What Happens When Robo-Advisor Meets Terminator?

As a former portfolio manager, far and away my biggest problem was controlling my emotions. Controlling your euphoria on a good day was easy- take a long lunch, engage in more small talk with colleagues or do your daily work with a big smile. I was excellent at that, in fact one of the best, but that wasn’t my problem. I ran head first into trouble on big down days when the market humbled me like it does to every investor. As the S&P sits at all-time highs, millennials and other robo-advisor clients may soon understand how emotions can get the best of you when the market has its inevitable correction or worse if Stan Druckenmiller (hedge fund legend) is right and “This is the Endgame”.

As an extremely competitive person when my portfolio was hit square on, my emotions pushed me to “over-trade”. Other colleagues would cover shorts during squeezes or sell out of positions that ultimately would have been highly profitable because they couldn’t take the pain. Besides catharsis, why do my travails as a portfolio manager have relevance to the robo-advisory market? I understand as well as anyone how easy it is to sit back and reap portfolio gains much like today’s millennials setting and forgetting their parameters with robo-advisors like Betterment. But when the inevitable market downturns arrive, if professional investors like me and many colleagues engage in highly shortsighted actions that cost us, how will inexperienced millennials react seeing their wealth take 20%, 30%, 50% hits?

Equity Backdrop

In 2008, the S&P 500 fell 57% before bottoming in March 2009. The S&P has more than tripled since then and now sits at or near all-time highs. Since the 2008 financial crisis, the S&P has not experienced a down year with the worst return occurring last year with a measly 1.3% gain. The annualized return from 2009 through the end of 2015 is an impressive 14.9%. Not bad to do well in this environment. It reminds me of the oft quoted investor maxim- “Don’t confuse smarts with a bull market”.

With this backdrop, many investors have been well rewarded for investing in almost any ETF or market index. Betterment, as representative of robo advisors, was formed toward the latter half of 2008 and launched in 2009 coincident with the stock market bottoming. Any individual investing via Betterment or any robo advisor was likely to have participated to some extent in the massive market rally. The worst two market corrections, not even deemed bear market corrections (hurdle of 20% sell-off), have occurred over the last year- -12% in mid-2015 and -13% in early 2016. Just when the market gets on the precipice of pain, a reversal quickly has taken hold and saves investors, for now at least.

Negativity Bias

Humans have an innate ability to survive in harsh conditions. Somewhere programmed deep in our neural network is the impulse that a negative trigger should receive paramount attention. According to psychologist Jonathan Haidt:

“The mind reacts to bad things more quickly, strongly and persistently than to equivalent good things.”

Emotions are the toughest part of investing. Negativity bias kicks in when your portfolio gets hit with different pain thresholds. A single, employed 25-year-old may be fine seeing a 20% hit in her portfolio because she knows that she will be able to dollar average down on future contributions. Conversely, a 35-year-old married couple who was fine investing aggressively in the equity market may feel sick to their stomach seeing 20% of their nest egg vanish, knowing that the husband may lose his research sales job at the investment bank.

There are clearly many scenarios of investors acting differently based on their emotional risk tolerance. Just like my poor decision was “over-trading”, some of these people may sell early and override the automated actions because they cannot bear the pain. It’s easy to say what you think you can handle before the fact and entrust the robo-advisor’s algorithms, but when it turns into real world dollars and effects real world life decisions (e.g. not being able to vacation this summer) people soon find themselves acting very differently.

Betterment’s chief executive, Jon Stein, said that it did not build portfolios around customers’ emotional tolerance for risk.

Robo-Advisors will not be able to provide the personal/emotional management and advice that experienced brokers often do when times are tough and your emotions want you to act. At these times, it’s important to not make compounding mistakes and let your negativity bias get the best of you. Unfortunately, these times will call for a human advisor to be able to relate to the individual or family’s specific situation to recommend a proper action plan. Is there a child in their near future? Does the husband/wife fear job security given they are in the financial services sector? These are all personal traits that are unlikely to get factored into dynamic risk tolerance. It’s not a set it and forget it risk profile that robo-advisors would like to use a constant input in their algorithms.

So What’s the Answer?

If you cannot control your emotions, you cannot control your money

-Warren Buffett

I don’t know when the inevitable stock market correction occurs, but listening to much smarter investors like the legendary Stan Druckenmiller gives me considerable pause to think it’s in the not too distant future. I caution anyone with money managed by a robo-advisor to do the actual markdown on their portfolio and ask themselves what will they do when their portfolio is down 30%, 40%, 50%, etc.. Do the math and feel the emotions in real numbers. Are they okay with their nest egg being reduced from $50,000 to $25,000? It will likely bounce back but the timing is uncertain. What will that mean for their lifestyle and financial well-being?

I strongly believe that robo-advisors like Betterment have brought really compelling, low cost products that allow people of any wealth great options to participate in the equity markets. I think the ultimate winner though will be a combination of automation/machine learning with access to experienced financial advisors (e.g. SigFig). You don’t need to talk with a financial advisor often, likely not monthly, quarterly or even yearly; however, he/she could be the difference in letting your emotions get the best of you.