Robo-advice firm Scalable Capital has berated traditional strategies on investment, claiming the “naïve” idea about risk and reward leads to extremely poor outcomes for clients.
Stefan Mittnik, founder and scientific adviser of Scalable Capital, pointed to the ‘Modern Portfolio Theory’, which was created in 1953 and has since been the crux of the investment industry.
The theory emphasises that risk is an inherent requirement for generating a return, an assumption investment professionals heavily rely on to determine where they place clients’ money.
But Mr Mittnik challenged these “simplified” assumptions, saying many just don’t hold true.
He pointed out, for example, that the theory measures risk using volatility, which reflects price moves in either direction, as opposed to focusing just on downside movements.
He also said this theory wrongly suggests correlations among different assets are constant, when in fact assets become more correlated in falling markets, causing diversification to break down.
By comparison Scalable Capital uses a risk management system which runs tens of thousands of simulations to show possible outcomes of different asset allocations on a single portfolio.
It also aims to give investors a clear understanding of how likely they are to incur losses by measuring risk using the 'value-at-risk' concept, instead of volatility, with value-at-risk showing investors the amount they could lose in a worst-case scenario.
The Scalable Capital founder also pointed to recent research which has refuted the “naïve idea” that high risk investments lead to a high reward.
Back in August, Gareth Lewis, chief investment officer at Tilney Bestinvest, said the “old-fashioned” relationship between risk and reward has broken down, with the definition of risk assets could currently be extended to even include those which are essentially risk-free.
Speaking to FTAdviser, Mr Mittnik said: “Risk is not a one-dimensional thing; we have market risk, liquidity risk, and our model compounds these in one aggregate risk number.
“We have identified major drivers of breakdowns when it comes to risk and reward and tried to avoid that.”
Scott Gallacher, chartered financial planner at Rowley Turton, said: "I wholeheartedly agree with Stefan’s comments on the use of volatility as a measure of risk.
"I personally prefer to look at the historic maximum drawdown on the portfolio, which is a much better measure of historic loss, and therefore risk as a client would see it.
"That said, I’m not sure this volatility focus is one that is limited to traditional investment approaches, as I understand that many robo-advisers have a similar focus."