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Posted by on Apr 21, 2014 in ETF Strategist

Robo Advisors & Behavioral Finance

Robo Advisors & Behavioral Finance

by Roger Nusbaum AdvisorShares ETF Strategist

Late last week I stumbled across two different articles covering behavioral finance and a look at robo-advisors from that both tie together.

Behavioral finance is always interesting because our emotions are regularly a bigger impediment to long term investing success than stock and/or fund selection. The article in question was an interview with Terrance Odean from Cal. Odean notes that “we can’t control our initial reactions, but we can learn to control what we do next.” He then goes on to discuss how to modify behavior.

I’m not sure that his quote above actually fits with reality. As bear markets go on you hear about whether or not there has been capitulation. Over the years I’ve written frequently about panic selling and the extent to which it does people in. Panic in this context ensues after some period of time of large declines. Fear mounts slowly at first, eventually turning into desperation and panic.

The initial reaction in that scenario is relatively mild anxiety maybe around a 10% decline (or less for some people) and there usually isn’t much to control or not control. The longer the decline goes on is when panic selling occurs and this is not an initial reaction watching a market decline by some large amount over several months and then selling is the “what we do next” but I would submit is not within people’s control.

For years I have blogged about defensive action based on an objective indicator such that it likely would prevent being in a position where panic selling can happen. In this context I’ve talked about a breach of the 200 day moving average but of course there are many indicators that warn of a higher probability of a large decline. There are obviously no guarantees with any strategy but a systematic reduction of exposure while the market is down a little is likely to reduce likelihood of panic after the market has gone down a lot.

The term robo-advisors refers to firms that build and manage portfolios typically consisting of low cost index funds and they also rebalance accordingly. The portfolios are typically determined by a survey/questionnaire filled out through the website by the client. The management fees for this service are very low. notes the potential flaw in having individuals determine their own tolerances by checking a couple of boxes on a web page noting that people doing this exercise in early 2009 would probably come up with different volatility thresholds than people filling out the same info sheet in December, 2013. The point there, tying into behavioral finance, is that people assessing their own profile would be too fearful while the market was low and too greedy when the market was high.

The robo-advisor do provide some support to their clients in terms of things like blog posts but people that seek out one of these firms feel they need some help because it would be pretty easy to find plenty of content on how to construct a low cost portfolio that covers a lot of bases with five or six funds. It is a good bet that robo-advisories will evolve into something slightly different but a huge part of what an advisor does is helping clients avoid or reduce behavioral mistakes that are so detrimental to long term success.

Clearly not everyone needs an advisor who will answer the phone or reply to an email at all hours but plenty of people do. Advisors need to understand how the industry is evolving in order to remain relevant and individuals need to consider how they might react under adverse market circumstances and take action before adversity arrives (by hiring an advisor or somehow taking action to avoid being in a position where panic might ensue).