Thankfully, Software Is Eating The Personal Investing World

Editor’s note: Nick Shalek is a Founding Partner of Sutter LLC. Previously, he worked at the Yale Investments Office, the firm responsible for managing the Yale Endowment.

Liquidity fever is in the air in Silicon Valley. I felt this viscerally last month when a friend from Facebook came to me to talk investing. A talented engineer who has been at the company for more than five years, my friend just reaped a pretty nice IPO payday.

As you might expect, he’s been contacted by a seemingly endless list of investment advisors, slightly different in their approaches but all promising the same things – a steady hand at the till, privileged access to top flight investment funds, and a portfolio that’s lower risk and higher return than the market. Fed up with all the competing claims, he has started thinking about investing his money himself. After all, he must be bright enough to outsmart the fickle fools who seem to follow Jim Cramer’s every whim. Right? He wanted to know what I thought he should do.

My first response was to slap him on the back and congratulate him again. It’s a rare and special time when so many people are rewarded so spectacularly for their hard work and ingenuity. As an entrepreneur myself, I love to see people with the courage to take an uncharted path succeed.

But my second response was to tell him that, when it comes to investing, I thought he should play to his strengths. He built his soon-to-be fortune by helping grow one of history’s most powerful software platforms; he is walking proof of Marc Andreessen’s assertion that “software is eating the world.”  So why manage his money the way it would have been managed 50 years ago? Hiring an expensive investment advisor or moonlighting as a stock picker were both bad choices in a world in which technology continues to make our lives simpler and cheaper.  My assertion to him: these days, software is better at investing than 99% of active investors.

To clarify a bit, by “software”, I really meant passive, software-based investing services. As opposed to active investment advisors who charge higher fees and pick individual stocks or mutual funds, passive software-based investment services determine a suitable asset allocation given your risk preferences and invest your money in a diversified portfolio of low-cost index fund and ETFs. Wealthfront is one such service in the Valley that I personally use and manages the investing process for you; online tools such as Future Advisor allow you to create portfolios yourself. For my money, these services are by far the smartest way of investing for people who don’t manage their money full time.

My friend was a bit incredulous. Coming from someone who used to work at an investment firm known for its active investing (the Yale Endowment), my advice might have seemed odd. He wanted me to put aside the finance jargon and explain how software could be better at something that allegedly required so much wisdom and judgment.

I thought more carefully about it and sent him an email later with a list of reasons why I prefer to have software manage my money. Here is the list I sent him:

Software isn’t greedy or fearful

As anyone who has had money in a wild bull or bear market can attest, investing can be an emotional affair: the panic that comes when everything suddenly plummets; the sense of missed opportunity as the market soars. When one of our stocks suddenly takes a dive, we doubt our original hypothesis about its value. This is why stop-losses – the practice of putting a ceiling on losses by triggering an automatic trade out of a falling position – are so prevalent, even though they go against principles of value. Sooner or later, all but the coolest investors let their emotions get the best of them and try to time the market, selling stocks before the market drops and buying again right before it rises.

I admit that, in spite of years of training to do otherwise, I am always tempted to try timing the market. Sometimes stocks just “feel expensive” to me. But I know a lot of academic work has gone into disproving the idea that investors can systematically generate excess returns by using this method. Some of the well-known studies include those by Kon (1983) and Chang and Lewellen (1984) on mutual funds; Becker et al. (1998) on asset allocation funds; Coggin and Hunter (1993) on equity pension funds; and Chance and Hemler (2001) on professional market-timers. The case build by these researchers is pretty damning evidence against those who say they know when the market will go up and when it will go down.

Moreover, market timing is a dangerous game. Between 1990 and 2005, missing just the 10 best days of the US stock market (as measured by the S&P 500) would have reduced the annualized returns on your portfolio from 11.5% to 8.1%. If you started with $1 million in 1990, this is the difference between having $5.1 million and $3.2 million in 2005. Of course, this cuts the other way a well – it would be hugely beneficial to miss out on the 10 worst days. But given that it’s impossible to predict those days, market timing is a lot like sailing at night close to a rocky shore.

Unlike us, software doesn’t get emotional. Software doesn’t see other people buying second homes in Florida on highly leveraged options trades or worry about losing its hard earned investment gains in a market crash. So it doesn’t try to time the market. Instead, software stays invested through market cycles, weathering the good and the bad without blinking. In the meantime, it systematically rebalances to buy more of cheap asset classes, a proven model for long-term success.

Software isn’t irrational

Even when we are able to set our emotions aside and try to act rationally, we still have a pretty hard time making unbiased choices. It turns out there are good reasons for this. Behavioral economists have uncovered a laundry list of faulty heuristics that underlie many of our decisions involving risk.

Some of the screwy cognitive tendencies include:

  • Overweighting Losses: In a seminal study on behavioral economics that outlined Prospect Theory, Daniel Kahneman and Amos Tversky demonstrated what many of us who have had a tough weekend in Vegas know to be true – losses tend to loom larger in our minds than gains.
  • Anchoring: Without realizing it, we often identify a reference point for an investment’s value, usually the first price we see. Once we are “anchored,” we have trouble shifting our views in response to new information.
  • Mental Accounting: We love to bucket and compartmentalize – “this pot of money is my ‘risky’ capital, and this pot of money is where I play it safe.” In reality, it’s all the same pot, and one investment strategy should be applied across all of our assets.
  • Confirmation Bias and Hindsight Bias: We are inclined to seek information that confirms our current beliefs, and we extrapolate too much from the past. One consequence: when we make money in the stock market, we tend to conflate luck and skill.
  • Herd Behavior: Because we are naturally social, sitting on the sidelines during a fast-moving market can be tough. For investment advisors, the pressure is worse – even when you’re fundamentally right in the long term, going against the herd in crazy times can mean your reputation or your job.

Unlike us, software doesn’t suffer from nutty cerebral ticks. It doesn’t anchor, engage in mental accounting, succumb to confirmation or hindsight bias, pay attention to what other software is doing (unless you tell it to), or obsess over losses. Instead, it just does what it is programed to do with cold efficiency. Software starts with a sensible plan and sticks to it, making adjustments solely based on actual market data, buying asset classes that are more likely to be relatively cheap (the ones that have gone down) and selling those that are more likely to relatively expensive (the ones that have gone up).

Software always loves investing

For most of us, investing our personal portfolio is not something we love to do. While it may be interesting at times, it usually doesn’t compete that well with reading a good book, riding a bike across the Golden Gate Bridge, or watching the latest Game of Thrones episode. In the face of even a bit of complexity, investing responsibly can feel like a chore. As a result, many of us fail to make the adjustments to our portfolio needed to maintain our ideal asset allocation. I know I have often fallen short in incorporating tax positions intelligently into investment decisions.

Unlike us, software doesn’t worry about the tradeoff between investing and spending time with friends and family. On the contrary, software is unfailingly intrigued by investing. It stays up to date on every market move and keeps track of the implications for our portfolio. As a result, we don’t have to worry about the latest news on the Chinese banking market, or whether we should sell some stock to harvest tax losses before the end of the year; we just need to make sure we put more money into our account than we take out. And while we’re sitting on the beach, software will continuously optimize and rebalance our portfolio (tax-efficiently, to boot).

Software doesn’t have a vacation home to pay for

Active investment managers of all varieties tend to make a living – a very healthy living, in many cases – in a few ways. First, they make money by selling their services; their primary income comes from collecting the largest pool of assets possible and charging a fee on those assets. Second, many also make money through marketing, by placing our assets in investment vehicles in which their firm has ownership or for which they have a fee-based marketing arrangement. In both cases, managers’ incentives are poorly aligned with the best interests of their clients.  They make money by building brand and relationships, not by investing well. While some investment funds do have incentive-based fees – including the famous “2 and 20” for many hedge funds – the alignment is still weak because more assets always means more potential fees.

Despite all the noise around fees since the financial crisis in 2008, I can’t imagine much will change anytime soon. Investment management firms are used to having these fees. They have corporate offices in downtown San Francisco or New York. They attract talented, well-educated people with the promise of big paychecks that support ski vacations, houses in Tahoe and private school educations.

These fees can seem like small potatoes at first glance. What is the big deal about being charged, say, 1.5% vs. 1.0% on your money? As it turns out, when you account for the powerful effect of compounding returns, the difference can be pretty staggering over the life of your investments. For example, if you invested $1 million over 25 years, the additional 0.5% fee load on your portfolio would cost you an amount nearly equal to what you invested – a whopping $1 million in extra fees. Given that the vast majority of active managers fail to outperform the market, this is a pretty corrosive toll.

Unlike us (or our investment advisors), software doesn’t need to be compensated for spending time investing. It brings the marginal cost of investing much closer to zero, so it doesn’t care whether you have $10,000 to invest, or $10 million. And software doesn’t have conflicts of interest or look for ways to create and hide fees. It doesn’t rent fancy office space or use soft dollars to buy bloated research services. Today’s software-based services enable you to invest far more cheaply than was possible even ten years ago.

I don’t mean this as a blanket criticism of financial advisors, some of whom provide invaluable services for complex personal situations such as tax and legal matters. But all investment management arrangements are subject to the fundamental principal-agent problem. It’s incredibly difficult to align the interests of people with capital and the agents they hire to manage that capital; this is relevant not only with respect to fee arrangements, but also in less obvious ways that matter a great deal, like investment time horizon. In my work with the Yale Endowment, we spent countless hours negotiating and structuring investment agreements to try to resolve some of these challenges. And this is exactly the kind of full-time work that most individual investors aren’t in a position to do. The magic of software-based investing is that the software is more principal than agent. It can be personalized to your needs and always acts solely in your interest.

Why only 99% of the time

Make no mistake about it: software is not a panacea in investing. The best investors are still, and in my opinion will long be, better at investing than any computer. Unlike in chess, in which computers have steadily developed mastery over the past few decades, I do not imagine that software-based approaches might “solve” the markets anytime in the foreseeable future. A short line of distinguished investors has shown that with a healthy amount of work, great judgment, an understanding of human nature, and the right time horizon, they can outperform the market. But consider these simple truths:

  • The market is generally efficient in pricing investments. This becomes truer as information becomes more ubiquitous.
  • Identifying mistaken pricings is very hard and costly; most professionals fail at it.
  • Identifying or accessing the short line of investors who might be able to beat the market is out of the reach for all but a very few.
  • Most of us do not enjoy spending our free time investing or interviewing other people who invest.

Given these realities, there are very few individual investors who can outperform software implementing a low-cost, passive approach. The educated personal investor recognizes her own limitations of time, passion and expertise.

That’s why my advice to my friend from Facebook was to remember how he made all that money. Unless you want to spend all of your time becoming an investor in the public markets, keep it simple and cheap. Determine an asset allocation that fits your risk profile, stick with low cost index funds and ETFs, and let the software do the work. Also, don’t make too many crazy angel investments (unless you want to make one in my new company, in which case give me a call).