An algorithm is a word that you hear with increasing regularity – facebook’s algorithm, for example, determines which stories appear in our newsfield; the genetic algorithm solves certain problems based on a natural selection process. In the financial field, however, it is usually coupled with investing and there is often the misunderstanding that ‘algorithmic investing’ means high-frequency trading. In fact, it is simply a set of rules that a computer can follow to make investments. However, this does mean it offers key advantages over emotional and impulsive decision-making for long-term investment. We’ve highlighted five of them below.
Rebalancing gives the algorithm the ability to adapt
It may be difficult for an algorithm to pick a portfolio for a twenty year horizon but this doesn’t mean it can’t perform well over the fairly long-term as long as it is rebalanced quarterly, half yearly or annually. This gives it time to adjust. The algorithm will typically pick a portfolio based on quantitative factors such as market prices or fundamentals which provide new inputs every day or even every minute or second. So to avoid repeated trading in and out of an asset, the algorithm developer will set up a rebalancing frequency to bring the portfolio back on track.
Aligned incentives
As the algorithm is a computer program, it works purely on data and can therefore be guaranteed to work entirely in your interest. It does not involve the issue of misaligned incentives which can potentially occur with a traditional model where your adviser may be compensated through distribution incentives or brokerage fees.
Can analyse a wider selection
Consider for a moment what a terabyte actually is. A terabyte is 1 million, million bytes or 916 million pages of plain text. And the typical algorithm works with terabytes of data in fractions of seconds. That’s an incredible amount of data! Especially when compared with what a human fund manager can process. This inevitably means it can provide a mathematically sound portfolio from a much wider selection of financial instruments. As it also doesn’t need to go to sleep and can run for twenty four hours a day, it can highlight events within the portfolio much more quickly. This, in turn, means it can enable you to find the highest quality stocks and shares within set parameters from a set of thousands of companies. It would take a human months to run a similar analysis.
Unbiased
Unlike advisers, you can rely on an algorithm to be totally unbiased and give you a completely impartial view of the situation at all times. Like us all advisers are only human and so are bound to be affected by what is going on in their life at the time. The ‘algo’ on the other hand, is only influenced by data, not whether the sun is shining or not.
Avoids repetition of mistakes
A final advantage is that algorithms, unlike humans, can be programmed to avoid mistakes that have been made in the past. They can also be programmed to follow advice that you believe should always be followed. So if, for example, some market events happen only once in a decade and are therefore likely to be missed by a human adviser, the algorithm can have the feature built in and still pick up on it.
There may be some things you still can’t trust an algorithm to do yet, such as prepare your favourite breakfast, take control of your driverless commute to work or even choose which way you’d have voted in the EU referendum – but there are some definite advantages where hard data wins over human emotions every time, meaning you can trust it with your long term investments.
If you’d like to know more about how algorithms work in our system, why not book a demo?
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