Domo Arigato, Mr. Roboto

Over the past few years I’ve been reading a lot about Robo-Investing and I have switched a good portion of my retirement account into Schwab’s Intelligent Advisor program. This is about as simple and low-cost as it gets for investing and automatic allocation. Other options in this space include Betterment and Wealthfront, with even Goldman Sachs getting into the arena, but the basic premise is all the same – you drop your money into your account and let Mr. Roboto and Mr. Market work it out. Scary?  Too good to be true?

Introducing Mr. Roboto:

Getting started in robo-investing is easy. You fill out a detailed survey detailing your age, goals, timeline, and risk tolerance and then your platform’s proprietary algorithm will generate an investment allocation spread among a dozen or so low-cost ETFs with the aim of maximizing your gain relative to the amount of risk in your portfolio. That allocation, however, is not random or haphazard – it is very scientific…

asset allocation
A sample asset allocation model from the Schwab robot-investing-investing platform

The risk versus reward aspect is a very important factor to consider in investing, and where I see Mr. Roboto with a huge advantage over Mr. Market. Anyone can go into an investment thinking they aware of the risk and then they can come out the other side tangibly holding a reward, but were you properly rewarded for the amount of risk you took on? And how do you know if Mr. Market gave you a good deal?

A Free Lunch…

Most folks understand that the riskier the investment the higher the expected return, but what if you could lower your risk and increase your return? Economist Harry Markowitz called this “the only free lunch in finance”. Why not take him up on the offer?

Markowitz was awarded a Nobel Prize in 1990 for a mathematical model he called the “Efficient Frontier” – an investment portfolio that offers the highest expected return for a given level of risk. William Sharpe later expanded upon this idea, and was also granted a Nobel Prize, when he developed the Sharpe Ratio – what has become an industry standard for calculating your risk-adjusted return.

Do you have to understand Nobel-level mathematics, economics, and finance theory to properly allocate your portfolio? It doesn’t hurt, but this where we’re going to let Mr. Roboto do the heavy lifting for us. I’ve often said that when it comes to investing you can try to beat math, but in the long run math is always going to win.

computer algorithm
The algorithm in action ©Nanex via LinkedIN

While building an Excel spreadsheet, calculating my Sharpe Ratio, and re-allocating my investments on a daily basis in an effort to minimize my risk and maximize my return sounds fun, and even beneficial, I like to have something else to talk about at parties other than alpha, beta, and delta curves. I’m going to let Mr. Roboto’s computer program monitor my account while I use my computer to monitor fishing reports.

performance graph

Take a look at the simple graph above from tracking $100 invested in the S&P500 alongside $100 invested in gold from 1971-2014. On its own, the stock investment gains 10.63% and gold gains 8.22%; HOWEVER, a 50/50 mix of stocks/gold (rebalanced annually) gains 10.82%. While that free lunch to the magnitude of .19% may not sound like much, consider you also lowered your risk by 15%. Lower risk, higher return.  We’re getting somewhere…

Below is another look with a similar result. Most folks consider bonds a very safe investment, right? But what if you could maintain the same level of risk as a 100% bond portfolio while increasing your returns by almost 2% – who wouldn’t do that?

tangent allocation.image

In the chart above you see Markowitz’s “Efficient Frontier” where a 100% bond portfolio offers a return of 9% with a deviation (risk) of 12%. Directly above it you’ll see that an allocation of approximately 70% stocks and 30% bonds offers the same deviation (risk) of 12% but a much greater return in the realm of 11%.

There ya go – a free lunch to the tune of 2% from Mr. Market, just like I promised…

sushi lunch
A free lunch from Mr. Roboto…  Enjoy…

It is interesting to note that in that Efficient Frontier graph, an allocation of 32% stocks to 68% bonds offers the lowest risk factor. If you are fearful, that is where you need to be allocation wise. It’s also interesting to note that the curve flattens out the higher you go, because you can’t beat math… To get from an 11% return to 12% return you increase your deviation (risk) from 12.5% to 18% in an effort to squeeze out that mere 1% gain. Is it worth it? That is for you to decide, but I say no. Portfolio efficiency in that 70/30 or 80/20 area is the sweet-spot for me…

Real Life…

So here is the real life example of investing with Mr. Roboto: I allocated a chunk of my portfolio to his platform and I “gamed” my answers on his questionnaire to establish his most aggressive allocation profile, which at Schwab is 96% stocks and 4% cash. When I tried to set a portfolio of stocks AND bonds, Mr. Roboto held too much cash for my liking, so I went with the 96:4 ratio and then I will achieve my total 80:20 stock:bond ratio by investing in bonds outside of the Robot’s control.

In the end my total portfolio allocation, across all of my accounts, is 82% stocks, 14% bonds, and 4% cash – that’s a good blend for now as I try to sneak that bond allocation up a little more toward 20%. Here is Mr. Roboto’s allocation:

Screen Shot 2017-03-24 at 7.09.08 AM

Mr. Roboto’s investments cover the gamut – everything from large-cap US stocks to micro-cap stocks in emerging markets, along with real estate the world over. The percentages are dynamically allocated based on maximizing the Sharpe Ratio (risk-adjusted gain) of the entire portfolio. When one category gets out of balance, the entire portfolio will shift to bring things back in line and keep me on track. My bonds are in TOTL, PONDX, and SCHO (outside of the robot).  All I have to do now is sit back and watch this money-machine in action…

computer server room
Let the computers do their job…

Does investing with Mr. Roboto sound scary? Consider that of the $20 trillion dollars under management today, robo-investing is on track to handle $7 Trillion within the next decade. Consider also that with robot-investing your fees will be under .3% per year and upwards of 6 to 7 times that for professional money management.  Lastly, consider the financial industry spent $19 BILLION last year developing financial technology.

Your minimum to begin at Schwab is $5,000 and if you need help creating a balanced and well-diversified portfolio, this is a very simple and low cost way to do it.

Just a note – Many bloggers have affiliate programs with Betterment or Wealthfront and they are mentioned often in the blogosphere due to the incentives of their affiliate linking programs. I have not created affiliate links to Schwab’s products, I merely use and like Schwab’s platform. You can read Schwab’s Robot-Investing-Investing White Paper here to learn more about their methodology. In the future we’ll look more at the advantages and disadvantages of robo-investing…

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