How Dangerous Is A Stock Market Run By Robots?

The interesting question is whether it would be any more dangerous than a stock market run by emotional humans. JL

Jason Zweig reports in the Wall Street Journal:

U.S.-based exchange-traded portfolios have amassed $2.6 trillion. Target-date funds hold $915 billion. “If the market does have a major crash, who will rebalance your account better: a human with emotions, or an algorithm that’s based on what’s actually happening in the markets? I don’t think a human adviser can stop a crash or protect you from it, and I’m not sure how much a hug will help if you’re losing money.”
Investors are turning into automatons.
So-called robo-advisers manage investments electronically; index mutual funds and exchange-traded funds roll entire markets up into a single bundle; target-date portfolios hold a predetermined mix of assets, marching savers mechanically toward retirement. Could all these millions of people investing on autopilot be pushing an already expensive market even higher?
Consider a few numbers.
Four leading robo-advisers — Betterment, Schwab Intelligent Portfolios, Vanguard Portfolio Advisory Services and Wealthfront — have roughly doubled their assets in the past year, to $77 billion.
In 2016, 82% of new retail investments coming through financial advisers (more than $400 billion) went into index funds and ETFs, according to Broadridge Financial Solutions, which helps process such trading.
All told, U.S.-based exchange-traded portfolios have amassed $2.6 trillion, says ETFGI, a research group in London. Target-date funds hold $915 billion, according to Morningstar, the investment-research firm.
We — including financial journalists, like me — have created a new breed. Today’s investors aren’t what the financial analyst Benjamin Graham described as “enterprising,” or willing to put time and energy into the search for bargains.
Instead, investors buy and hold (or at least intend to) regardless of whether entire markets are undervalued or overpriced.
“There’s an automaticity of investing here,” says the Investment Company Institute’s chief economist, Brian Reid, “where the vast majority of assets seem to stay in place.”
In short, the moralistic and puritanical view of investing that has prevailed for decades — how well you succeed at it is determined by how hard you work at it — is being replaced by an agnostic model in which you hope to succeed by clicking and letting it ride.
Benjamin Graham also warned that “there are no sure and easy paths to riches on Wall Street or anywhere else.” So it’s tempting to conclude that when we make investing effortless — and, frankly, mindless — we make it more dangerous.
In the late 1960s, Wall Street strategists argued that a flood of money from pension plans would drive stocks irresistibly higher. The favorite shares were called “one-decision stocks”: Your only choice was how much of them to buy. You’d never need to consider selling. The 37% crash of 1973-74 stifled that argument.
Many of the newest converts to automated investing, including plenty of financial advisers, are undoubtedly chasing the hot performance of index funds. When markets cool, they will flee — potentially turning a dip into a dive.
But there’s also no doubt that many people are making a mindful choice to invest mindlessly. Far from believing in magic, they are renouncing belief in it.
Rachel Racz, 30, is a manager at a financial-services firm in Houston who has become a client of Wealthfront, one of the leading robo-advisers. “If the market does have a major crash,” she asks, “who will rebalance your account better: a human with emotions, or an algorithm that’s based on what’s actually happening in the markets?” Adds Ms. Racz: “I don’t think a human adviser can stop a crash or protect you from it, and I’m not sure how much a hug will help if you’re losing money.”
That sort of pragmatism is sensible. As the mathematician and philosopher Alfred North Whitehead wrote in 1911, “Civilization advances by extending the number of important operations which we can perform without thinking about them.”
And the evidence that automated investing has driven up stock prices is tenuous at best.
Over the past decade, stocks in the U.S. — where the automated investor is much more dominant — have significantly outperformed shares from the rest of the world. U.S. stocks are trading at 29.5 times their long-term average earnings, adjusted for inflation. That’s only a whisker below their levels in July 1929, shortly before the Great Crash.
But correlation isn’t causation. Market valuations were at their modern highs in 1999, when index funds held less than 10% of all stock, points out Fran Kinniry, an investment strategist at the Vanguard Group, the giant of autopilot investing. Since then, index funds have roughly tripled their share, but stock valuations have fallen by almost half.
Jeffrey Ptak, global director of manager research at Morningstar, points out that robo-advisers and target-date funds don’t buy more stocks as stocks go up. Instead, as stocks rise, robo-advisers trim automatically to get back to a predetermined level, while target-date funds prune their positions as their investors age.
Wall Street has long mocked the “dumb money” of individual investors who drove markets higher on the delusion that they knew how to pick stocks. Have the same people become more dangerous to the markets now that they’re admitting they don’t know how to pick stocks?