financial robo-advice: fancy software is not a substitute ...the main points • pure 100%...

Financial Robo-Advice: Fancy Software Is Not a Substitute for

Trustworthiness and Good Science

By Zvi Bodie October 1, 2018

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TheMainPoints

•  Pure100%robo-advicehassofarbeenafailure.

•  Almostallprovidersofadviceofferahybridservicethatincludesahumanadvisor.

•  Almostalladvice–roboorhuman--isbiasedtowardsencouraginginvestmentinequities.

•  ThereisadangerthatparticipantsinDCretirementplanswillfaceriskunprepared.

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6KeyQuestions

•  Whatisthehistoryofrobo-advice?•  Howgoodisrobo-advicetoday?•  Whatisworsethannothavinginsurance?•  Cantheregulatorsbetrustedtoactinthebestinterestofordinarypeople?

•  Whatisthefutureforrobo-advice?•  Caninnovativestructuredproductssubstituteforgoodadvice?

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“TechnologyCanGiveEveryonetheHelpTheyNeed”

! Financialadvisorscanbeexpensive,can’talwayssufficientlyanswerallofthemanyquestionsweneedanswered,andmanyarefocusedonwealthierclients.

! Thesolution?Highqualityretirementcalculators,detailedonlineinformationandserviceslikeroboadvisors—canhelpeveryoneaccessthedetailedmodelingyouneedtoassesswhereyoustand,discoverwaystostrengthenyourfinancesandmakebetterdecisionsaboutyourmoneyandwhen,whereandhowtoretire.

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The Case of Financial Engines

•  First robo-advice service founded in 1996 applying William Sharpe’s model

•  Widespread adoption by plan sponsors to satisfy regulatory requirement to offer help to participants

•  Evolution towards hybrid model through acquisition of advisory firm and recent merger with Edelman.

•  It is now the largest independent RIA in the U.S.

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Roleofhumanadvisors

“SomedayBobandSuemaybeabletositattheirdiningtablewithanon-lineprogramandmakegoodretirementincomechoicesbythemselves.Butitseemslikelythatforsomewhileanexperienced,unbiased,andfrugalhumanadvisormaybewellworththeaddedcost,atleastattheoutset.”WilliamSharpe,RetirementIncomeScenarioMatrices.(2017)

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How good is robo-advice today?

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! Advice is flawed Example: Betterment

“At Betterment, we believe that … the more long-term your investing goals, the more risk you can afford to safely take.” No free lunch: You cannot earn a risk premium safely, no matter how long your time horizon.

TheBestOnlineRetirementIncomeCalculators

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Accuracy Usability Education Weighted Result

ESPlanner Basic 3 3 3 3 New Retirement 3 3 2 2.8 AARP 3 2 2 2.6 MarketWatch 3 1 2 2.4 T. Rowe Price 2 3 2 2.2 Schwab 2 2 2 2 Vanguard 1 3 2 1.6 Bankrate 2 1 1 1.6 Fidelity 1 2 1 1.2

Retirement Calculator Scorecard

Adviceisnotconsistentwitheconomics.

Robo-advice (wrong) Economics (right)

Saving is for the short run. Investing is for the long run.

Saving = income minus consumption; investing= saving

The only way to manage risk is to diversify.

Three ways to manage risk: hedge, insure, or diversify.

Stocks become safe in the long run.

If they did, there would not be an equity risk premium.

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4FallaciesAboutStocks

Fallacy#1:Stocksarenotriskyinthelongrun.Fallacy#2:Stocksareagoodhedgeagainst

inflation.Fallacy#3:Dollar-cost-averagingimprovesyour

risk-rewardtradeoff.Fallacy#4:Youcanidentifythebestequity

managersbysimplylookingattheirtrackrecords.

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2018 10

The“BodieParadox”

•  Asthetimehorizongetslonger,theprobabilityofashortfallrelativetotherisk-freeassetgetssmallerandsmaller,butthemarketpriceofinsuranceagainsttheshortfall–a“shortfallput”--getslargerandlarger.

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Explanationoftheparadox

Theexplanationforthisapparentparadoxisthattheprobabilityofashortfallisnotasufficientmetricofrisk.Theriskmetricmustalsoreflecttheseverityofapossibleshortfall.Thecostofinsuringagainstashortfalltakesintoaccountbothelementsandthusisabettermetricofshortfallrisk.

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0

0 5 10 15 20 25 30

Time Horizon in Years

6% risk premium Cost of shortfall put

Probability of shortfall vs. cost of shortfall insurance

Prob

abili

ty

Fraction of investment

0.5

0.4

0.3

0.2

0.1

0.0

0.5

0.4

0.3

0.2

0.1

0.0

The“BodieParadox”

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Lookingatdistributionofrateofreturnismisleading.

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Lookatdistributionofterminalwealthorlifetimeincome.

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Thegraphicontherightistheonetopayattentionto.

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Needabetterwaytocommunicaterisk

LotsofoverlappingsimulationsDynamicchartshowingsimulationrunsoneatatime

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Whatisworsethannothavinginsurance?

!  Thinkingyouhaveinsurancewhenyoudonot.

!  Distinguishessentialneedsfromwantsand“immunize”essentialswithrisk-freeassets.*

*Noassetiscompletelyriskfree.Theideaistogetascloseaspossible.

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IstheSECacaptiveoftheindustry?

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ROADMAPTOSAVINGANDINVESTING

Buthow“safe”isasavingsaccountifyouleaveallofyourmoneythereforalongtime,andtheinterestitearnsdoesn’tkeepupwithinflation?

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Ibondsbeforestocks

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Roboadvisers(WithHumanHelpers)

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HybridApproach

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Structuredproductsolutions

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KeyQuestionsandAnswers

•  Whatisthehistoryofrobo-advice?– Trendistowardshybridmodel.

•  Howgoodisrobo-advicetoday?– Biasedtowardsequitiesandlogicallyflawed

•  Whatisworsethannothavinginsurance?– Thinkingyoudowhenyoudonot.

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KeyQuestionsandAnswers

•  Cantheregulatorsbetrustedtoactinthebestinterestofordinarypeople?– No.Theyareindustrycaptives.

• Whatisthefutureforrobo-advice?– Hybridmodel

•  Caninnovativestructuredproductssubstituteforgoodadvice?–  Intheoryyes,butnotyetinpractice.

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