How technology is able to outwit human investors

Simon Miller of Scalable Capital explains how the robo-adviser’s algorithm can predict economic shocks.

Sometimes technology can just do things better than humans. Headlines like to shout about ‘the rise of the robots’ and how ‘robots will destroy our jobs’, but the reality is that there are many areas in which technology would outperform any human. We believe that modelling risk and dynamic asset allocation are two such areas, which is why we manage our clients’ portfolios using a data-driven investment approach, powered by sophisticated algorithms.

Our investment methodology was first tested by the Brexit vote last year, shortly followed by Donald Trump’s presidential victory. Our portfolios rose over these periods when many others fell. We put this down to a broad reduction in risk across our portfolios in the lead-up to these events, followed by allocation towards areas with the best risk-reward dynamics as calm returned to the markets.

Ultimately it was a data-driven approach delivered through technology that enabled us to make these successful changes, and not the beliefs of any individual or committee of portfolio managers.

Focus on risk

So what do we do differently? Private investors and active managers tend to manage their portfolios by trying to predict the future direction of stock prices, but numerous empirical studies have shown that it is impossible to predict whether a stock will go up or down from one day to the next.

However, research shows that risk can be predicted much more reliably and that there are persistent trends of high or low volatility within asset classes. A period of high volatility, be it a day, week or even a month, has an increased likelihood of being followed by another period of high volatility. Furthermore, periods of elevated risk are often associated with negative performance – so if you can predict and avoid periods of high risk, you can limit your exposure to losses.

We use this analysis of volatility to manage portfolios. When it came to Brexit and Trump, our algorithm had already picked up on above-average volatility in certain markets and adjusted our clients’ asset allocation to control the exposure in their portfolios.

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We call this type of adjustment ‘dynamic asset allocation’ and it is a key differentiator between us and traditional wealth managers. In the past, wealth managers have used fixed asset allocation and rebalanced portfolios periodically – typically every quarter. This means that the asset class weights remain constant, but it ignores the downside risk that the client faces, particularly as markets go through volatile periods.

We are the first to offer private clients access to this stable level of risk. Risk stays in line with the category specified by the client in all market conditions, which in turn smoothes their performance over the long term.

Keep emotion under control

Not only does our investment technology enable us to control the risk in client portfolios, it also allows us to overcome the behavioural biases that we all face when investing. Private investors often sell in the heart of a downturn, fearing greater loss. They then stay in cash for extended periods before their confidence returns and they re-enter the markets as they are rising.

The result is that they sell low and buy high, missing out on the gains they would have otherwise enjoyed with the market recovery. Furthermore, they have also added to their misfortune in the period through the various transaction costs they have incurred. All in all, it’s an expensive mistake.

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The decisions we make on behalf of our clients are driven by an algorithm based on underlying market data, and not by emotion, so we avoid these pitfalls. Both the input and output of this algorithm are constantly monitored by our team of financial experts who check every trade before it is placed and executed.

Using algorithms to manage portfolios drives better investment outcomes. Having a dynamic asset allocation smooths performance and avoids common behavioural biases. Finally, the application of technology every step of the way keeps fees low and client service high. 

Simon Miller is co-founder of roboadviser Scalable Capital.

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