Be Fearful When Others Are Greedy and Greedy When Others Are Fearful
This is one of the most famous quotes by the legend of investing community Mr. Warren Buffet. But he is Warren Buffet! He has probably mastered the art of overcoming his emotions of greed and fear. But for ordinary folks like you and me, it is easier said than done.
And suppose that we do somehow achieve that Zen state, how many of us here have the knowhow and the bandwidth to actively manage our portfolio so that we can consistently get the best out of our Mutual Fund investments?
Unless you are an Ultra High Networth Indvidual (UHNI), being serviced by the biggies of wealth management industry, chances are that your investment will continue to perform way below it’s true potential.
This is where robo advisory comes in. By using an algorithm-generated rule-based approach, it not only overcomes the human emotions of greed and fear, it gives you access to active portfolio management that consistently generates that alpha return for you.
Before we move on to discuss the nuts and bolts of a good robo advisor, lets first understand who they are and why do we need them:
What are robo advisors exactly?
Here is a definition from Investopedia:
Robo-advisors (robo-advisers) are digital platforms that provide automated, algorithm-driven financial planning services with little to no human supervision. A typical robo-advisor collects information from clients about their financial situation and future goals through an online survey, and then uses the data to offer advice and/or automatically invest client assets.
The definition is pretty self-explanatory. The underlying idea is that since humans are subject to emotions of greed and fear, they end up taking irrational investing decisions. Robo advisors help us overcome this by following a rule-based investment approach.
Why do we need robo advisors to manage our investments?
There are 2 main reasons for it:
#1. Active management of your portfolio
In order for your investments to generate alpha returns and at the same time keep the risk to an acceptable level, you need an active management of your portfolio. Just imagine the number of factors involved:
- Is my portfolio loaded with under-performing funds and should I shift to the high performers?
- How and when do I make that shift?
- How do I know which are the best funds at that point of time?
- Does my portfolio need a rebalancing? If yes, how do I get it done?
In most cases, people will not have answers to these questions and even if they do, they will not have the bandwidth to actively manage their portfolio.
My colleague Indranil Guha has explained the need for an actively managed portfolio in his blog – Why should you invest in equity mutual funds only through robo-investing platforms?
#2. The trap of greed and fear
Even if you have the knowledge and the bandwidth to actively manage your portfolio, you are still at the risk of falling prey to greed and fear. For example, you might end up selling all your equity during a crash (fear) or start taking ultra risky bets during a booming market (greed).
This is where robo advisors come in. By following an algorithm-driven investment strategy they do not deviate from the “rules” of the strategy. If you are not an expert on timing the markets (and trust me, no one is), you are better off following a rule based investment approach.
What makes a good robo advisor?
Now this is the tricky part. These days, everyone who sells Mutual Funds claims to be a robo advisor! The truth is that “robo advisory” as a term is being rampantly misused in India. Robo advisory is NOT the same as an online investment platform. Robo advisory is letting algorithms run the show – from asset allocation to fund selection to rebalancing to exit.
So what makes for a good robo advisor?
#1. One that has algorithm-driven investment strategies for different risk levels
Solutions offered by most of the advisors are far from it. Consider these critical aspects of investment management – Asset Allocation, Fund Selection, Rebalancing, Exit Strategy and Return Guidance. And now consider these questions:
- What is the optimal asset allocation and what are the best funds to create that allocation. Is there an underlying algorithm that decides the optimal asset allocation?
- What’s the methodology for selecting the best funds? Is it driven by a proven time-tested mathematical model?
- At any given point of time in your investment horizon, are you still invested in the best funds at that point of time? Does the strategy offer a rule to move to the best funds?
- Is there a rebalancing rule? If yes, what is the basis of the rule? Is it geared towards maximizing your returns and minimizing risks?
- Is there an exit strategy? Again, is it geared towards maximizing your returns and minimizing risks?
- Does the strategy give you concrete return guidance or a vague one like “you can expect 13% plus returns”?
Below is a quick summary of what is actually being done and what ought to be done:
|What is being done||What ought to be done|
|Asset allocation||Allocation based on the age of the individual - something like a 90% - 100% equity portfolio with monthly SIPs to someone in his/her 30s and a 100% debt portfolio to a retiree.||An optimal allocation based on tenets of Modern Portfolio Theory that minimises your risk for a given return level.|
|Fund Selection||Either top-rated funds (based on their recent performance) or worse with funds that offer highest commissions.||Fund selection should be based on a proven time-tested mathematical model. Should factor funds performance over all cycles.|
|Rebalancing/Switch||There is no concept of rebalancing or a switching strategy. You stay invested in funds that were once great but are no longer so.||A rule-based rebalancing and switching strategy so that you always maintain your asset allocation and are always invested in the best funds.|
|Exit strategy||There is no exit strategy whatsoever. Exits happen either when you need the money or when markets crash (fear)||A rule-based exit strategy that is geared towards maximising your returns and minimising risks.|
|Return guidance||Vague guidance such as “You can expect 14% plus returns if you stay invested for 5 year”||A probability based guidance – “You can expect X% plus returns with a probability of Y%”|
#2. One that has a reliable and efficient technology to execute the strategies
While this is the easier part, it is still not being done and more so because no one is actually offering strategies that need execution!
So as you can see, most of what is being offered today is not even robo advisory, forget being good robo advisory.
This is where Finpeg comes in
Finpeg is one of the few robo advisors in the truest sense. All our investment decisions are made by time-tested and simulated algorithms and executed in a seamless manner through our technology platform.
At Finpeg, we follow a Standard Deviation Compression (SDC) approach, which comprehensively covers when to invest, redeem and rebalance. By running millions of simulations, we arrive at an optimal combination of entry strategy, holding period, rebalancing rules and an exit strategy that maximises returns and minimises risk.
We offer tailored strategies for different risk profiles (return expectations) and all our strategies our geared towards maximising the chance of hitting the expected return. And when we offer a strategy, we give concrete return guidance like “you can expect X% plus returns with a probability as high as Y%”.
Do visit our website and if you like what you see, please do get in touch!