In the last year or so, the popular buzzword “robo-advisor” has essentially gone viral on Wall Street. Supporters have touted the benefits of this new breed of financial advisors, while critics warn investors of the potential drawbacks of such an automated and computerized strategy.
Today, I’d like to take a brief look at technology’s influence on today’s financial markets, as well as highlighting the latest robo-advisor craze.
Democratizing the Market
If you haven’t already read Michael Lewis’ Flash Boys: A Wall Street Revolt I highly encourage you to do so. In his book, Lewis dives into the murky yet sensationalized topic of high frequency trading and technology’s influence on trading and investing. While some critics believe Lewis’ portrayal of a rigged U.S. market is far-fetched, there are some key, crucial elements you can learn from reading his book.
First and foremost, Lewis explains how technology was first introduced on Wall Street in an effort to democratize the financial market. The ideology behind automating trades via computer systems stemmed from the belief that all investors should have the same information at the same time, helping to mitigate asymmetric information.
Of course, as with most innovations on Wall Street, people took gross advantage of these technologies, creating complex “black boxes”, sophisticated algorithms, and high frequency traders to essentially exploit price inefficiencies that occur within fractions of a second. If you ever ask a trader (as in a human day trader) what this has done to their career, most likely they will tell you “it’s impossible to win against a machine.” Sounds a bit apocalyptic or even a like a plot for a sci-fi movie? Perhaps, but they aren’t too far from the truth.
And while us long-term, buy-and-hold investors usually are not concerned with the nuances of day-trading, it is important to understand what exactly happens when we click the buy or sell button in our TD Ameritrade or E*Trade accounts. More importantly, learning the so-called “pluming” of the financial markets can help us better understand the increasingly popular high-tech trends seen throughout the industry – including the newest robo-advisors.
The Hype: Robo-Advisors
If you really take a close look at some of the companies offering “robo-advisors”, you’ll realize that the majority of the strategies involve applying basic fundamental principals into computerized financial modeling systems. The use of these highly intelligent algorithms are nothing new on Wall Street. In fact, many companies utilizing these technologies have seen successful historical results.
The key issue long-term investors need to be aware of is that there is a significant lack of transparency with some of these robo-advisor products. If you read the fine print, you may find that the seemingly simple, and fundamental methodologies actually involve some complex financial applications, including leverage, short sales, and “mimicking” investments.
Furthermore, robo-advisors are marketed as a “one-stop-shop” for investors looking to create “custom” retirement portfolios. Their logic is that by eliminating the human element from investing – i.e the irrational element – investors will be left with a near- perfect financial model. This sort of philosophy, however, does not always pan out as expected.
The Human Element
At Dividend.com, we have always encouraged investors to avoid irrational behavior and to stick to fundamentals. Do we always follow this advice? Absolutely not – we are human and make mistakes. But what a robo-advisor can not do is perfectly create a retirement plan or investment portfolio that completely matches an individual’s risk/return profile.
Think of some of the big financial decisions you have made during your lifetime. Were they always planned? Did they always pan out? Were you ever forced to change directions because of unforeseen circumstances? These questions all require some kind of human element, which more than likely can’t be solved or answered by an algorithm.
Will maybe one day these technologies make investing easier and more efficient? Perhaps. What we know for certain is that it is always better to know exactly where your money is going to, how it will be used, and whether the investment actually suits your long-term goals.
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