Financial planning

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.

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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.