Behavioral Finance Disruption & Diversification

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Staying Ahead of Robot Investing Disruption

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Our world has become greatly automated over the past few decades with the Internet of things (IoT) – a system of interrelated computers, objects, animals and people that are provided with unique identifiers and the ability to transfer data over a network without requiring much human or computer interaction while powered by deep learning.

From Netflix eerily recommending your next movie to smart homes listening in to a baby, AI is not so quietly integrating into our lives. Simply put, AI works to build machines that imitate human intelligence capable of processing massive data and executing tasks around the clock.

We’ve seen tech replace switchboard, lift and toll booth operators, to robots eliminating manufacturing jobs. While the workforce is being redefined by the AI revolution, human investors and financial advisors should not lose sleep just yet over industry disruption from robot traders.

Robo Management

Robo-Advisors offer retail investors a low-cost “fee-based,” automated approach to investing utilizing low cost ETF model portfolios. While Robo-Advisor companies and their slick advertising can be alluring from the likes of Betterment, Wealthfront, Fidelity, Schwab and SigFig, make sure to consider whether outsourcing your money management and planning needs to a machine is the right decision for you.

Robo models, like target date fund models, have set restrictions on sector allocations and could be a challenge when developing tax efficient or income focused portfolios, to providing more globalized or eclectic strategies such as socially responsible investing. A human advisor may have greater leeway to diversify into a larger range of customized tactics while also utilizing individual securities as well as active managers and tax efficient strategies.

Consider that most Robo-advisors entered the market just over the past decade and have not yet really been tested through a grizzly bear market. While “cost may be king,” other similar “one-stop” package- deals from target-date funds in employer retirement plans to some quant models and hedge funds did not hold up as well as expected during the market crash in 2008.

Imagine being two years away from retirement and seeing your 401(k) — which you may have thought was shielded from massive market corrections — tank by more than 30%. As discussed in 2008 401(K) Beatings, that was the reality in 2008 for workers who had invested their savings in target-date funds.

Even more unsettling, a few major robo-advisor companies had their websites crash during the pithy corrections in 2018 where clients could not even get online. Even with the recent addition of human advisors to the robo-call centers, meeting “eye ball to eye ball” with an accredited financial advisor (such as a CFP® pro) to holistically coordinate your planning, tax, retirement and investor mindset concerns – may be of more value than just a low cost robo-investment program.

Quant Management

Quantitative trading incorporates strategies based on quantitative analysis, which rely on mathematical computations and AI number crunching to identify trading opportunities. Price and volume are two of the more common data inputs used in quantitative analysis as the main inputs to mathematical models.

These tech systems can be reading” Trump’s tweets overnight and then selling specific stocks or sectors at the opening bell – before you even get your morning coffee.

Recent studies indicate passive and algorithm-driven “quantitative investing” account today now for more than 50% of stock trades. Trading algorithms respond to the same evidence as humans that they are trained to sniff out, yet quickly sell- out from broad indexes to individual companies if they recognize certain triggers.

The robots unemotional, high frequency trading is another form of disruption to watch out for, that can then cause humans, in mass, to panic and follow the trend thereby causing mass havoc in the global markets

While we cannot control the robots, we can control our behavior in the short term to not panic with our investment strategy based on a belief that geopolitical events such as war, impeachment, tariffs or major epidemics will put the quants into a dizzying selling fervor.

Strategically and tactically managing and diversifying your portfolio while incorporating different sectors (cash, bonds, stocks, alternatives) and maintaining a global approach (as the planet gets more interconnected) can also be key to lowering your downside potential and buffering the effects of short-term AI trading and pullbacks and working to keep your correlation low to any one index or sector.

Global Diversification

Global stocks are in the red this year due to fears of the spreading coronavirus and geopolitical instability while the U.S. and developed market indices have not suffered as much. Given this knowledge, staying calm and internationally diversified is key. This is true for a few key reasons.

First, the Chinese stock market, and emerging markets more broadly, are only components of the larger investment universe. Even today, despite the size of its economy, China only constitutes about one-third of the MSCI Emerging Markets index and about 4% of the All Country World Index.

So, while headlines out of China may spark fear, and daily market swings there may be sizable, they can be “counter-balanced” in a diversified portfolio by the rest of the world. For instance, while the Shanghai Composite Index has fallen by about (-10%) year-to-date, the impact on the global market is roughly less than 1%. (see below).

Second, since holding a diversified portfolio helps investors over longer timeframes, it’s important to maintain the right perspective. While global markets are negative year-to-date, they only fell by about -1% through the end of January. At its worst point, global markets were down (-4%) (see below)- much less than the average intra-year market pullback. In other words, the returns of a single month or quarter are nothing in comparison with the long-run returns that matter to patient investors.

Third ,international diversification isn’t just about stocks – global bonds can help as well. In fact, with volatility rising and interest rates falling, both U.S. and international bonds have helped to cushion portfolios. This dynamic has been true throughout the market cycle of the past decade with interest rates remaining relatively low, central bank policy being stimulative, and companies taking advantage of debt financing.

Thus, it’s important for long-term investors to maintain a globally diversified focus across regions, countries and asset classes. Over the long run, emerging markets may be volatile, but this goes hand-in-hand with higher expected returns. In fact, many international markets are significantly cheaper on a valuation basis than the U.S. (see below), despite higher earnings growth expectations. It’s important to take advantage of all of these trends in balanced portfolios, regardless of whether markets are up or down over the past 30 days.

Below are three charts that put recent global volatility in perspective:

1. Global stock markets have fallen slightly this year

Global stock markets have fallen slightly this year. However, not only has the decline been small, but the largest decline of 4% is minor compared to historical averages. It’s important to keep this in perspective as news of coronavirus spreads and as volatility continues.

2. Emerging markets can be volatile but have performed well in the long run

Many international markets, especially emerging markets, are volatile by their nature. Over the past two decades, these markets have swung wildly over short-term periods. However, in the long run, they have performed extremely well for those investors who have been able to stay patient and have diversified properly in their portfolios.

3. Growth expectations are still healthy for international markets

Not only are earnings growth expectations for many international markets comparable or better than those of U.S. large cap stocks, valuations are significantly cheaper across the board. This is because the U.S. stock market has risen steadily and outperformed significantly last year, despite weak earnings growth. Valuation levels are a key factor in future returns over the long run which, coupled with faster growth, suggests there may be growing opportunities in international investments.

The bottom line? Diversification provides investors “insurance” against inclement weather and helps to better control your own portfolio volatility in the short run, even if market swings are fueled 50% by robots, AI and quant-trading programs. Despite global uncertainty, it’s important for long-term investors to be internationally diversified and to focus on investing for the long run.

For more information on our firm or to request a complementary investment and retirement check-up with Jon W. Ulin, CFP®, please call us at (561) 210-7887 or email [email protected]  Get Started Today: Contact Us .

The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without Ulin & Co. Wealth Management’s or IFP’s express prior written consent.

Diversification does not ensure a profit or guarantee against loss. You can not invest directly in an index.

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