Three reasons investors should speak with their advisors about algorithmic investment strategies
DEAN SMITH
CHIEF STRATEGIST | FOLIOBEYOND
4 min read
If you are like most prudent investors, you expect your financial advisor to always be on the lookout for new products and tools that can potentially improve returns over time, manage risk and make it easier for you to reach your long-term investing goals. Well-designed algorithmic investment strategies (“algos”) can help you achieve all of these objectives. Here are three important reasons why:
1) Algorithmic investment strategies respond predictably to market events.
While it may be impossible to predict market events before they happen, a well-designed algo should have a predictable response to events that do occur. For instance, a strategy designed to manage volatility and drawdown risk will reduce exposure to sectors experiencing a period of higher than typical market volatility. And when that sector reverts to a more normal pattern it will add exposure. Sound algos don’t “roll the dice” and they don’t ever say “this time is different!”
Another important property a good algorithmic strategy will exhibit is that it will regularly rebalance exposures to stay within preset tolerances for diversification and risk management. It won’t forget to rebalance, and it won’t be tempted to overplay recent market moves –either up or down. When sector, industry, or other exposures get out of line due to market movements, the algo will rebalance automatically.
You might be thinking this goes against the oft-stated adage to “cut your losses and let your winners run”. But the reality is this quip is really only applicable, if at all, to active traders, not to ordinary investors looking to manage their wealth over the long term. Regular rebalancing to manage risk and stay with a discipline is far wiser for the vast majority of private investors, who, after all, are looking to get rich slow and not risk financial ruin. Smart, algorithmic strategies ensure this discipline.
2) Algorithmic investment strategies don’t exhibit style drift.
This is related to but distinct from the first point. It’s very easy for even good investment advisors to get caught up in recent market trends, and to react to the news cycle. When this happens it can be almost imperceptible in the short run. A trade or two here or there can seem smart or opportunistic at the time, based on fleeting market trends or some news that could well be ephemeral. It’s only with the benefit of hindsight one can see how far from an initial plan any particular investor’s portfolio has drifted. With a well-designed algorithmic strategy, this doesn’t happen.
This does not mean that a solid algo can’t have a lot of inter-sector rotation. They can and do, so the actual portfolio allocations can vary widely over time. But the underlying logic of the strategy is always maintained. The permitted investments, minimum and maximum sector of securities positions, maturities, credit quality, and other metrics will have to be met or the algo simply won’t make the trade. This ensures that the parameters, constraints, and goals of the strategy won’t vary unpredictably over time. The investor is assured of getting what you bargained for.
3) Using algorithmic investment strategies helps your advisor serve your clients better by saving you time and energy.
Your advisor may very well be an excellent investment analyst. He or she may have a knack for finding undervalued or overlooked companies. And you would still be better off if they use that time to understand and serve your long-term financial goals.
If we are being honest with ourselves as investors, we know that the most important thing an advisor can do for us is to take time to understand our specific goals and plans in the near, medium, and long-term. In terms of value-added, having a better and more complete picture of that far exceeds any incremental return you might gain through superior investment selection. The most important thing your advisor can do for you is to help articulate and understand your goals and then design a plan to help you achieve them. And then most importantly, they have to take the time to make sure that plan stays relevant over the years.
Each minute your advisor spends selecting individual stocks, bonds, or funds detracts from that much larger goal and can ultimately make them less effective as your advisor.
Your advisor might object to this characterization. Some advisors truly believe they have superior stock-picking skills that bring great benefits to their clients. The hard truth is this is almost certainly not the case. Investors get the most benefit from working with an advisor who takes the time and effort to understand their needs and to stay on top of life changes that call for adjustments to the game plan.
The use of well-designed algorithmic strategies frees up time for those higher touches, higher value-added activities. And ultimately it need not even reduce your overall investment performance if the provider of the strategies is competent and disciplined. You owe it to yourself to ask your advisor to explore the potential for algorithmic strategies as a component of your overall investment portfolio.
