There is a whole generation of retail investors, new to planning their own investments, that are almost certainly going to learn the lesson that bad assumptions generate bad outcomes. No matter how many times the terms “robo” and “fintech” are put into a pitch.
Ultimately a formula that transfers a set of assumptions into a set of results – no matter how clever the formula – is a garbage in/garbage out machine. If you put dumb things in, don’t expect to get insight on the way out. This is particularly a problem in the robo advising world where the extent of the real-world investment experience of the industry seems to be planning how they will spend their millions on exit.
One of the biggest assumptions that seems to be glossed over in all the pretty UIs is “What exactly do I think equity markets will return in the future?”. How can a portfolio be “optimised” without some perspective on what are realistic returns going forward? After 25 years doing medium- and long-term forecasting of financial markets, let me give you a couple of tips on what to look for.
Assuming you can actually find out the process that your favourite Robo is using to predict markets into the future (don’t even get me started on risk), I’m going to start with the What Not To Do. I group the most common mistakes made into the broad categories of i) Momentum Wins and ii) Economics Explains All.
The most common mistake made by inexperienced portfolio constructors is to simply extrapolate the past into the future. This happens when a simple Markowitz optimiser package is downloaded and just plugged into data. It takes the past (however recent the data set the portfolio constructor has been able to access) and generates risk and return estimates – the expected return simply being the return over the history of data we had. Let’s say we are at the end of 1999. We have the last 10 years of history of the US stock market so that is our “forecast” for the next 10. The US market delivered investors total returns of 18.2% per annum to Dec 1999. Makes a reasonably forecast of the future? 10 years is a fairly long history. The problem is the future return was -0.9% per annum for the next decade. The naïve forecast turned out to be 19.1% PER ANNUM out.
This strategy is backing momentum. What has happened in the past will continue into the future. While there is some evidence this works over shorter periods, it is no basis for estimating returns for medium to long term portfolio allocations.
Economics Explains All
This problem comes at the opposite end of the spectrum and is often postulated by economists with a more theoretical bent. The idea makes some intuitive sense – it just doesn’t work.
It goes something like this – a stock market is representative of a country, so all we need, to work out capital growth, is an understanding of GDP growth going forward (sounds easy enough I suppose). We add the current dividend yield and just simply project inflation and voila we know what the stock market will do.
The biggest problem with this is that there is no relationship between GDP and earnings growth over the medium term. Dimson, Marsh et al have shown this conclusively in their collection of works, starting with the Triumph of the Optimists. If we are thinking about mapping earnings growth, then GDP is exactly the wrong place to start (sector composition, dilution, change in profit share are all part of the reason).
An interesting further complication is this – even if you knew with certainty the exact earnings growth in a market, it only explains less than 10% of realised returns in equities (US and UK since 1955). So, with perfect foresight around what will happen to earnings, we “only” miss 90% of the explanatory power of 10-year returns.
How does your favourite robo make these assumptions? Do they even disclose them? Or is your “garbage out” being dressed up in a nice graph with lots of dollar signs so you don’t care? You should also look under the hood and find out whether they have financial relationships with product providers. Ultimately, who is “managing” your money and for who’s benefit? Investing money is a combination of a science and an art – make sure you see evidence of both in the team that you are trusting. It really is the age-old adage – do your homework before you invest. Caveat Emptor.