Robo-Advisors aren’t the problem. Your models are.

Author John C. Maxwell is credited with the phrase, “Change is inevitable. Growth is optional.” His words were used to describe the human capacity for growth in an evolving life situation. We’re going to apply them to investing. Change is what we’re experiencing in global equity markets right now. Advisory firms are struggling to adapt to it.

In Maxwell’s book “The 21 Irrefutable Laws of Leadership,” he talks about how everyone has the capacity to change, but many choose not to. Static investment models, which have been the foundation of modern investing since the 1950s, aren’t working. The alternative is to switch to active investing and tactical models, the best option for growth in this climate.

Exercising the option to grow takes courage, especially when your clients’ retirement savings are at stake. In the 20th century, the market could be relied on for a 10% return over time. Since 2000, that number is down to 7%, with the S&P at 5% if you adjust for inflation. The inevitable change has arrived. In this article, we’ll show you how to exercise your growth option.

Why are models ineffective in the “new normal?”

The world was a very different place when Harry Markowitz first introduced Modern Portfolio Theory (MPT) in 1952. An investment portfolio diversified across market sectors to mitigate risk was a new concept that quickly took flight with financial advisors. “Modeling” became the status quo. Those who specialized in it created a brand-new niche in financial services.

One of the core tenets of MPT is the belief that market trends will repeat themselves given enough time. Like the fashion industry, the financial sector has always believed its business is cyclical. Set up a balanced portfolio model and convince your clients to focus on the long-term picture. Those losses will turn into gains at some point. Hopefully.

Fast forward to the 21st century. Markowitz, like Asimov’s Harry Seldon in “Foundation,” did not account for technology innovation that would change everything. We’re talking about the internet, a foundational building block for social media, retail trading, and real-time market analysis. Those developments changed how the stock market works.

Think about this in mathematical terms. An algorithm that can predict an outcome when you change a few variables. The internet added speed and transparency to stock trading. Black swan events like 9/11, the 2008 housing crash, and the 2020 pandemic added volatility. Those variables weren’t part of the original MPT equation.

Rise of the Machines: The Robo-Advisors Revolution

Another glitch in the theory of repetitive market cycles was the development of robo-advisors. The “Rise of the Machines” began in 2008 when Jon Stein launched Betterment. Robos instantly became the scapegoat for struggling advisory firms. Algorithmic trading, which was first introduced in the 1980s, soon accounted for 70 percent of daily activity on Wall Street.

Not to burst your bubble, but Robos aren’t your problem. Don’t blame the bots for lost clients. Robo-advisors use model portfolios too. Clients are leaving advisors because their investments aren’t making them money. Clients get their quarterly report, see that certain positions have been consistent losers, and don’t want to hear that it’s “part of the model.”

Robos, like Betterment, hedge risk by buying ETFs and index funds that track a broad spectrum of different equities. They’re not doing any better than you are with their performance. Robo algorithms don’t initiate trades based on evolving markets. They’re preset to rebalance when the portfolio doesn’t match the inputted model. That’s the same thing you’re doing.

Did a lightbulb just come on for you? Robo-advisors are doing the same thing you’re doing with models and getting the same result. Many firms recognize that and have incorporated a robo-advisors into their practice. The “machine” works in the background while the advisor focuses on client engagement. That’s an excellent idea for scaling, but it doesn’t solve the model problem.

The “Cramer Effect” on Model Portfolio Performance

There are certain client issues that every advisor can relate to. For instance, how many times has one of your clients asked you to make a move because they “saw something on TV” about it? We call that the “Cramer effect.” Jim Cramer, the host of the show “Mad Money” on CNBC, is one of the most influential voices in finance. He’s talking to your clients every day.

Mad Money is financial theater. Don’t take that the wrong way. Jim Cramer is a smart guy and many of his stock picks pay off. The “Cramer effect” we’re talking about is the impact he has on his viewers by being loud, instilling a sense of urgency, and honking a horn to grab your attention. He has a following, and they listen to him. That affects market movement.

Take this to another level. In 2021, meme stock traders used Reddit to drive the share price of GameStop far above what it was worth. That action showed that social media can influence the stock market. If GameStop was in your model portfolio, would you have sold it at its peak or kept it to offset losses elsewhere? Would your robo have rebalanced around it?

Growth can be achieved with Tactive investing

We believe the only way to achieve growth in the “new normal” is to combine active trading with tactical, dynamic investment models. We call it “Tactive investing.” Get used to the name. You’ll be seeing it everywhere in the next few years. We’re not saying that just because we coined the phrase. Tactive investing just makes more sense in modern times.

The key to this concept is flexibility. Model portfolios do poorly because the investor is locked into a mix of specific holdings in a market where the bottom could fall out on any given day. Active trading is the key to getting out on time. Tactical models are the blueprint to get back in. It’s quite simple when you think about it. Maybe Jim Cramer will talk about us someday.

 

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