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Benjamin Graham's Value Investing versus The Robo-advisor

We live in a time period where the "winner-takes-all" outcome is no longer restricted to a handful of industries. Actors and professional athletes are two classic examples of this "all-or-nothing" phenomenon, where a few elites make all of the money and the rest are waiting tables. Unfortunately, through no fault of anyone in particular, this brutal business model has now moved into a number of other industries, thanks to disruptive technology. Someone who is a competent Certified Public Accountant (CPA) in a small town preparing tax returns for various small businesses has now been displaced by an online accounting package that knows all of the tax-avoidance angles and provides tax preparation for little to nothing.

One reason these disruptive technologies are gaining traction in a number of white-collar service vocations is their scalability. For these Internet-based business models, scalability means incurring a fixed amount of computer programming overhead spread out over ever more customers. This expanding customer base results in only a sliver of increasing variable costs due to the need for more server space. The latest industry to be disrupted by Internet software is the world of investment management. A few firms are now experimenting with eliminating biological financial advisors altogether by having customers interact directly with a robo-advisor.

The robo-advisor determines what percentage of capital to allocate to equities based on some automated system for gauging an individual's risk-tolerance level. After the risk-tolerance level is determined, the appropriate percentage of capital is allocated toward reputable low-cost stock index funds. The entire process is completed with no human interaction on the part of the automated investment advisory firm. This scalable business model is now the talk-of-the-town among the financial trade journals. Let's lift the hood off of one of these newfangled gadgets and see how it performed over the previous decade.

Below is a chart of the various average annual returns, including dividend income sorted by decade. The results use the S&P500 index fund as our measure of stock market performance. As the evidence shows, returns over each decade can vary quite a bit. Some decades produce negative average returns, while others blow the doors off of a portfolio with averages in the high teens.

S&P500 Total Returns by Decade

Be mindful of the fact that the average returns by decade on the S&P500 index exceed the returns on an account managed by a robo-advisor. After all, the masterminds in Silicon Valley who created the asset allocation algorithm deserve at least a 25 basis point cut (0.25%) for the trouble of cranking out the code. The reputable low-cost fund company also deserves its pound of flesh to the tune of say 20 basis points (0.20%) for the trouble of gathering assets parked in a passive stock index fund.

Assuming that robo-advisors existed in the first decade of the 21st century when the Internet was moving out of its infancy, how was the performance of a robo-advisor who was managing the stock portion of a portfolio? The table below shows the annual return breakdown on both a nominal and inflation-adjusted basis.

Stock Market Performance of Robo Advisor
Larger Image

The total return over the previous decade was around -13%. It's even worse on an inflation-adjusted basis. If I add in the compounding effects of inflation over this dismal decade, an investor lost around a third of his or her capital. Granted the results would have been worse if the fees were higher for running the same strategy through a commissioned broker. Putting the microscope on this one decade, the table paints a far different picture from the rose-colored view of robo-advisors' turning investment management into a technological utopia for the retail investor.

But robo-advisors didn't exist in the first decade of the 21st century. Should investors embracing the cult of robo-advisors expect a similar outcome over the next decade (2010-2019)? Nobel Prize winner Robert Shiller shows the current stock market at a lofty valuation based on his cyclically adjusted-price-to-earnings ratio (CAPE). The complete picture has yet to be written for the coming decade, but if Wall Street catches up to Main Street in terms of the malaise, it could be another loser run. On a positive note, if nominal returns in this overvalued decade turn out to be negative once again, I'm confident that robo-advisors will be more equipped to stomach the mass exodus of naïve former clients who embraced the notion that stocks as an asset class perform the best over the long term.

Is there a road less traveled for the retail investor forced into choosing either a higher-fee investment plan through a biological broker or a low-cost robo-advisor? The answer is yes. Benjamin Graham highlighted in his book, The Intelligent Investor, the strategy of purchasing stocks trading below net-current-asset value. This holds true even if some years resulted in few candidates available for purchase, forcing some capital to sit idle on the sidelines until more value stocks bubbled up to the surface.

Assuming that an investor restricted stock purchases to only ones that met Graham's strict value-investing criterion, the chart below shows the percentage of years that remained underweighted in various degrees. Most years over the long study period were fully invested in stocks trading below net-current-asset-value, but when these value stocks were hard to find, the balance sat idle in Treasury Bills. As reviewed in the Net Current Asset Value Approach to Stock Investing, stocks that met Graham's strict criterion over the past 60 years outperformed both a large and small-cap index fund. Periodic underweighting in stocks did not translate into underperformance over the long term in comparison with an index fund. As presented in the book, this also held true over the previous dismal decade (2000-2009).

Percentage of Years over Study Period
* No more than 10 percent was invested in any one stock trading below 75% of the net current asset value, and all of the stocks were held for exactly one year. If few stocks could be found, the balance remained idle in a money market fund.

If Graham's value criterion is such a great idea, why isn't the concept being promoted by the nouveau financial elites of Silicon Valley? Is programming a robo-advisor to tell potential investors to come back another day when more deep value stocks are available for purchase a successful business model? This notion doesn't strike me as a great way to attract potential venture capitalists to your techy advisory startup. The robo-advisor concept needs scalability as a business venture to succeed, and a strict interpretation of Graham's principals for the enterprising investor is not a scalable business model. For most younger individuals who hand over cash to robo-advisors because of their high level of comfort with technology, the long term is not a 30-year holding period but rather 10 years. If someone had the good fortune to join a startup company that's less than a decade old and the public offering later made him or her rich, a 10-year stretch probably feels like eternity. It remains to be seen whether or not a scalable business model applied to the stock market will turn out to be a winner. A repeat of last decade's dismal stock performance might result in an entire new generation of disappointed investors similar to what occurred in the 1930s. Perhaps if another stock market crash ensues, the robo-advisor's experience will qualify them for future disaster relief and put them in the winning circle in the next Defense Advanced Research Projects Agency (DARPA) challenge.


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