robo-investing

The Future of Investment Advice

Investors , , ,

In order to understand the future of investment advice I think it is essential to understand how the industry has developed to where it is today.

When I started in the financial services industry back in the 1970’s retail customers got advice about what to buy and sell from their stockbrokers.  At the larger brokerage firms that usually meant that your broker would call you and tell that they or the firm’s research department had identified a stock that was a “buying opportunity”. This was often accompanied by a recommendation of what you should sell to pay for your new purchase so your broker would make not one, but two commissions from the recommendation.

When the stock market suddenly crashed in 1987 a lot of customers asked their stock broker why the broker had not seen the crash coming. The brokers really had no good answer. The crash took a lot of money out of the market and caused a lot of customers to lose faith in their broker’s ability to select investments for them.

Partially to placate those customers with something new and partially to make more money the industry introduced wrap accounts. A wrap account places the customer’s account into the hands of a professional money manager for an annual fee which is shared with the introducing stockbroker.

Wrap accounts introduced the idea that the individual brokers would be compensated on the customer assets under management (AUM) rather than the commissions that their accounts generated. This let the brokers do what they do best (sell) and let the professional money managers manage the accounts.

It also created a conflict of interest. Managers kept investors fully invested because that is what they had been hired to do. If the managers started to accumulate large cash positions in customers’ accounts, the customers might withdraw the cash. That would be counter-productive to the brokers who were being paid to bring in more and more new assets.

By the mid-1990s the market had recovered nicely and people started asking how long the boom would last.  At the end of 1996 Fed Chairman Alan Greenspan attributed the sharp run up in stock prices to “irrational exuberance”.  Neither the brokers nor the money managers advised the customers to sell when they had large profits and maintain a cash position

Much of the run-up in the 1990s was attributed to new tech companies that not everyone understood. Consequently, the firms hired highly qualified research analysts to parse through the various issues and recommend what they considered to be the best.

At the same time, the brokerage firms were making a lot of money by underwriting new issues of these tech stocks. In many cases the research analysts were working to support the efforts of the firms’ investment bankers. They only wrote reports describing why their firm’s banking client’s offerings were a “buying opportunity”.

That also created conflicts of interest.  When the market finally crashed it was revealed that some analysts had never suggested that the price of any of the stocks they covered would not go higher. Some analysts never recommended a “sell” on any stock they followed even when fundamental analysis told them that they should be selling.

Again, when the market crashed in 2001 a lot of people asked their broker why they did not see the crash coming or take some defensive action to protect their profits.  And again, the brokers did not have a good answer other than “no one can really predict the market” which, of course, is exactly the skill that the stockbrokers and money managers had been espousing to customers all along.

The brokers themselves got more than a little frustrated with the large wire houses and many jumped ship. Sometook their clients and set up shop as independent investment advisors.

The accounts were still housed at a brokerage firm that got paid a commission on each trade but the advisors now kept all of the annual account management fees. This was a better deal for the advisor even if they now needed to pay their own rent and overhead. The idea that no one can really predict the market suited these independent advisors well because they were more interested in acquiring new customers and assets than picking good investments.

That led to a concept that as long as a portfolio was diversified it really did not matter which stocks were in it. By diversifying the stock portion of the portfolio into different asset classes the advisors were trying to avoid what had happened in the tech wreck. The theory was that if you bought stocks in different asset classes, the collapse of one sector, like tech, would not hurt you too badly.

This did not help investors when the market crashed in 2008. This crash was caused by a bubble in real estate and foolish lending in the financial sector. Most companies are affected by what occurs with banks and real estate as both effect business and consumer spending. Diversification only mitigates certain risks. This crash involved a systemic risk, not an asset sector risk, a fact that many brokers never understood.

It should not surprise anyone that investors again asked their advisors why they did not get them out of the market before it crashed.  Again the response was “no one can predict the market”.

Since 2008 the advisor industry has seen the rise of robo-advisors.  These are popular with millennial investors who do not trust the Wall Street professionals after 2008.  Robo-advisors select portfolios based upon algorithms. This makes as much sense as throwing darts at a list of stocks and bonds even if you are a champion dart thrower.

Robo-advisors are not even attempting to predict the market and they are not programmed to ever sell the portfolio if the market starts to crash, which we all know, it will. They are just selling diversification at a lower price. They achieve “diversification” by buying mutual funds or ETFs. These contain so many stocks that mathematically, there is no actual diversification.

Robo-advisors advertise that people pay too much for investment advice. I would argue that most customers pay too little.  My current advisor spends countless hours poring over financial statements and research reports to pick individual stocks.  He gets the same 1% of AUM as advisors who put all of their clients into pre-selected diversified portfolios of various funds and ETFs without really knowing a lot about them or how they might be expected to perform. With investment advice, like everything else in life, the rule should be that you get what you pay for.

What I think may be an intelligent alternative going forward is for people to just put their investment advisor on a fixed monthly or yearly retainer.  It would cost more for a larger portfolio than a smaller one because all portfolios need to be constantly monitored and larger portfolios require more time. Advisors would keep their customers and get referrals by keeping their customers happy.

And what makes customers happy?  They want to have more money in their accounts at the end of the year than they had at the beginning of the year. That is true even if the market crashes because there is nothing more foolish than staying in the market when the market is going down.

The customers will never truly be happy and get the results they truly want until advisors thoroughly analyze and review the stocks they recommend and purchase and hold only those that they believe are likely to appreciate. They will never get there if advisors refuse to take profits and move to cash when the market indicates that they should. They will never get there if advisors diversify to mitigate some risks, but not all.

People actually do predict the future performance of individual stocks and the market in general. I doubt that you would be surprised if I told you that the ones who do it well get paid a lot of money by investment banks, mutual funds and large institutions.

The advisor industry needs to understand that parroting the phrase “no one can predict the market” every time the market corrects is the fastest way to be demonstrate that you do not know what you are doing. Providing beneficial investment advice takes time and effort. Advisors are entitled to be paid for their efforts. But first they have to actually do the work and that work is accurately predicting the future price of individual securities and the market in general.

 

 

Investing for Millennials

Investors ,

There is an ongoing discussion in the investment advisor industry regarding how to attract millennial investors. I have read several articles that suggest that a great many millennials have minimal savings.  And for those who do, investing for retirement may not be a high priority.

Many millennials are drawn to robo-advisor platforms. I find robo investment advisors to be a sick joke foisted on millennials and others by an industry that makes its money gathering assets.  If for no other reason than robo platforms will never advise investors to sell, the portfolios of many robo investors will suffer losses when the market comes down.

There is nothing wrong with the idea of asset allocation if you have a portfolio of size, are investing for the long term and allocate and re-balance your portfolio correctly.  But most robo platforms do not allocate portfolios correctly. There is a wide variance of portfolio allocations from platform to platform so investors really cannot know with any certainty how the platform they select will perform.

I have seen more than one study that suggested that millennials are attracted to robo investment platforms not just for their convenience and affinity for technology but because a great many millennials distrust the human financial advisors who their parents used.  Trust is important when you select any professional to work for you.

But the wholesale lack of trust in financial advisors is misplaced. I say that as a representative of the generation that coined the phrase: “don’t trust anyone over 30.” The truth is that the best investment advisors are older, having been seasoned by a market cycle or two. There was a lot to be learned when the market crashed in 1987, 2001 and 2008.  Advisors who were around and learned those lessons should be less likely to let their clients take losses in the next crash when it comes.

There is an annoying debate based upon studies that suggest that the average financial advisor cannot get even average returns, meaning equal to a broad index, year in and year out. The debate tips toward the idea that passive investing, just buying the index or sectors within the index, is superior.  Passive index and sector investing is what you get with a robo platform.

For the most part, the large institutions, insurance companies, pension plans and endowments, still invest the old fashioned way; using fundamental securities analysis to purchase investments that will either provide a good continual rate of income or which are likely to appreciate in price. Most stocks and bonds are bought and sold on the basis of research. Robo and passive investing is still a small portion of the overall trading volume.

Most asset allocation models counsel that younger investors can accept more risk and allocate a higher percentage of the portfolio to stocks.  The theory is that younger investors can take more risk because they have more time to make up losses if they occur.  Stocks are usually riskier than bonds.  If you invest a significant portion of your portfolio in stocks or a stock index you are guaranteed to experience losses when the stock market comes down.

Investing in an index, riding it up and then down is foolish. A smart investor gets out of the market before the market turns down. A smart investor takes their profits when their stocks move up and then invests in something else.

There is also an idea that millennials can begin investing with a very small amount of money. In some cases, I have seen firms advertising that you can start with as little as $500 or $1000.  I would certainly encourage any young person to begin saving, but a diversified portfolio of securities on a robo platform is not where you should begin.

If you were to take a reputable course in financial planning one of the first lessons that you will learn is about something called the investment pyramid. If you Google “investment pyramid,” you will find that there are many versions of it but that all are variations on the same basic theme; save first, invest later.

An investment pyramid starts with the idea that before you invest your first dollar you should have some cash in savings.  The standard has always been enough to cover 6 months of living expenses in case you find yourself unemployed because the company downsized or you cannot work due to an accident or illness.

The idea behind any investment pyramid is that you build a sound base for your portfolio of safer, income producing investments, usually bonds, before you buy anything else. The interest from the bonds, together with your annual contributions, will help the portfolio grow.  After you have built a sound foundation you can move up to the next layer of the pyramid.

The second tier of the pyramid also contains income producing investments, usually dividend paying stocks and REITs. At this point the idea is to have a steady income stream from everything in which you invest.  In many cases, the companies in which you invest will have dividend re-investment programs that will allow you to accumulate additional shares without paying commissions.

As you move into stocks you should diversify your portfolio into different sectors, some energy stocks; some pharmaceutical companies; some transportation companies.  It matters less if all the companies pay dividends. In years when one company’s share price is down, the dividend re-investment program will purchase more shares at the lower price. Over time, this will have the effect of lowering the average price per share that you paid and increase the overall dividend yield of the portfolio.

Once you have a solid base and a second tier both of which produce income that will continue to add value to your portfolio, you can add a third tier of growth stocks and a smaller top tier of more speculative investments.  Do not take risks with your money unless and until you have taken care of the business of building a portfolio that will take care of you after you retire.

Let us say that you are fortunate enough to put away $50 -$75 thousand by the time that you are 35 years old. Using an investment pyramid you will likely hold only cash and bonds.  If you use a robo investor platform you are likely to hold mostly stocks which may be worth more or less than the money that you actually put into the account.  This is a lot like the story of the tortoise and the hare; the tortoise usually wins over the long term.

The counter argument, and you will find it everywhere, is that stocks will potentially give you more bang for your buck. Smart people will tell you that you will be sorry if you fail to invest in the next Amazon when it comes along. If you can spot the next Amazon and the one after that and so on, you do not need advice from me.

The importance is that you realize that if you use a robo platform they are more likely than not going to steer you into stocks. If you use the investment pyramid model, you are going to start out with bonds and stay with bonds for a while. Its apples and oranges.

 

Blogging for Fun and Profit

Capital Markets ,

Why blog?  For many people the answer would seem to be that they blog to bring attention to themselves and their business; they blog with the idea that it will help them to make money.

I started blogging just about a year ago. It began at the suggestion of the editor of my book.  She advised me to start a blog to help get my name out there and sell the book. Blogging is free, she told me, and I had no budget to promote the book.  I receive nothing from the proceeds of the book, all of which go to cancer research.

She also advised me to publish the blog on Linked-in, rather than Facebook where she thought more “serious” people would see it. At the time, I knew very little about either writing or publishing and I willingly took her advice. If I am doing something that I have never done before, I always hire someone who knows what they are doing or seems to know.

The blog follows the basic theme of the book. Its avowed purpose is to call out “foolishness” in the mainstream capital markets. There is certainly enough foolishness to go around. Much of what I write is a reaction to what I see or read elsewhere.  Many of the articles were inspired by conversations that I have with friends or strangers.

Because I write about foolishness in the financial markets, several articles have gravitated to two subjects, Robo-advisors and Crowdfunding.  Both are championed by fools who put a lot of bad information into the marketplace.  I try to counter that bad information with reason.

Robo-investing is foolish because it cannot work.  If you invest with a Robo program you are guaranteed to lose money when the market turns down.  Automated trading programs have been around in the commodity markets for a long time and are universally rejected by regulators and people who understand that a computer program cannot predict the markets.  If you are not investing to make money and are happy to lose, then in my mind, you are foolish.

Robos-advisory programs have become big because they eliminate the most expensive part of the investment transaction, the human advisor, which leaves much more profit for the firm that is offering the program.  A theme of the book, which carries over to Robos is that if the financial industry offers a product it is more likely than not designed to make money for the industry not the investor.

I get a little pushback from the Robo industry when I write negative articles about it. A number of people who contacted me after one article in particular, told me that whatever I thought about Robos, human advisors were terrible. In my experience not all investment advisors are terrible. I responded by inviting people to contact me for the name of my advisor who is very intelligent, competent and hard working and who gets good results for his advisory clients because of it. A few people took me up on my offer and seem to be happy to be working with him.

I get a lot more pushback when I write negative articles about Crowdfunding. I personally think that Crowdfunding has a lot to offer for the companies in need of funding. Unfortunately the Crowdfunding industry is populated by many people with zero experience raising money for small companies. Much of the activity in Crowdfunding is people giving seminars to other people teaching useless information and patting each other on the back.

Pointing out that fact makes those people very angry but it does not change the fact the Crowdfunding industry is remarkably unsuccessful at raising money. It takes money to raise money. The Crowdfunding industry is busy telling people just the opposite; that an inexpensive  social media campaign is all a company needs to successfully attract investors.

Many companies who try Crowdfunding do not get the funds they want. That is a shame because it really is not that difficult for a good investment to attract investors.

There is a very small group of Crowdfunding platforms that close every offering that they list. The people who run those platforms don’t give seminars because they are too busy being successful.  Several are run by people who came out of the mainstream financial industry and understand what works and what doesn’t.

One of the reasons Crowdfunding is failing is because not every company that wants to be funded is a good investment.  Early on I offered to read any company’s pitch deck and make comments for free. That has brought me into contact with a fair number of entrepreneurs, most of who I have found to be quite interesting and appreciative.

I also write about the markets themselves, especially regulations of the markets, FINRA and FINRA arbitration.  If I write fewer articles about these subjects it is because there are a great many lawyers and others who put out good information. The mainstream securities industry is usually careful to stay within the regulatory white lines.

So has blogging been good for my business?  Yes, but in unexpected ways.

Blogging has certainly gotten my name “out there”.  When I started the blog I had about 200 Linked-in connections, mostly friends, colleagues and former clients.  I add new connections with every article and the number has increased 8 fold and continues to increase weekly with each new article.

My articles on the investment industry got me the opportunity to write articles for a mainstream digital publication serving the investment advisor market. Some of those articles reach thousands of readers. I am still very much at the Jimmie Olsen, cub reporter stage but the editors there have been very patient and supportive.

The articles on Crowdfunding, especially the negative ones, put me in touch with a several groups that want to do Crowdfunding correctly, with due consideration to what investors want and deserve.  I have been helping these Crowdfunding platforms move from the planning to the implementation stage. Each shares a goal of funding every company that it lists. I expect that other groups seeking to start Crowdfunding platforms or make existing platforms more successful will seek me out as well.

The articles on arbitration and market regulation have resulted in a few expert witness gigs in FINRA arbitrations and a consulting assignment for one of the larger Wall Street investment banks. I suspect that more will come.

The best part of blogging has been that it has put me in touch with a large number of people with whom I would not otherwise have been in contact.  I speak to 2 or 3 people every week. Some of those conversations go on for an hour or more.

During most of the conversations I find myself laughing over a good joke or comment.  For me it is these personal connections that are the best thing that comes from blogging.  A good laugh in the middle of the business day seems harder and harder to find.

 

 

 

7 Reasons Why Robo-Investing Will Not Work. Millennials – Wake Up

Capital Markets, Investors , , , , , ,

Robo-investing is the next really big, really dumb thing. Millennials are expected to pour enormous amounts of money into these programs in the next few years. That would be an enormous mistake.

Robo-investment programs promise to help users to set up investment portfolios now and then to help manage those portfolios for the next 25 or 30 years. The portfolio with which you will end up, all those years down the road, is likely to be a disappointment.

I looked at a number of the websites and advertisements for these programs as I was writing this article. One proposes that a”moderate risk” portfolio would have 90% held in stocks. Another has a member of their investment team who takes a “holistic” approach to financial planning. That may be fine for some people but is not a serious approach to managing your money as far as I am concerned.

These computer programs do not have what it takes to intelligently construct a portfolio for you now or to manage it over a period of many years. Years from now, you will wish that you had a portfolio put together and monitored by a well trained and intelligent flesh and blood investment adviser. By then it will be too late.

Robo-investment advisers tout the fact that they cost less than a human investment adviser would cost. It does not really matter. Robo-investment advisers are inexpensive because they provide investors with little or no value.

If you have any doubt that these robo-investment adviser programs are less than worthless, here are seven obvious reasons why the actual portfolio that you will get from a robo-investment adviser program is likely to perform poorly.

Number One: It is not about your age.
One of the few personal questions that a robo-investment adviser program will ask is your age. If you are thirty the program will assume that you can afford to take on more risk than a person who is sixty. If it is suitable for you to take on more risk then your recommended portfolio will get more stock funds or ETFs and fewer bond funds and bond ETFs.

Investing based upon your age assumes that your age and the markets are somehow related. What you should or should not buy today is dependent upon the market, not upon your age. If you start down this path, what you will have bought or sold over the years that you stay with the program will have had nothing to do with what might have been a good investment at any time.

Number Two: Today might not be a good day to invest in either stocks or bonds.
Let us say that the program suggests that you create a portfolio that is 35% bond funds or bond ETFs and 60% stock funds or stock ETFs with 5% held in cash. In truth, it does not seem that most of these programs ever hold a lot of your funds in cash which always increases the portfolio risk.

If you begin investing this year when the stock market averages are making new highs it is reasonable to expect that next year or the year after the market might correct. It is very possible that five years down the road 60% of your portfolio will be worth less than it is today.

After seven years of forced low interest rates is this a good time to put 35% of your money into bond funds or ETFs? Savvy investors know that bond funds do not do well when interest rates rise. The computer will not adjust for the hike in interest rates that everyone knows is coming until after it happens and the portfolio has taken the loss.

Number Three: It is about the right math, the right data and more.
Robo-investment advisers claim to have sophisticated algorithms that will crunch the numbers and produce good results. The algorithms may be good but these programs look at the wrong numbers. A robo-investment adviser never gets past a limited set of gross market data. A robo-investment adviser never actually looks at any company’s balance sheet. They are an example of the GIGO principle of statistical analysis; garbage in, garbage out.

It is not only about the numbers. Before I would invest in any company I would want to know about products that the company might have in the pipeline, what its competitors were up to and what the CEO is thinking about. I am not alone. A robo-investment adviser is never interested in these things that most other investors would want to know.

Number Four: Investing cannot be done in a vacuum.
The computer program does not get a live news feed and would not know if Germany had invaded Poland so events leading up to any crisis that might affect the markets and the portfolio would necessarily be ignored. The program does not concern itself with current commodity prices, currency rates or international politics. Intelligent investors do.

To my mind, using a robo-investment adviser to construct and manage your long-term portfolio is the same as making all of your investment decisions from inside a small closet with the lights off and the door closed.

Number Five: The markets will not be static for the next 25 years.
The noted theorists upon whose works Modern Portfolio Theory and asset allocation are based were examining data from the markets prior to 1990. The financial markets have evolved significantly in the last 25 years. It is not just the speed or the technology. The markets are now global, there are a lot more participants and there is a lot more money in play. How the markets will continue to evolve and operate in the next 25 years is anyone’s guess and is certainly not built into any robo-investment program.

Number Six: The data that the program uses to select portfolios is based upon the past performance of the markets and past performance only. I should not have to tell you that past performance is an unreliable indicator of future results. If you invest with any one of these programs future results are exactly what you are trying to achieve. Why use data that is unlikely to get you there?

Number Seven: Human beings are actually necessary.
The sales pitch for these robo-investment advisers suggests that can do better than any human financial adviser. One company even touts that its program alleviates the risk of human error.

Using a robo-investment adviser will inevitably lead to portfolio losses every time the stock market goes down or interest rates go up. It will never tell you to avoid downturns or to get out of the markets all together before a crash. Likewise, the program never looks for new companies that might do very well or for any other investment opportunities that might make you money.

Severe market downturns can be scary. Investors are prone to panic. When your account value is dropping you are going to want someone to call. The robo-investment adviser will offer neither solace nor advice. That will only come from a knowledgeable human being. For that you have to pay a little more.