The rise of the machines

1st July 2012

These days there's little doubt that technology is revolutionising the way businesses run – and also the way we invest. But while it's possible to construct a portfolio on the net, is this the way forward, or does active investment management still hold the key to big profits?

As Psyfi blog comments: "Global electronic networking has changed the business environment irrevocably, destroying some business models and badly disrupting others.  The financial industry is no less prone to this than the music, newspaper, publishing or sundry others, but this hasn't necessarily resulted in better results for investors."

Nick Shalek argues on TechCrunch on a post entitled ‘Thankfully, Software Is Eating The Personal Investing World' that software is better than 99% of humans who attempt to invest money.  His post soon spread across the industry, with professionals asked for their opinions.

One who voiced theirs was Josh Brown. He agrees that ‘simple is better', and all new investors should begin with low cost index funds and set up their accounts to automatically add the same dollar amount to them on a regular schedule – regardless of price or market conditions. 

However, he adds on blog Reformed Broker: "I firmly believe that wealthy people will always prefer to get financial advice from living, breathing, thinking people rather than software.  They are happy to pay so as to have real relationships with their estate planners, financial advisors, CPAs and private bankers.  This seems obvious to me and probably to you.  But it is not obvious to many others."

Even so, this is an idea that's been gaining traction ever since Paul Meehl published Clinical vs. Statistical Prediction back in 1954, adds Psyfi blog.  "What Meehl showed was that statistical predictions were always at least as good as expert judgement and often better.  Even when only as good they were a great deal more cost-effective."

Daniel Kahneman devotes a chapter of Thinking Fast and Slow to the results of Meehl's work. "The important conclusion from this research is that an algorithm that is constructed on the back of an envelope is often good enough to compete with an optimally weighted formula, and certainly good enough to outdo expert judgement.  This logic can be applied in many domains, ranging from the selection of stocks by portfolio managers to the choices of medical treatments by doctors or patients."

So what are the other benefits of machine over man? The removal of the emotive biases is one obvious pro, such as the power of fear and greed in investment decisions.

After all, investing is an emotional affair, so perhaps software hold the trump card when it comes to tackling doing so during financial crisis. "Sooner or later, all but the coolest investors let their emotions get the best of them and try to time the market, selling stocks before the market drops and buying again right before it rises," says TechCrunch.

However, software stays invested through market cycles, weathering the good and the bad without blinking and works towards long-term success.

But what about the learning curve that real life investing allows? "They (investors) also need to learn their own risk tolerance by making mistakes with fear and greed and dealing with the consequences," adds Brown.

And anyway, there are always asset managers worth their fees – it's just a case of separating the wheat from the chaff.

As Leigh Drogan comments on the TechCrunch piece: "There are not many managers who deserve the fees, and individuals should not be investing for themselves in public markets.

"But there are some really great managers, that 1% who consistently execute several different types of active strategies, whether it be deep value, momentum, quant based, or other. I had the privilege for working for one of them as a trader, then ran my own fund where we performed extremely well. The goal should not be to throw people into asset allocation models run by software, it should be to open access to and identify great active managers."

There is a revolution going on across all industries, with distrust prompting a shift in how we manage our finances. But what do you think – should we turn to software to manage our money, or turn to human experience in the pursuit of profit?

 

More on Mindful Money

The sins of high frequency trading

Stockopedia – Steering away from story stocks

Wolfram Alpha: Google for investors 

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