
Before tackling this question (assuming you don’t already know), let me first review the historical “human advisor” experience for those of you who have avoided enduring such an activity. Whether you go to a broker-dealer, your bank, or any other place, the experience is roughly the same: a securities registered advisor (either in person or on the phone) takes down some information on your financial situation and recommends an investment portfolio “tailored” to you. How is a robo-advisor different?
A robo-advisor essentially limits the human interaction and intervention in your investment plan and portfolio. You enter your personal information online, and the robo-advisor provides you with an automated plan and portfolio allocation using various mathematical algorithms.
These technology driven advisors have really picked up momentum the last couple of years. Many of them have seen explosive growth, new startups have been created, and even some big name brokerage firms have been quick to pick up on the trend and now offer their own version of the service. But why the need for them in the first place?
Iatrogenesis and the Race to the Bottom
The two most common arguments I hear for automated robo-advisor investing are lower costs and the elimination of human error. The former is obvious, and represents a continued race to the bottom of the pricing barrel within the financial world. Commissions and fees are a drag on investment performance, so any way to reduce them represents a higher return to the investor (or so the argument goes, although this is a completely different topic). Thus the emergence of low cost index funds, DIY discount trading, and now the robo-advisor, with all of the above an attempt to cut out the “middle man” and reduce cost.
The second reason, and I think more intriguing of the two, is the attempt at elimination of human error that represents a drag on performance. It is no little-known fact that oftentimes investors, not excluding investment professionals, make mistakes that erode returns (think irrational and emotional decision making driven by fear or greed). Sometimes we get in our own way and cause more harm than good. The medical community knows this as iatrogenesis, or complications being caused by the medical professional, medical procedure, or treatment; basically restated, it means creating unintended consequences. Such iatrogenic decision making happens in all number of areas of consideration: environmental studies and human attempts to right their impact on our planet, a simple trip to the auto mechanic gone wrong, or probably every politician to have ever made a decision in the history of mankind. The investment community is obviously not immune to unintended consequences, be it from conflicts of interest a financial professional has to deal with, uninformed and uneducated decision making, or just simply fear and greed getting the best of a sound recommendation.
The hope of many, creators of robo-advisors and end users of them alike, is that automated decision making and portfolio management eliminates the human error from the system, therefore eliminating resulting performance drag and providing potentially higher returns (or at least more consistent returns) to the consumer. Simple enough, right?
My Thoughts and Ramblings on the Matter
Let me first state that I am all for technological advancement. I think the financial industry as a whole is especially ripe for innovation. If technology has advanced to the point that our job can be replaced or eliminated, it might be time to shift gears and move on.
That being said, to reason that human interference can ever be eliminated from any system, financial or otherwise, is total folly. Someone created the technology, someone told it how to act and behave, and therefore any design or assumption errors in the system will be present. Even if the principles and inputs backing up a new piece of innovation were perfect, external human error will never be eliminated; how will the system cope with such externalities? Mathematical and algorithmic trading and investing is not new; in fact, it has been around for a very long time (in the form of technical analysis especially). That being the case, it begs asking a few questions about investment strategy based on mathematical inputs, be it from a robo-advisor or from your traditional human in the flesh advisor:
‘What is the stated investment strategy of who or what I am working with? Historically, how closely have they stuck to that strategy?’
‘What has been the historical performance of who or what I am working with? What has been their strategy’s historical performance?’
‘Do I have the patience to stick with that strategy in a variety of market conditions? How do you judge if the strategy is broken and no longer working, and at what point would it make sense to change to a different one?’
‘Does the stated strategy make sense for my personal circumstances at this particular point in time?’
To round out this discussion, I do think there is a place in today’s world for the robo-advisor, algorithm based investing, mathematical based decision making, or whatever you want to call it. However, it would be naïve to think that human input and error can be eliminated. It is equally naïve to think that any mathematical equation can be developed to create the perfect investor experience. So what is the robo-advisor, really? Is it truly game-changing and revolutionary technology, or is it yet another new low-cost alternative designed to inveigle investors into doing business? If they do provide sound advice for you, great! If not, bad advice is still bad advice, no matter how little you spend on it.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Past performance is no guarantee of future results.