Why a robot will never take my job

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor.  These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost.  Two of the largest providers are Wealthfront and Betterment.  Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k).  Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement.  If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing.  A financial advisor should know your personality, your family situation, your dreams, and your frustrations.  This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields.  When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized.  The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication.  When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that well trained professional financial advisors do for their clients.

Original post at pwlcapital.com

Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 


Using Visual Basic for Financial Modelling

I learned a fair amount of programming when I studied mechanical engineering, and it is always fun when I get to apply those skills to problems that I see in finance.

I was recently asked to determine if a particular client would be better suited to deposit money into an RRSP or to leave it in non-registered investments.

The problems I had to solve revolved around the following issues:

  • Minimizing taxes
  • Minimizing OAS clawback
  • Maximizing net income

But which strategy would produce superior cash flows based on these parameters?  I structured my model as I would structure a discounted cash flow analysis for a company, selecting my inputs to match an individual.  Gross income became a proxy for revenue, and then I added minimum RRIF payments after age 71, and CPP and OAS benefits at age 65.  I treated taxes and OAS clawback like cash outflows .  I calculated taxes based on marginal tax rates, and OAS clawback based on 15% of any income over $70,954 in any year OAS is received.

I wrote functions in visual basic to find the appropriate tax bracket for a given income, to find the minimum RRIF payment based on age and RRIF amount, and to find the amount of OAS clawback.  The calculations in the model lead to two numbers: the present value of the free cash flow in each scenario.  I was able to link the difference between these two numbers to a sensitivity analysis; using scenario 1 (no RRSP contribution) minus scenario 2 ($31,000 RRSP contribution) shows that when the result is negative (red) it makes more sense to make an RRSP contribution, and positive means it is better to forego RRSPs.

The value of writing these programs did not come in creating the original spreadsheet; I could have realistically input all of that data by hand.  The value in coding a fully linked model is that it allowed me to perform the sensitivity analysis for varying growth rates, inflation rates, and levels of CPP income.

I had hoped that there would be a conclusive answer to the initial question, but the result shows that it all depends on what the market does.  If market performance is strong, the RRIF becomes so large that taxes and OAS clawback are overpowered, but with lower market returns, the tax savings make avoiding the massive RRIF accumulation a better option.

For some context, the client is 47 today and will live to 100.  They are making a one time $31,000 RRSP contribution.  The RRSPs value today before any new contribution is $100,000.  Earned income is $110,000.

My very boring and simple code is linked here.

Insights of a First Year Mutual Fund Representative

I wrote this letter to my managers within my first four months of being an insurance and mutual fund representative.  In reflection, I find it interesting that almost exactly a year later I have found myself in a firm that recruits and trains advisors in the manner that I describe here.  In my opinion, this type of model will have to be the future of the financial advisory business, especially when the changing regulatory environment is considered.  When I wrote this, I was not aware of the fee based model.  The fee based model is far more conducive to operating in the manner that I describe below, which is likely one of the reasons why the embedded commission model is under so much fire today.

 

The letter:

 

The broad expectation that I have for my current position is that I am constantly learning and fuelled by activity.  I will go into more detail later in this document.  When I entered into the position I had a vision of it being similar to a high level law practice.  I will explain what this looks like in my mind and then draw parallels to show how it applies to a high level financial advisory practice.

After performing casual research by speaking with a corporate lawyer and two litigators (one in family law one in intellectual property law) I have learned that when entering into a firm as an associate, excess clients are passed from the partners to the associates to give the associates an opportunity to learn and build their practice.  Associates are allowed and encouraged to bring in their own clients, but the high level business from the partners is what allows them to gain the type of experience required to add value to the firm; clients passed on from the partners also allow the associates to build a client base that fits with the image and quality of the firm.  An analogy that I discussed with one of the lawyers that helped me understand how a high level law firm works compared the way that financial advisors currently enter the business to a lawyer opening up their own law firm on the street; they are starting a practice with no brand equity, no referral base, and no high level cases to work on to gain the experience needed to become a high level practitioner.  This model is not conducive to building an elite practice.  Partners have spent years, if not generations, building a name and a referral base that brings in clients.  This difference in the way that a lawyer enters the business compared to the way an advisor enters the business explain the disparity between the average level of recruit entering a law firm and the average level of recruit entering an advisory firm.  This model also increases the barriers to entry for an advisory practice.  The current model allows managers to maintain relatively low standards when they are hiring new recruits for multiple reasons: new recruits are difficult to find due to the nature of the business, and the high turnover rate is somewhat justified by the relatively low level of investment by the firm.  It is a vicious circle and a chicken before the egg type situation.  If a model representing a law firm were adopted then the quality of advisors coming into practice would increase.  In the event that advisors knew they would be getting clients upon beginning to practice the business would be far more enticing for compensation and experience purposes; referring to my previous analogy, lawyers are far more likely to join an existing firm than to start their own right out of law school.  The reasoning of a lawyer choosing not to start their own practice is similar to that of a high level professional considering financial advisory; it is necessary to start a business from the ground up.  The alternative law firm hybrid model also increases the investment from the firm which will inevitably result in higher risk, but also greater reward.  The risk of high turnover will be mitigated by replicating the hiring standards of a law firm with an articling process, and a progression into the business.  The reputations of advisors in our business are damaged by the lack of an articling period and the rapid succession into practice.  If lawyers were able to write one two hour exam and begin practicing, the public would be as skeptical of them as they are of advisors.

In our discussion yesterday we referred to the trials and tribulations that people will go through to be analysts for Fidelity.  We failed to discuss some key aspects that make this possible, and the ways that they can be applied to revolutionize our business.  The people putting themselves through hell to become analysts for Fidelity are the cream of the crop.  They are top students from top schools competing for a top position that, if achieved, is guaranteed to come with a large payout and huge opportunities for the future.  In contrast to this, financial advisors often enter into the business with little idea of what it is that they are getting into, high hopes for the potential of income, and unrealistic expectations for what the first few years will be like.  Financial advisors are often second career people looking for higher income, or university graduates that were unsure of what they would choose as a career.  It is very possible for advisors to go through their career never making one tenth of what an analyst at Fidelity will make, while continuing to scramble as if they were fighting for a spot.  It is a difficult expectation for the firm to hold that individuals with high income potential will walk into a business with such a high failure rate when they could be entering into fields with guaranteed income.  I understand the argument that the income potential in this business justifies the initial risk, but imagine the advisors that are being overlooked due to being averse to the risk.  Changing the broad business model to the law firm-like approach will make gaining a spot in this firm a cherished opportunity that graduates with high expectations for themselves and their careers will compete for.

The law firm business model sounds attractive and flashy, but is it feasible to apply this model to an advisory practice?  Lawyers are paid on a salary with an opportunity to earn a bonus based on their performance and the revenue that they are able to produce; billable hours are charged to the firm and used in analyzing the performance of associates.  In the event that associates are brought into cases with a partner their billable hours are combined with that of the partner.  The billing system records how files come in and associates are paid a bonus between .5 and 2% of the total bill for that case.   This occurs if the associate refers a case in, or if they are present in the initial meeting and throughout the case.  Associates are given “sales” targets that must be met using either billable hours or set block fees.  The cases handed to associates by partners count towards fulfilling these quotas; the same system could easily be applied to DSC sales and aum, using commissions and assets instead of billable hours.  From the samples that I took, it is common for first year associates to have to fulfill between 1200 and 1800 billable hours per year.  This does not include administrative work, so it is apparently very difficult to achieve these quotas.  Again, this system is very relatable to commissions.  Advisors would still be motivated to sell and gain clientele to meet their quotas, while having the safety of a salary.  When a lawyer is awarded a position in a firm they are required to go through a period of articling which lasts 10 months; they are paid a salary of approximately $40K during this time.  The next step is to become a first year associate, during which time they are compensated with a salary of approximately $65K and incentives based on activity.  A small percentage (.5-2%) of the business that a first year associate brings to the office is paid out to them.

I understood entering the business that it would not look like what I have described in this document, but I certainly did expect it to be somewhere between what I have described and what it is.  I believe that if we are able to build a model that operates in line with what I have described, we will be able to bring in higher level advisors and bigger clients, take advantage of the concept of functional specialists, and create young advisors that operate on a level that usually takes a life time to achieve.

Understanding that there is a small chance that any of this will actually happen, my expectation going forward is that I will be included on large cases, I will be compensated according to the level of work I am performing, which may not be directly related to premium submitted, and I will be given the type of guidance and structure that an articling lawyer would receive.  It is my preference that I am put on a salary as my current lifestyle cannot be maintained with my level of pay, and the clients that I am attracting to try and pay the bills are not conducive to building the type of practice that I envision.  A structure similar to a first year associate in a law firm, with bonus based on performance, is preferable.

A final note that I hope will make all of these ideas make sense when applied to our office:  There are a select few prestigious law firms that were built by charismatic people with affinities for both law and business.  They have built practices that bring the biggest law cases in the world to them because of the name they have built.  These firms employ massive amounts of highly intelligent and well respected lawyers which allow the firm to attract and handle even more business and bigger cases.  If every lawyer at Gowlings had opted to open their own practice instead of joining the firm, not only would they suffer from having to start from scratch, but the firm would suffer due to decreased capacity and an inability to grow.  Asking financial advisors to start from scratch every time they enter the business is inefficient.  A charismatic and talented advisor should be able to build a practice, and then continue to grow it by adding other advisors that he is able to pass his extra cases to and increase the capacity of his practice.  There is a huge difference between having people on a sales team and having people integrated fully into a practice.  Financial advisory fits so well into the model of a law firm; I believe that shifting to this model is the future of the business.

RRSP vs. TFSA

Have you ever been confused about the differences between Registered Retirement Savings Plans and Tax Free Savings Accounts?  They are both gifts from the government that allow us Canadians to save money in special accounts that are not taxed as they grow from investment income.  This infographic explains some of the most notable differences between a TFSA and an RRSP.

RRSPTFSAinfographic.png

*This infographic is for information purposes only and contains data from sources considered to be reliable but are not guaranteed.