“I am not a robot. I have a heart, and I bleed.” -- Serena WilliamsSubmitted by TandemGrowth Financial Advisors LLC on May 1st, 2017
After winning her 23rd Grand Slam singles title at the Australian Open on January 28 this year (while pregnant, no less!), Serena Williams was ranked the number-one woman in singles tennis for an amazing seventh time. Her accomplishments are nothing short of stunning, and many regard her as the greatest female tennis player of all time. And yet, as perfect as she is at the game, it is her very human self that makes her a champion. In sports, excelling requires more than technical perfection. It requires immense determination, guts, and often the ability to see beyond the moment. Serena is not a robot, which is why she is a winner.
It’s amazing how much that also rings true in investing.
Back in 1986, when I was first starting out as an investment advisor, a technique called “Mean Variance Optimization,” or MVO, was all the rage. (It was a time in history when we all thought computers had all the answers. The Internet was in its infancy, room-sized mainframe computers were still the norm, but we knew our future was somewhere in those bits and bytes!) To apply MVO, we relied on computer programs to tell us how to allocate capital based on past risk-and-return relationships for any given level of risk, and risk meant one thing: volatility. Since small value stocks had historically provided the highest historical returns relative to their risks, the computer program, using data as its only guide, would consistently suggest allocating 100% of assets to a single asset class, small value stocks.
It’s not a bad strategy, really, but it’s far from perfect. If you compare 35 years of performance data of the Russell 2000 Index, the most common benchmark for small cap funds, to the S&P 500 Index of large cap stocks, small caps slightly underperformed compared to large caps, on both an absolute and a risk-adjusted basis. So much for the advice of the computer!
Don’t get me wrong: I’m not averse to using the power of computers. But when computers are used to provide all the answers, they can often fail to see the big picture. Numbers don’t tell the whole story, and risk tolerance alone (which is what today’s robo-advisors use to make their decisions) is not the whole answer!
Luckily (for both me and my clients!), I learned this lesson quickly. In the early 90s, I picked up a book by Roger Gibson that changed my perspective completely. Now considered a classic text for advisors, Asset Allocation, Balancing Financial Risk showed me that a broadly diversified "multiple asset class" portfolio was a much more prudent way to manage assets. Armed with this new information, I was able to show my clients the light, shifting our conversations away from computer-generated MVO and helping them to understand the long-term benefits of building smarter diversified portfolios using a variety of asset classes, including cash, bonds, US stocks, international stocks, and real estate securities. I was still using the power of the computer, but I now knew to put constraints on the computer’s suggested allocations. The result: much more sensible portfolios that clients would actually implement and, even more importantly, stick with over the long term.
My belief in this core philosophy has not changed in 25 years. But something has shifted, and this shift has led to even better “outcomes” for our clients. As a holistic wealth manager, I have seen first-hand that the biggest risk factor to any investor’s financial outcome isn’t that old enemy, volatility. The enemy isn’t even the computer… or the economy… or even the market itself. So what is the real enemy of success? Investor behavior.
Investor behavior, more than any other factor, dictates long-term financial outcomes. That means that even if you have a less-than-perfect plan, or the market falls, or equities are outperforming your diversified portfolio at the moment, sticking with your plan is the key to success. “Strategy abandonment” is the #1 enemy of the investor, and the best way to battle that enemy is to stay diversified and stay focused on your goals.
Unfortunately, no robot can help control investor behavior (at least not yet!). Robo-advisors are designed to invest your assets based primarily on your “risk tolerance,” meaning they measure your theoretical tolerance for pain, and then suggest a portfolio that is almost certain to deliver that level of pain at some point in the future. That’s a tricky game to play. Instead, take the time to determine what is required to meet your life goals, and then work with your human advisor to explore a mix of assets that has a reasonable chance of funding those goals with the least amount of pain.
Computers are great at crunching numbers, but in real life, there is often more than one right answer. Until computers can find a way to focus on your personal goals and build a plan designed to help you reach them, it’s probably best to focus on the human side of planning for your future and, like Serena, be a winner for the record books.