Less Wrong is a community blog devoted to refining the art of human rationality. Please visit our About page for more information.

Comment author: V_V 16 September 2014 09:59:08AM *  1 point [-]

his is fairly common of private practice type industries like dentistry and law.

Is it? I never heard of a dentist refusing to take a client because of age difference. Do you have any reference?

Anyway, I understand that while a dentist or a lawyer may be interested to short-term goals, a financial adviser should be interested more to long-term goals, which may cause an age effect. But then, why don't financial managment practices scale to large corporations, or become more like investment funds that provide standardized products?

Maybe I'm overestimating my understanding due of the Dunning–Kruger effect, but from the outside view, it looks like this industry should have substantial economies of scale, since large corporations don't have this age bias, and they can better reduce risk using asset diversification, while the benefits of having a personal financial adviser making a personalized investment plan seem small unless you are truly unusual.
I mean, even luxury items such as Rolex watches and Ferrari cars are more or less standardized products made by corporations. Even if you are very wealthy you are most likely not going to hire a personal engineering team to make and maintain your own fancy car.
Things like medicine and legal assistence need to be personalized because different people have significantly different medical and legal issues, but investment?

I can't help but notice that proven investment strategies (index investment) are usually provided by large corporations like Vanguard, while more speculative investment strategies that promise to outperform index investment are provided by small-scale firms operating according a business model which, will all due respect, reminds me of tarot readers.

I don't mean to imply that that all financial advisers are charlatans. There are obviously lots of incompetent investors and advisers who consistently underperform index funds and a few highly competent investors and advisers who consistently overperforms index funds, probably by taking value from these incompetent investors. Finding the latter while avoding the former looks like a non-trivial problem.

Comment author: ColbyDavis 16 September 2014 06:50:02PM 1 point [-]

There's nothing I strongly disagree with with what you just said, but I think you are probably underestimating the heterogeneity of peoples' financial lives and the degree to which many people enjoy a personal touch.

Things like medicine and legal assistence need to be personalized because different people have >significantly different medical and legal issues, but investment?

Since I have started working in my current role I have been impressed with just how complex and particular an individual's financial situation can be, especially when dealing with high net worth individuals well into their career. Multiple accounts with different tax treatment, employee stock grants and options, insurance, inheritance, real estate holdings, dependents, charitable giving, trusts, required minimum distributions, loans and other financial obligations, etc. are all things I regularly encounter and deal with in considering portfolio construction. Add to this the fact that most people are very emotionally invested in and/or have ugh fields about their money and are prone to making foolish mistakes like selling at the bottom of a bear market (I've seen it from people who I know understand the efficient markets hypothesis) and you can see why there is a market for financial professionals who personally know their client and can hold them responsible to their financial goals. Not that everybody needs this, but I think younger people who have never had (or lost) a lot of money underestimate this aspect.

That said, I more or less agree with your point, and I think in a more competitive market there would be larger scale corporate consolidation in this market, along with law and medicine as well. One thing law, medicine, and finance all have in common is a system of occupational licensing and other cartelization policies in place that protect incumbents.

Betterment and WealthFront are trying to push our industry in that direction and have so far been quite successful for themselves. I would not be surprised, however, if after the next bear market their reputations take a hit when investors panic and hit the sell button when there's nobody there to talk them off the cliff. Maybe that won't happen. Time will tell.

I don't mean to imply that that all financial advisers are charlatans.

Thanks! =)

Part of the reason I got in the business I am in is because there is so much bullshit in the financial industry. I would like to try to bring a little more sanity to it, because I do think it is so important for our economy. This paper is part of my efforts to do so. I hope you appreciate it.

Comment author: V_V 15 September 2014 10:55:04PM *  1 point [-]

The average FA is 50+ years old and so is generally more interested in how your portfolio looks right now than what it will look like in 20-30 years, but younger advisors are much more interested in the trajectory of your wealth.

Why does the age of the financial adviser matter?

A firm can be expected to professionally outlive its employees and keep providing its services to its customers after any specific employee retires or quits, provided that employees operate according to known principles and their expertise if generally transferable. That's how engineering and medicine are done, for instance.
Is financial advising some kind of non-transferable "dark art" such that advisers aren't easily replaceable? This rings some alarm bells...

Comment author: ColbyDavis 16 September 2014 12:08:20AM 3 points [-]

The age of the advisor matters not because of the skills he is or is not able to transfer to employees but because it may effect whether he wants to bring you on as a client in the first place. Most wealth management practices are owned by a single advisor or a small number of partners who are more concerned about maintaining their lifestyle than ensuring that their firm remains competitive in perpetuity. If a 55 year old advisor has an established practice working mostly with clients about her age who she likes, she is unlikely to take on a 25 year old from a different culture with few current assets just because the client can be expected to have a sizable portfolio after the advisor has already retired, even if doing so may theoretically increase the NPV of her firm. This is fairly common of private practice type industries like dentistry and law. Business owners are humans who like to form tribes, even if it means not being maximally efficient.

Comment author: Punoxysm 15 September 2014 04:53:17PM 3 points [-]

So I'm supposed to actively manage my own portfolio according to a Mean-Variance variant? Or find a financial advisor who is almost certainly uninterested in someone of my net worth?

I gotta be honest, Vanguard-and-wait seems better, unless the premium is substantial and certain.

Comment author: ColbyDavis 15 September 2014 08:32:30PM 2 points [-]

Vanguard may very well be better for you, and I am happy to tell people to take advantage of Vanguard if their fortunes are small or they don't want to spend a lot of time on their portfolio or hire an FA.

I want to quell the notion, however, that you're only worthwhile to a financial advisor if you have millions of dollars. The average FA is 50+ years old and so is generally more interested in how your portfolio looks right now than what it will look like in 20-30 years, but younger advisors are much more interested in the trajectory of your wealth. My firm has, and I have known other FAs who have, taken on younger clients with trivial amounts of current assets because they were dedicated to an aggressive savings plan.

Comment author: malo 15 September 2014 06:50:24PM 2 points [-]

In my opinion it is not really possible to scale a market-inefficiency-exploiting strategy to the level that Betterment and WealthFront are after.

Yeah, I can imagine it's hard to take advantage of some of the inefficiencies you pointed out at that scale. Though they do invest in funds like Small-Cap ETFs because of the market inefficiency you pointed out.

I consider their approach to be an alternative to using Vanguard . . .

This confuses me a little since the vast majority of the funds they invest in are Vanguard ETFs. Maybe you mean something more specific that I'm missing?

Comment author: ColbyDavis 15 September 2014 08:12:13PM *  4 points [-]

This confuses me a little since the vast majority of the funds they invest in are Vanguard ETFs. Maybe you mean >something more specific that I'm missing?

Haha, ok. So you can just go buy a Vanguard target-date retirement fund and let the fund's internal structure take care of the asset allocation for you, or you can go talk to somebody at Vanguard who will either give you some straightforward advice about how to build your own portfolio for a one-time fee or build your portfolio for you for an ongoing fee, or go to Betterment where they will build you a portfolio out of Vanguard funds, or you can build it yourself using some of the insights you gleaned from this article. All of these are reasonable solutions.

Comment author: pcm 15 September 2014 06:38:21PM 2 points [-]

Angel investing is not like buying small publicly traded stocks. Transaction costs cause some of the better startups to refuse to deal with small Angel investors. The obstacles to becoming publicly traded weed out some of the worst startups.

Comment author: ColbyDavis 15 September 2014 08:04:30PM 4 points [-]

I completely agree and would add that just because you know a lot about tech does not mean you are qualified to identify angel investment opportunities. Knowing a lot about accounting is probably just about as important. David Swensen, portfolio manager for the Yale endowment fund, and probably the most successful venture capital investor in the world, constantly stresses that only the top 10% or so of private equity funds have posted returns that have beaten small cap indexes and justified their costs and risks, and you're only going to have access to the top 10% of these funds if you have billions of dollars to work with.

Comment author: V_V 15 September 2014 03:36:42PM 1 point [-]

that losses feel bad to a greater extent than equivalent gains feel good

That sounds like usual risk aversion. How is that a bias?

The only sense in which e.g. value and momentum stocks seem genuinely “riskier” is in career risk ... but if he chooses Ol’Timer and it underperforms he is a fool and a laughingstock who wasted clients’ money on his pet theory when “everyone knew” NuTime.ly was going to win. At least if he chooses NuTime.ly and it underperforms it was a fluke that none of his peers saw coming, save for a few wingnuts who keep yammering about the arcane theories of Gene Fama and Benjamin Graham.

A financial adviser advising an individual investor that only buys few assets might have this problem, but a fund could diversificate on thousands of different assets, therefore reducing this "reputational" risk. Which brings us to the following point:

Though traditional index funds are a reasonable option, in recent years several “enhanced index” mutual fund and ETFs have been released that provide inexpensive, broad exposure to the hundreds or thousands of securities in a given asset classes while enhancing exposure to one or more of the major factor premiums discussed above such as value, profitability, or momentum. Research Affiliates, for example, licences a “fundamental index” that has been shown to provide efficient exposure to value and small-cap stocks across many markets.56 These “RAFI” indexes have been licensed to the asset management firms Charles Schwab and PowerShares to be made available through mutual funds and ETFs to the general investing public, and have generally outperformed their traditional index fund counterparts since inception.

Why in recent years? Why aren't these funds more common? And since you are talking about "rebalancing" in the next paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?

I think there is a kind of "meta" risk you are not considering here: index funds are proven investment strategies, based on empirical evidence and economic theory. The investment strategies you propose here are more uncertain.
You link many studies in favor, but I don't have the expertise to evaluate their relevance, and I suppose this holds true for pretty much anybody who isn't a professional investor.
From the "outside view", the strategies you propose are inherently more risky than index fund investment.

One of the greatest misconceptions about finance is that investing is just a zero-sum game, that one trader’s gain is another’s loss. Nothing could be further from the truth. Economists have shown that one of the greatest predictors of a nation’s well being is its financial development.

Correlation doesn't imply causation. It is plausible that correlation actually goes in the way opposite than what you are proposing: in wealthier nations people have more disposable money to play zero-sum games with.

Comment author: ColbyDavis 15 September 2014 07:56:16PM 2 points [-]

Correlation doesn't imply causation. It is plausible that correlation actually goes in the way opposite than what you are >proposing: in wealthier nations people have more disposable money to play zero-sum games with.

Which is why I said predictors, not correlates. There is plenty of research to support my claim; the source I cite points to some of it. Obviously teasing out the arrow of causality is difficult in large scale, trans-generational, international macroeconomic settings, but economists have done their best and the evidence supports the Solow growth model that Metus has brought up.

Comment author: Salemicus 15 September 2014 05:23:20PM *  2 points [-]

Re: Momentum:

Firstly, a momentum strategy would have taken huge losses (50%+) in the big stock rebounds of July-Aug 1932, and March-Sep 2009. That certainly supports the view that momentum generates returns only by assuming huge market risk. I can't help notice that your footnote on this point only goes to a paper discussing the value anomaly, not the momentum anomaly. Do you have any thoughts about this?

Secondly, my understanding is that the momentum anomaly has been very small since 2000. See e.g. here. Although you can argue that this "just" reflects the disaster of 2009, it's something that needs to be taken into account.

Comment author: ColbyDavis 15 September 2014 07:50:41PM 4 points [-]

Good point. Again, these strategies don't always work, and their returns are more skewed and leptokurtic than broad market averages, which is probably at least part of the reason they work in the first place. An interesting thing about value and momentum though is that the two strategies have negatively correlated active returns, i.e. value tends to outperform when momentum is underperforming and vice versa, which allows for portfolio construction that can be less volatile than a broad index.

It is true that momentum hasn't been very strong in the US equity market since 2000. It has continued to work among global stocks in general, as well as in other asset classes. Though momentum might just be temporarily out of favor in the US I would generally expect this pattern to continue as the US equity market - and especially blue chip US companies - is the most efficient around. But the global capital markets are a very large place.

Comment author: V_V 15 September 2014 03:36:42PM 1 point [-]

that losses feel bad to a greater extent than equivalent gains feel good

That sounds like usual risk aversion. How is that a bias?

The only sense in which e.g. value and momentum stocks seem genuinely “riskier” is in career risk ... but if he chooses Ol’Timer and it underperforms he is a fool and a laughingstock who wasted clients’ money on his pet theory when “everyone knew” NuTime.ly was going to win. At least if he chooses NuTime.ly and it underperforms it was a fluke that none of his peers saw coming, save for a few wingnuts who keep yammering about the arcane theories of Gene Fama and Benjamin Graham.

A financial adviser advising an individual investor that only buys few assets might have this problem, but a fund could diversificate on thousands of different assets, therefore reducing this "reputational" risk. Which brings us to the following point:

Though traditional index funds are a reasonable option, in recent years several “enhanced index” mutual fund and ETFs have been released that provide inexpensive, broad exposure to the hundreds or thousands of securities in a given asset classes while enhancing exposure to one or more of the major factor premiums discussed above such as value, profitability, or momentum. Research Affiliates, for example, licences a “fundamental index” that has been shown to provide efficient exposure to value and small-cap stocks across many markets.56 These “RAFI” indexes have been licensed to the asset management firms Charles Schwab and PowerShares to be made available through mutual funds and ETFs to the general investing public, and have generally outperformed their traditional index fund counterparts since inception.

Why in recent years? Why aren't these funds more common? And since you are talking about "rebalancing" in the next paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?

I think there is a kind of "meta" risk you are not considering here: index funds are proven investment strategies, based on empirical evidence and economic theory. The investment strategies you propose here are more uncertain.
You link many studies in favor, but I don't have the expertise to evaluate their relevance, and I suppose this holds true for pretty much anybody who isn't a professional investor.
From the "outside view", the strategies you propose are inherently more risky than index fund investment.

One of the greatest misconceptions about finance is that investing is just a zero-sum game, that one trader’s gain is another’s loss. Nothing could be further from the truth. Economists have shown that one of the greatest predictors of a nation’s well being is its financial development.

Correlation doesn't imply causation. It is plausible that correlation actually goes in the way opposite than what you are proposing: in wealthier nations people have more disposable money to play zero-sum games with.

Comment author: ColbyDavis 15 September 2014 06:05:06PM 3 points [-]

That sounds like usual risk aversion. How is that a bias?

Loss aversion is different than risk aversion, though they are related concepts, the shape of an agent's utility function under loss aversion can lead to inconsistent preferences.

Why in recent years? Why aren't these funds more common? And since you are talking about "rebalancing" in the next >paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?

I can only speculate as to what the average of all the millions of decisions that go into releasing an investment product and whether it gains popularity looks like. As to why in recent years, I think it mostly is a function of the rise of index strategies, the emergence of the ETF as a vehicle that is well-equipped to execute strategies like this, and the general fall in popularity of expensive, black-box, active management strategies.

Internally, these products rebalance according to some rules-based methodology. IMO the "active vs. passive" debate is a false dichotomy, the better scales to judge an investment by are "cheap" vs. "expensive" and "transparent/rules based" vs. "black box/dependent on skill." Some of the enhanced index funds are in fact cheaper than some of the "true" index funds on the market.

Externally, there is currently no such thing as target date retirement fund which tries to strategically target these factor premiums in a rules-based fashion, they are generally limited to single-asset classes and so will require some measure of asset allocation/portfolio management decision making.

I think there is a kind of "meta" risk you are not considering here: index funds are proven investment strategies, based >on empirical evidence and economic theory. The investment strategies you propose here are more uncertain. You link many studies in favor, but I don't have the expertise to evaluate their relevance, and I suppose this holds true >for pretty much anybody who isn't a professional investor. From the "outside view", the strategies you propose are inherently more risky than index fund investment.

I basically agree. And you may say the possible greater expected return from these strategies is compensation for this meta-risk. As I am quick to point out, these strategies do underperform from time to time, sometimes badly. It is during these periods that investors proclaim that "things are different now" and change course, often to their detriment. This epistemic factor can make the strategies more risky in practice.

I have laid out what I consider to be the best evidence to support my philosophy, much of it is Nobel-prize winning research (not that having Nobel laureates on your side is always profitable...) But how comfortable you feel evaluating that evidence or trusting me to present it in a fair manner is a question I can't answer for you. If you are doubtful, and I do not find that an unreasonable proposition, you would do well to use index funds and be done with it. More intrepid investors may have a different attitude.

Comment author: cata 15 September 2014 05:10:03AM *  6 points [-]

You mentioned at your talk that you were leveraged well past 100% of your net worth in equities. Can you elaborate on how you came to make that decision? As far as I can see, the only source of money at a reasonable rate that I can easily invest is margin, and that comes with both a 1.5-2% interest rate and the risk of margin calls, which makes me nervous. (In addition, I'm not so confident that I would be psychologically capable of making good decisions if such a really huge volatility happens to me.)

What's your thought process about that like?

Comment author: ColbyDavis 15 September 2014 01:32:08PM 4 points [-]

I've obtained my leverage mostly through credit card stoozing, the act of taking advantage of low and 0% promotional credit card balance transfers and rolling the balances over as necessary. As I said at the talk and every time I bring this up, I do NOT recommend this unless you, like me, have an Asperger's level attention to financial minutiae. This is also a strategy that only is worthwhile while your net worth is relatively low. I started doing it in college and am now winding the strategy down, to be replaced with portfolio margin, which is cheaper and more scalable for people with more substantial assets to work with. You are right though that margin calls are a risk, however, so active portfolio monitoring and careful use of mean-variance optimization and other risk management techniques is essential. If you do not have the time or skills to employ these, or to use a financial advisor who is, then I cannot recommend it.

Comment author: malo 15 September 2014 05:58:11AM *  6 points [-]

Am I right that services like Betterment and WealthFront are basically automating most of this? They offer automated investment in a mix of ETFs (of stocks and bonds) weighted to ones risk tolerance, which is rebalanced automatically, and bought/sold in the most tax efficient manner (all for a small fee).

I recently spent some time figuring out how I wanted do investing in the US, and settled on using Betterment. Using a service like theirs seems strictly better than doing it myself, and I haven't found any compelling arguments that finding a financial advisor would be worth the effort.

Comment author: ColbyDavis 15 September 2014 01:14:45PM 5 points [-]

The online services Betterment and WealthFront explicitly state they hold the efficient markets hypothesis is true and invest exclusively in broad-market index funds. I consider their approach to be an alternative to using Vanguard, which is to say, they offer an excellent service and many people would be well to use them, but I believe more optimal investing is possible. In my opinion it is not really possible to scale a market-inefficiency-exploiting strategy to the level that Betterment and WealthFront are after.

View more: Next