“No individual in a 2020 Volvo will be killed or seriously injured.” This remarkable claim from company CEO Hakan Samuelsson and the accelerating pursuit of the autonomous automobile illustrate the auto industry’s ongoing effort to overcome its weakest link—the driver. This two-part series (read part 2 here) will examine what autonomous automobile development can teach the investment industry about its own weakest link—the investor.

The case for autonomous automobiles

Autonomous autos have 24% fewer collisions than conventional driver-controlled vehicles and accidents tend to be less severe, finds a 2016 Virginia Tech report. Further, when accidents do happen, the fault is not with the autonomous auto, but usually with other vehicles, notes a University of Michigan study.

Even in conventional cars, automation technology could save lives. According to the Insurance Institute for Highway Safety, nearly a third of the 32,000 traffic deaths in the U.S. in 2011 (2,075 in Canada during that year) could have been avoided if all cars were equipped with technologies such as forward collision and lane departure warning systems, blind-spot assist and adaptive headlights.

Consider that 39% of fatalities involve drunk driving, and the safety potential for self-driving cars becomes very clear, notes the Insurance Institute for Highway Safety. Mercedes Benz, Audi, Toyota, Google, BMW, Microsoft and Apple are aiming to deliver autonomous automobiles soon. Volvo says it’ll offer self-driving cars by 2017; Tesla by 2018.

Autonomous cars must do two main things: sense, identify and avoid risk in the vicinity of the vehicle; and guide passengers to their destinations. In the investment world, risk avoidance and destination guidance are portfolio functions that, if they exist at all, have broad scope to improve.

Driving at full speed

Asset allocation is usually established from investor responses to a risk questionnaire. Typically, conservative (40% equities), moderate (60% equities) and aggressive (80% equities) are used to describe portfolios scaling from low to higher risk.

If these equity weights represent speed in kilometres per hour, these portfolios would have a top speed of 40 kilometres per hour, 60 kilometres per hour and 80 kilometres per hour, respectively. Asset managers who rebalance to the investor’s fixed strategic mix (the portfolio’s maximum speed) unwittingly assume that:

  • all roads are straight, flat and dry;
  • the weather is always clear and sunny; and
  • there are never any traffic jams.

This approach is dangerous at best, and deluded at worst. Importantly, there is no attempt to avoid risk.

We’ve all taken this approach from time to time, but compliance departments, securities regulators and modern portfolio theory share the blame.

Table 1: Hypothetical performance from March 2002 to December 2015

Performance refers to Canadian securities

Constant Risk (Equity & Bonds) 60% Equity
40% Bonds
Equity Bonds
Return 11.77% 6.71% 6.59% 5.72%
Risk (SD) 7.48% 10.17% 17.50% 3.96%
Worst 1 Year -8% -25% -42.74% -2.46%

Suitability protects the wrong thing

Compliance departments focus on matching the suitability of each security to the investor’s conservative, moderate or aggressive risk tolerance. This practice is designed to limit advisor liability if any single investment fails, but has almost nothing to do with getting investors to their goals or protecting them from immediate market risk.

Regulators, listen up: it’s the portfolio that will get the investor to her destination, not its hub caps.

Re-risking or de-risking?

Rebalancing to a fixed asset mix, like 60% stocks and 40% bonds, is like replacing a damaged bumper after a collision—the auto (i.e., the portfolio) looks okay but the damage is already done.

Rebalancing to a fixed mix encourages the sale of winners and purchase of losers, contrary to the adage “cut your losses and let your winners run.” Regret, a behavioural response, accounts for this contradictory conduct that does little to de-risk a portfolio in the face of market volatility and may actually increase it—buying losers on the way down.

Chart 1, shows the risk (standard deviation) of a 60% Canadian equity and 40% Canadian bond portfolio continuously rebalanced from 2002 to the end of 2015.

Note that risk stays between 5% and 10% most of the time, and spikes to 25% in 2009. Diversification is the primary tool investors have to combat risk, but the chart shows that it tends to fail when needed most.

By contrast, maintaining a consistent level of portfolio risk (standard deviation) and rebalancing to this constant level in the face of heightened capital-market volatility, and vice versa, accomplishes two things:

  1. It automatically de-risks the portfolio when market risk is elevated.
  2. It keeps the investor exposed only to the risk for which they signed on, avoiding wild swings.

These asset-allocation shifts benefit investors.

See Table 1, to compare statistics for a constant risk portfolio with the 60:40 fixed-mix portfolio. Constant risk also provides an effective way to avoid risk around the portfolio without having to identify it. This risk management strategy is the first step in building an autonomous portfolio.

Volatility stifles ETFs in Canada, U.S.

ETF flows stagnated in Canada in January, with inflows barely positive at $22 million, according to a report by National Bank’s Daniel Straus, Ling Zhang and Tiffany Zhang.

That’s in stark contrast to the strength of ETFs last year. The report says, “Redemptions from Canadian equity offset flows to fixed income and currency-hedged U.S. equity. The main story of the month was the 5% intra-month decline in CAD vs. the USD.” As a result of that dip, “U.S. equity ETF flow tallied to $117 million on a net basis, but currency non-hedged ETFs had outflows over $300 million.”

In the U.S., ETF flows were also flat. A second National Bank report found that “total ETF assets dropped 4.7% to US$2.03 trillion, driven by stock market volatilities in the United States and worldwide.”

The second report notes some “asset classes experienced strong rotations as investors piled into safer assets.” While equity ETFs saw significant withdrawals, those “outflows were mostly offset by US$13.5 billion in creations in safer fixed income assets. [And], commodity ETFs took in $2 billion toward energy and gold, two areas of the market driven by very different factors.”

Investors retreated from U.S. ETFs, the second report says, redeeming $12.4 billion, or 1% of assets across all market capitalizations. “International Developed Equity was the only region that held ground, resulting in a net positive flow of $1 billion, or 0.4% of beginning assets,” write Straus, Zhang and Zhang. They note the Emerging Markets category had the largest relative outflow, “down $3.6 billion, or 3.3%, from the beginning of [January 2016].”

Read part two here.