By Ryan Dolan
The last several years has seen a surge in DIY investing, with people either managing their own investments or outsourcing to “low-cost” options such as robo-advisors. DIY investing is always popular in extended bull markets which make everything look so easy. But as I originally wrote in 2018, I smelled trouble on the horizon.
2022 has experienced sharply falling stock and bond markets amidst rising inflation. The data on robo-advisor and self-managed investing platforms this year is not pretty. According to Kitces.com:
“Research from Parameter Insights [shows] usage of digital advice tools fell for the first time in 2022…Notably, the biggest losses were seen at higher levels of wealth, with usage among those with a net worth of at least $500,000 declining from 38.3% to 14.5% (compared to a decline from 23.6% to 20.6% among those with less than $50,000 of assets). Further, the use of online brokerages by US self-directed investors fell from 35.9% to 22.9% in the past year.”
While a do-it-yourself approach can work, it is a rare individual who can both determine a sound investment strategy and, more importantly, stick to that strategy over time through all the emotion and temptation of markets. In my admittedly biased view, the majority of investors would achieve far better long-term investment outcomes if they worked with a trusted and competent investment advisor who could both structure proper portfolios while also preventing self-inflicted investment mistakes that bedevil most individual investors.
The core issue I see with do-it-yourself investing is that portfolio asset allocation, the central question of investing, is given superficial attention at best, and is unlikely to be properly answered. Individualized asset allocation combines elements of both science and art, and demands considerable time and consideration at the beginning of the investment process. The science comprises what asset classes to invest in, what to avoid, diversification, asset-class valuations, the investor's time horizons and objectives, among many other factors. The “art” involves an objective view of the investor’s psychology and past investment behavior and mistakes to determine risk tolerance, while taking a comprehensive account of the investor’s financial assets and cash flow, not just investment assets.
In reviewing the portfolios of prospective clients who are self-managing their investments, the asset allocations often look materially inappropriate. Typically, these portfolios have considerable “rear view mirror” characteristics. They tend to be aggressively exposed to the asset classes that have performed best in the past few years, and underexposed to those that did worst. The opposite of sound investing. In the financial crisis, many investors went into the crisis with too much equity exposure, which increased the likelihood that they would make an emotional fear-based reaction to sell stocks, just at the wrong time. It was a classic example of the dangers of getting asset allocation wrong: you are likely to compound those mistakes by making belated adjustments, typically at the worst time, the dreaded whip-saw.
Robo advisors attempt to address these self-inflicted investor mistakes, and on paper sound great. Robos help you determine asset allocation, rebalance your portfolios regularly, and do so for a fairly low price. The issue is that the methods used for determining asset allocation are incredibly superficial and simplistic. Asking a few basic questions about an investor’s time horizon, income, retirement age, and perceived risk tolerance is unlikely to generate an accurate result. This is compounded by the fact that robos take no account of the highly important “art” component of asset allocation: the client’s relationship with money, their realistic risk orientation based on behavior in the past, etc. The biggest issue with robos is that they assume their customers will always behave rationally, particularly in market extremes. Anybody who has worked in financial advisory knows this is far from reality.
In my opinion, the surge in popularity in do-it-yourself investing is partly due to the fact that equity markets have been in a 10 year bull market. Investor mentality becomes: who needs to pay an advisor or an active investment manager when you can just buy the S&P 500 or the NASDAQ at 0.05% and just be fully invested? This is reminiscent of the surge of individual investors into passive equity mutual funds in the late 1990s. David Swensen in his book “Unconventional Success” noted that in 1993 investors’ allocation to equities was just 30%. By 1998, as the market surged, it pushed to 50%. At the peak of the market in 2000, investors had a peak equity allocation of 60%. As Swensen noted, “At the market peak in March 2000, investors exposed the maximum amount of assets to the maximum amount of risk.” When stock markets bottomed in 2003, with the S&P 500 down 50% and the NASDAQ down 80%, and poised to begin the next bull market, investor allocations had been slashed to 40%. The wrong allocation at a market peak increases the risk that an investor will slash exposure at the worst possible time.
In truth, an advisor earns his fee in two ways. First, in having both the quantitative and qualitative ability to collaboratively determine the optimal asset allocation for the client-defined as one the client can stick with through the rising and falling tides of financial markets. When clients are invested in the right way, they are less likely to want to make the rash emotional decisions which can be so damaging to their long-term investment outcomes. Nevertheless, even with a sound allocation, there will be those rare times when investment markets’ alluring siren song can reach even these investors. It is at these times when the advisor really earns his fee. A competent advisor is able to keep his clients focused on the long-term, resist fear and greed, and prevent large self-inflicted investment mistakes.
You get what you pay for. Are you ready to finally start taking your money and investing seriously? Schedule a 20-minute introductory call to see if Dolan Partners could be a fit for you and your needs.
Dolan Partners works with professionals and business owners (primarily in the real estate, technology and executive search industries) who:
-Are at least 35 years old.
-Own a home.
-Have at least $750,000 in investment assets.
-Are natural savers.
-Do not have the time, energy or desire to manage their increasingly complex financial life.
-Are looking for holistic financial planning which comprises cash flow and balance sheet management, goal definition, insurance, estate, tax and investment planning and more.
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