WealthFront, Betterment, SigFig and a Bankrupt Investing Philosophy

In August of 2011 Marc Andreessen wrote an op-ed in the WSJ titled “Why Software Is Eating The World.” While many had already put together those dots previously, his very public pronouncement via the WSJ which is ready by the investment community at large, was significant. Since then, software companies, both in the public and especially private early stage markets have gone on a huge run in terms of the appreciation in their valuations. Multiples are rising because the threat of disruption by software, at scale and speed we’ve never seen is getting larger and larger.

And it wasn’t hard to see that eventually the Silicon Valley hackers would attempt to disrupt the investment world as well. While capital markets and personal finance are certain not low hanging fruit for entrepreneurs, we have seen several companies over the last 5 years succeed in different ways. Putting aside success as meaning building a big business, and focusing on disrupting old ones and providing something better to the world, in capital markets we’ve seen StockTwits, YCharts, Covestor, and now Estimize disrupt or begin to disrupt important pieces.

Finance is a tough space though, the barriers to entry are high and it takes a great deal of domain knowledge to succeed. For software to really eat the financial industry, you need a mix of DNA in the founders which doesn’t come along often.

And that brings us to WealthFront, Betterment, SigFig, Personal Capital and other companies who are attempting to eat the personal finance and investing world with software. A brief overview, these companies make the case that instead of having a financial advisor pick mutual funds and ETFs for you and put them into an asset allocation model, they believe you should just let their algorithm do it, for a lower fee. Last I heard Betterment had about 50M under management.

These companies have raised an enormous amount of venture capital. And for good reason, the VCs are betting that by providing a simplified online experience for the average investor, he or she will take their money away from Oppenheimer, Fidelity, Merrill, or another asset manager and give it to their computer to do, well, pretty much the same thing, for less. The VCs see scale, they see money flooding out from behind the old walls of those institutions. The pitch decks of these new companies are probably stacked with how big their potential market is, hundreds of billions of dollars they say.

So great, let’s assume that they are successful in convincing the average joe to give his money to a computer to asset allocate based upon, well, based upon what? And here we run into our first big problem that brings to light a central problem of this whole thing. Silicon Valley nerds inherently do not understand the deeper problems to be solved within the capital markets and personal finance industries. You can throw software at a problem all day, but if that software replicates the same bankrupt way that the world operates right now, you haven’t solved anything.

Their software asks you a set of questions to determine your risk profile. Anyone who has read the literature on this field knows that this is an inherently flawed system, asking someone to assess themselves almost never works. We don’t know ourselves, we don’t truly understand our own risk tolerance. When shit goes crazy in the market and we have a 10% flash crash do you really think that guy who put down that he can withstand a lot of risk is just sitting there like, oh well, it’ll come back. NO. He’s freaking the fuck out, because that’s what people do if you give them control. Remember, all of these algorithms have manual override. The human can come in there at any time and press the stop button, which means that at the end of the day, any quant strategy is only as good as the human will let it be.

So the first issue I have is that these platforms do not in any way accurately identify the correct amount of risk their algorithms should be taking, not to mention the fact that the human can interrupt the process at any time rendering it useless anyway.

The second goes even deeper, to the real problem behind these platforms. They all use Modern Portfolio Theory, better known as asset allocation strategies, to invest your capital. MPT is a bankrupt ideology that has been proven false, and that’s the end of it. Large asset management firms love it because they can throw a client’s money into these passive strategies and give him all these pretty charts that say in 10 years he will have X amount of money based on this Monte Carlo simulation, blah blah blah blah. It’s all a bunch of bullshit if the underlying philosophy is just plain wrong.

Here’s the sad part, everyone knows MPT doesn’t work, yet they continue to use it because it allows asset management firms to scale their AUM, in a few ways. One, it takes “performance” out of the hands of the investment advisor by saying that “the market will do what it will do, we invest over the long term and this is what the simulation says if we stick to it”. So the client can’t blame the advisor for 2008 when correlations all converged to one and MPT got blown to hell. And two, the avisor doesn’t have to do any real work, he just has his 24 year old associate run the simulation and ask the client some questions that don’t matter anyway, and that’s pretty much it. These guys are babysitters of a broken and bankrupt philosophy.

So when these new financial software companies come to market with the same exact philosophy, minus the actual human advisor, they aren’t actually solving the real problem, all they are doing is reshuffling the deck. I do believe that to some extent they will be able to take money away from the humans, because deep down people know that they are getting screwed by giving large fees to these guys to screw up over and over. They just don’t understand what the real problem is, the asset allocation strategy is the route of the problem, not the human. And even then, these companies will have a hard time making money because my computer can do what your computer does just as well, which means that it’s now a commodity business, and that means falling margins.

While WealthFront, Betterment, SigFig, Personal Capital and others may take money away from the brokers and investment advisors, their don’t really have a business because their margins are going to suck.

At the end of the day these guys aren’t solving a real problem for the market, they are just using software to eat it. And that’s fine if that’s what you call success, but not me.

Here’s the real problem that needs to be solved. The discovery and centralization of great active management talent. The first thing I was taught by David Geller was that there are two rules to running money. Rule #1: don’t lose money. Rule #2: see rule #1. Asset allocation doesn’t give a crap about losing money, it believes that it’s just part of the game. No, it’s not. Risk management means active management, and everyone should be managing risk or not participating in markets.

Their software can eat the world, but because their founders don’t inherently understand the underlying problems they won’t ever solve any real ones.

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