Overview: Robo Advisors vs Financial Advisors
In answering the question, “Will robo advisors replace financial advisors?” the words of the late football coach George Allen are fitting: “The future is now,” or so a glance at market statistics would indicate.
Automated trading software accounts for approximately 75% of all financial market volume in today’s market.
So, does that mean all investors should transition to an automated trading desk for their stock trading?
This article takes a look at the potential benefits of automated stock trading, along with the challenges of affordably developing effective automated trading strategies as investors consider what the future of investing means for them.
For those who ultimately decide that automated stock trading is the right answer, this article will also take a look at a list of robo advisors and examine robo advisors’ performance for the sake of comparison.
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Robo Advisors vs Financial Advisors – The Challenges of Setting Up and Using Automated Stock Trading Software
Although, by volume, a large majority of trades are conducted by automated trading desks, for the vast majority of amateur and independent traders, the cost, complexity, and difficulty of setting up and using automated stock trading software is prohibitive. Challenges to setting up and using an automated trading desk include:
- Technological and market knowledge
- Back testing
- Need for monitoring
Robo Advisors vs Financial Advisors – Do You Have the Know-How to Program Automated Trading Strategies?
Unless you are familiar with the specific programming languages associated with direct access brokers, the technological hurdles of setting up automated stock trading software can be daunting.
To do so requires either a background in software programming, and specific knowledge of the programming language to be used, or the expense of hiring a programmer who has the proper background and knowledge.
The ongoing development of drop-and-drag technology is beginning to provide access to automated stock trading for investors without the technical savvy to do their own programming. However, easier access to automated stock trading carries with it some additional concerns.
Of greatest concern is whether individual investors have the combination of market knowledge and understanding of how automated stock trading software is designed to properly set up and use an automated trading desk.
In many, instances, the answer is probably no.
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Robo Advisors vs Financial Advisors – The Need for Back Testing and Avoiding Overfitting or Look-Ahead Bias
Once the automated trading strategies have been programmed, the automated trading desk must be tested and back tested. Back testing is the process of applying the automated trading strategies to historical trading data and determining the efficacy of the overall strategy.
Effective back testing requires the use of massive amounts of historical data to ensure the sample size is large enough to accurately represent the range of variables that might affect the market and automated trading strategies over an extended period of time.
Back testing typically also requires a series of tests, with incremental improvements after each round of back testing.
Until recent times, obtaining large datasets required for accurate and effective back testing was extremely costly, and thus generally out of reach for individual investors. As more databases have become accessible online, this issue has become less of a hurdle.
There are several potential missteps involved with back testing. One of the most common errors is overfitting or look-ahead bias.
In short, there is the potential for overreliance on successful back testing without accounting for factors that could mean the robo advisor’s performance will not be similarly successful when applied to live, future market activity.
A simple example would be back testing automated trading strategies against a company that is a known success and expecting similar success with a different company in future trading but failing to account for the multitude of variables that could produce a different result.
Image Source: Is Automated Stock Trading the Future of Investing?
An article in Bloomberg, citing a study by the 126-year-old American Mathematical Society, indicates that much of the back testing that is presented as supporting evidence for the future performance of automated trading strategies is based on selective historical data and is not scientifically reliable or mathematically sound.
In short, back testing is a complex, challenging process that even experts have struggled to execute as a consistently accurate predictor of future automated stock trading. The ability of individuals to properly back test a proposed automated trading strategy would be a significant hurdle to overcome.
Robo Advisors vs Financial Advisors – The Lack of Human Awareness and the Requirement of Monitoring
Another potential shortcoming of automated stock trading, in both the development and use of an automated trading desk, is the lack of human feel or awareness.
Automated stock trading software is only as good as the information it is provided and the programming designed to process that information.
Common sense dictates that humans will have greater awareness of world events and other outside factors than computers. Additionally, there is the potential for mechanical breakdown – disruptions to connectivity, loss of power, and hardware failures, to name a few.
As such, major trading houses frequently employ top graduates from Ivy League colleges to design and monitor their automated stock trading software. Because of those concerns, the future of investing, while likely to continue trending towards automated stock trading, will always require a component of human monitoring.
Unfortunately, most individual investors are unlikely to have the resources required to employ competent monitors.
As such, to be successful using automated stock trading, investors must either be knowledgeable regarding the financial industry, automated stock trading software, and world affairs or invest through a personal investment company with the resources to employ skilled and talented monitors.
Robo Advisors vs Financial Advisors – The Benefits of Automated Stock Trading Software
Despite the concerns and challenges discussed above, there are significant benefits to automated stock trading. Some of the primary benefits include:
- Emotionless, rule dictated trading
- No human error
The future of investing is now. Due to the substantial weight of these benefits and others, the automated trading desk will continue to be a major part of stock trading, even in light of the challenges discussed above.
Robo Advisors’ Performance Eliminates Emotion
Do you play blackjack? If so, you know the rules, you’ve studied the odds; you know when to hit, when to stand, and when to double down.
It’s all about the cards and the percentages.
But, there you sit in a Las Vegas casino, flush with winnings and on a roll, when, defying all logic, you decide to split those Jacks you just got on the deal, because you are certain fate will continue providing the cards you need to keep the roll going.
Those who have spent any time investing know that the same types of emotion can play into stock trading decisions. The tendency for some investors to be too tentative in certain scenarios or overly aggressive in others is removed when automated stock trading is employed.
All orders are dictated by the automated stock trading software with its inherent and unwavering adherence to the rules it was programmed to follow. For the blackjack player above, who took a 4 on one hand and a 6 on the other, the unchanging discipline of computers can be a good thing.
Automated Stock Trading Software is Infinitely Faster than a Financial Advisor
How fast are your fingers? How quickly can you receive information, process it, make a decision, and act upon it? Without exception, your computer can do it faster. Exponentially faster. Automated Stock Trading Software can perform literally millions of calculations per minute. Information is received, processed, applied against the programmed rules, and, when rules are met, an action is performed, all in an instant. The computer never gets tired, distracted or bogged down with information overload.
The ability to respond instantly to changing market conditions can make a critical difference in the outcome of a trade.
In a fast-moving market, humans simply aren’t fast enough, and are too susceptible to disruptive factors, to consistently receive information, process it and enter an order immediately when a profit target or stop loss level is reached. Sometimes, things simply move too quickly.
Automated Stock Trading Software Avoids Human Error
You are on top of it. Stock A hits the stop loss level. You quickly and confidently respond by entering an order to buy 1,000 shares. Wait, what? You didn’t mean to do that!
That’s human error, and it happens with some regularity. Absent mechanical failure, and assuming the programming was correctly written by the human programmer, automated stock trading software won’t make absent-minded mistakes. Ever. Can your financial advisor promise you that?
Can your financial advisor follow through on that promise with 100% perfection?
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Will Robo Advisors Replace Financial Advisors?
As discussed, they have, they can, and they will continue doing so. More to the point, at present: should you replace your financial advisor with automated stock trading software? Perhaps, and with one important qualification.
After weighing the challenges and benefits discussed above, if you are comfortable replacing your individual financial advisor with automated stock trading software, you won’t be in the minority. The benefits are real and significant. But, and this is a substantial qualification, the majority of individuals using automated stock trading are doing so through a personal investment company.
Unless you have very substantial individual wealth — or are extremely experienced, knowledgeable, and well-informed regarding financial markets, world affairs, and software programming — you would be operating at a substantial disadvantage by replacing your entire personal investment company, with its resources and expertise, with reliance on your own, individual use of automated stock trading software.
List of Robo Advisors and Robo Advisors’ Performance
The list of robo advisors is extensive and growing. The AdvisoryHQ Review Team recently published its own robo advisors comparison of the 5 Best Robo Advisors in 2016. AdvisoryHQ’s list of the best robo-advisors and online investment platforms is based on assets under management (AUM), ease of use, highly advanced user interface, comprehensiveness, strategic investing structure, low fees, minimum requirements, security, and popularity. The results are as follows:
- Personal Capital (hybrid)
- Betterment (robo-advisor only)
- Wealthfront (robo-advisor only)
- FutureAdvisor (hybrid)
- Charles Schwab (Intelligent Portfolios)
Keep in mind that the right automated trading desk that is right for others might not be right for you. Research several robo advisors before making a decision on which automated stock trading software is best for you. This report from Paladin includes a more comprehensive list of robo advisors and a linked overview of each.
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