Have you ever heard the phrase “the rich get richer, but the poor get poorer”? Well, part of the reason that expression might be true is that rich people tend to put their money to work for them in the form of investments. It takes a decent amount of research and introspection to understand what type of investment management is for you, but if you can put cash away each month, time will work on your side and allow your savings to grow.
One of the most rewarding means of investing is to invest directly into the stock market by purchasing stocks (shares) of profitable companies. But direct investing isn’t the most ideal solution for me. Buying stocks directly from a company and watching it to make time-sensitive, clever decisions is something for which I have neither the patience nor aptitude. I know for a fact that I’m too forgetful and cautious to make meticulous decisions based on current trends in the market.
This is why I decided to pay someone to do it for me. Well actually, I ended up paying something to do it for me: robo advisors. [DISCLAIMER: This post is neither sponsored nor to be taken as actual financial advice. It is just a personal piece about what I’ve been doing and why I decided to try robo-advisers]
So what is a robo advisor? How do they work? The theory behind many robo-advisors is based on the Modern Portfolio Theory, the details of which are described in this excerpt from WealthSimple, a popular Canadian company using this investment management strategy:
Modern Portfolio Theory
So, what is it exactly?
In the 1950s, a guy named Harry Markowitz won a Nobel Prize for figuring out how to manage your retirement account. That’s an oversimplification, of course, but what you need to know is that a great deal of what governs the advice almost all financial advisors give comes from the work of this man.
Before modern portfolio theory was developed, the operating principle of investing was to look at individual stocks and find “winners”—equities that would produce decent returns without too much risk. The problem was that individual stocks are risky by nature. This new theory said that what investors should seek instead is diversification. That way, you bet on bigger slices of the economy and take advantage of “winners” you might not have thought of, while protecting yourself against unforeseen disasters.
Modern portfolio theory has a basic aim that by now probably sounds familiar: Minimize volatility (risk) and maximize reward (money!) by finding a combination of stocks that won’t have wild swings in value but will provide decent returns.
What are the pros?
The first advantage is that this approach tends to manage risk well. You’re investing in lots of stocks, which helps diversify your portfolio. The stocks are also selected to be balanced. For instance, modern portfolio theory argues against investing in equities that are dependent on each other—say, energy stocks and the automobile industry—instead, it preaches investment in things that are not correlated, like oil and the technology sector.
By trading off a bit of risk, optimized portfolios gain reward.
Is there anything to be careful about?
Not understanding the reasoning behind what you’re doing is the biggest risk involved with trying to implement modern portfolio theory. People who wake up one day and say, “I’m going to create the perfectly optimized portfolio!” without knowing what they’re doing or understanding the math behind it will likely fail. Also, because the data used to calculate the perfect portfolio is based on past performance, there is no guarantee that it will yield the same results in the future.
I’ve been reading documents describing the pros, cons, and how-to’s of robo advisors. Despite its name, it’s a financial investment management system that is controlled by humans who oversee investments selected by automated stock selectors.
The website Investopedia has a great explanation as to why they’re so popular now:
Robo-advisors have surged in popularity as people seek low-cost, automated investment opportunities. Within minutes, robo-advisors allow you to set up a customized, diverse portfolio and can give you access to wealth management services previously reserved for the ultra-wealthy, like tax-loss harvesting and access to a certified financial planner. For these reasons and more, robo-advisors are increasingly attracting attention from investors.
With all this good news, there must be a catch to using automated investment systems like robo advisors. According to this NASDAQ article, you have to be careful with robo advisors because they won’t be able to adjust to changes in your life, your financial situation, or take into account complex tax situations arising from large purchases like a home.
For my particular situation, I don’t feel like those are huge con’s, but to each their own. I’ve decided to try out ModernAdvisor (this is a referral link) because I see it as an appropriate alternative to bank-owned mutual funds, which I had been using previously.
But whether you decide you’re going to use mutual funds, dabble in the stock market as a direct investor, or pay someone to manage your money for you, there’s just one thing I want you to take away from this blog post: how are you investing for your future?