What robo advisors can’t do is to fully assess the risk tolerance of investors when accounts are opened. I say that because I don’t think anyone or any machine can do that. Sure, we all fill in our risk tolerance when we open a brokerage account, but for most of us, these are abstract questions. We associate risk with upside risk, not downside risk. And let a portfolio really dive 25% or more, are you still comfortable with the risk tolerance parameters provided? This is a human weakness, but it doesn’t mean one can ignore it. I tell investors: if you get sleepless nights because of your investments, you are over-exposed. An investor should look at the most volatile periods and try to assess: would I really be comfortable holding x% of my portfolio in this security/fund if it went down as much as it did in 2008, or some other bad period? Such mind games are ever more difficult the further one is from the most recent crisis; with 2008 being far in the rear-view mirror, I allege there are millions of investors that have not properly assessed their own risk tolerance.
The bad of the early generation of robo advisors is that, in my view, they are too limited. They follow the most classic way of investing in stocks and bonds; that’s wonderful for normal times. But I question whether, after eight years of stock prices rising, we are in normal times. That said, because such model portfolios have done great, their sales argument is compelling.
In my humble opinion, investors may want to take advantage of the good while trying to mitigate the bad. That is, investors may want to have a rigorous investment process that includes rebalancing; they also should look at fees, although they should look at them in the context of what they are buying. If a robo advisor helps in terms of the “good” they may provide, great. However, so long as such investment strategies focus only on the basics, I would caution anyone not to deploy all their assets into such a strategy.
What shall investors do?
During extended bull markets, and the current market qualifies as such, I believe investors lose sight of what investing is all about. Call me old school, but I do not think investing is about chasing indices. Similarly, investing is not about lifestyle investing.
At any time, imagine what were to happen if markets were to crumble. How would you be able to pursue your investment goals?
If you have savings, you don’t need to chase investments; you can pursue your investment goals by looking for value; it’s okay not to participate in each and every market rally. If, however, you don’t have savings, you feel like you have to chase returns to catch up; in doing so, you are quite likely never to achieve your goals as you’ll invest at the top, then realize you are too exposed when prices tumble. In the opinion of yours truly, the irony is that even with modest savings, the more cautious approach should pay off more in the long run.
What do I do?
As a registered investment adviser myself, I am not allowed to give specific investment advice in a general analysis such as this one. But I can tell you that for myself: I seek to get my returns with as little equity risk as possible. My current view (which is subject to change at any moment) is that even as I believe equity prices are at risk of a severe correction, buying insurance is too costly given that I know as little about when the next bear market will come as anyone (I do have a hard time believing we’ll never have a bear market or financial crisis again). As such, I try to get my returns elsewhere. To the extent that I like specific equities, I hedge out equity risk (this is not an encouragement to use derivatives, as those come with their own set of risks that may not be suitable for many investors). Then, I look to generate return streams that are not correlated with equities. Those that have followed our work for some time know that I try to achieve at least some of that by investing in currencies and precious metals. Those are but two ways of trying to achieve uncorrelated returns.
We spend a lot of time on both macro and systematic work. While the heavy hand of policy intervention might be shifting from monetary to fiscal policy, I believe it is nonetheless important to gauge their impact on portfolios. With what I believe are distorted asset prices due to policy makers, we also spend a lot of time using other gauges, such as shifting risk sentiment in the markets.
The short of it is that there are many ways I believe one can weather the storm that may lie ahead in the markets. However, what may have been one of the more profitable approaches in recent years, namely to invest and forget, might be hazardous to your wealth in what’s ahead.
Axel Merk is president and chief investment officer of Merk Investments.