Robo advice meets professional guidance

It is life in practice that the algorithm still misses

Published on:
January 12, 2020
Reading time: 2 Minutes.
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

"If you want to improve the quality of decision," said Daniel Kahneman in an interview to Farnam Street, "Sse algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better."

Robo advisors or automatic trading promises just that. It is a software that calculates your risk and return profile. It shows you the right mix between stocks and bonds. It is an algorithm that attempts to answer how much you need to save today to live in retirement comfortably. You can now build a financial roadmap in a few clicks. Have we discovered the one recipe for success in financial life?

Not so fast. The term 'auto trading' gives the impression that our financial destiny is an airplane ride. Where all we need is to sit down, buckle up, and let the pilot set the journey on auto. But life rarely works that way.

What happens in practice is that life is full of surprises. And what sets you apart from others is how you will manage these surprises. In my view, to prepare for life events, you need to ask questions repeatedly.

For example, should you use your 2019 bonus to upgrade your home or to add to your savings? Or you may read about loan-backed funds and wonder if you should invest in them. Or, perhaps you want to help out a relative and need guidance on how best to manage the process.

Robo advisors will have little to say about these questions.

While I believe auto advisors serve a great purpose [1], they cause harm if not used correctly. From conversations I had with readers, I often see that auto investing creates an illusion. For example, a married couple boasted to me that they were on track for college education for their child and had enough safety nets. But they were taking far too much risk to meet their return objective.

Auto advisors are akin to Fitbit watches [2]. But just as a heart monitoring device cannot create health ,to achieve your financial goals, you will need more support that what auto advisors offer.

The world is better for robo advisors. But to reach your financial goals, you will need more resources.

Feedback mechanisms are essential.

Here is what Charlie Munger says on Matt Ridley's The Rational Optimist "

In the course of the book Ridley missed a major factor as to why capitalist economies outperformed all other forms of economics organization."

He continues:

"It isn't just a division of labor that works so well. What communist Russia lacked was a feedback mechanism. The process of free capitalism drowns businesses in feedback. If you do things right, you win new customers, and if you do things wrongs, you start to lose the ones you've got."

We need feedback on our behavior - Just as thriving economies do .

Two illustrations

A reader reached out to me about a year ago. She lived outside of the United States but wanted to buy U.S. real estate, an office building. But she had difficulty in understanding the tax consequences [4], and she was getting mixed opinions whether the investment was a good idea.

She wanted me to decide for her. But instead, we had multiple conversations about why she had wanted to buy a U.S. based property in the first place. She had never asked herself that question. We discovered she had one goal in mind:  to help her grandchildren with college tuition. And once we understood that, we found a better investment vehicle.

Another story happened just a few weeks. A reader was working as an investment banker when we met. He said the hours were long and that his clients expected him to be available 24/7.

He was facing a dilemma. He was contacted by a large organization that offered him a secure job with additional intangible benefits [5]. But he was unsure whether to accept the offer. He feared he was giving up on his dream as a self-made entrepreneur, and that there was no 'upside' to working at the large firm.  

Instead of prescribing a solution, I said: "let's ignore the financial-side, and only consider the domestic-harmony-side between you and your wife and between you and your children. Which occupation would improve the latter side?

He took the offer.

FOOTNOTES: [1] Since robo advisors compete with traditional model of financial planning, the advisory fees dropped. [2] Fitbit measures things. Like the quality of sleep and heart rate. [3] Auto advisor uses a 12-question survey. An insufficient practice, in our opinion. [4] IRS taxes foreign investors at a higher tax bracket than U.S. citizens. [5] Intangible benefits such as work/life balance, an easy commute, and great culture to be part of.
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