Can Your Digital Platform Withstand Regulator Scrutiny?

Ryan: I agree, Jasmin. Trading apps have an opportunity to package important principles of investor education into features that make them seem like entertainment. The software that my firm has created, “The Big Picture” is designed to place the day-to-day information that investors receive within the grand scheme of the historical market and to illustrate time-tested investment principles.

Jasmin: How does The Big Picture work?

Ryan: The program relies on the rolling-period methodology developed by William P. Bengen (creator of the “4% rule”). It reconstructs the investment experience of nearly 1,000 investors, each starting their journey on the first of the month from January 1926 onward. Users can find answers to questions like: Would your portfolio have survived history’s worst conditions, such as the stagflation of the 1970s? If so, it may survive whatever downturns yet await. Or did it fall short, even in the stock market booms of the 80s and 90s? The software then lets you illustrate the tradeoffs associated with different asset allocations, savings and withdrawal rates, fees, and investment horizons. The Big Picture adds an evidence-based, real-life perspective to conventional software’s hypothetical projections.

Jasmin: Can you explain how your software can illuminate a specific foundational investment principle?

Ryan: Sure, let’s take the principle of diversification. The software can help investors see the benefits of diversification across a range of dimensions, from safe-withdrawal rates (SWRs), to portfolio longevity, to the minimum required nest egg balances that are needed to support a certain dollar level of spending in retirement.

Perhaps retirees’ single greatest concern is their SWR. The question is: Does the progressive addition of asset classes boost a portfolio’s safe withdrawal rate and, if so, by how much?

To answer this question, we constructed six portfolios in the Big Picture software. The following table describes the composition of the test portfolios:

Exhibit 1

*Standard deviation of annual portfolio returns. Portfolios rebalanced annually.

Each portfolio has been back-tested over rolling 30-year retirement periods. Additionally, a confidence level (i.e. success rate) of 95% was selected. This meant that the software would solve for the highest withdrawal rate that still allowed a given portfolio to remain solvent in 95% of historical 30-year periods.

The impact of diversification was remarkable. Portfolio 1 (base case) was able to sustain a 4.2% withdrawal rate in 95% of historical 30-year periods. Portfolio 2 could sustain a 4.4% withdrawal rate, while portfolios 3, 4, 5, and 6 could sustain a 4.6%, 4.7%, 5.0%, and 5.0% rate, respectively.

Exhibit 2

*Safe Withdrawal Rate.

Overall, portfolio 5 allowed for a whopping 19% higher spending level than portfolio 1! This exercise tells us that the strategic addition of asset classes to a conventional portfolio has yielded meaningful benefits historically, in most cases at little cost to portfolio stability.

Jasmin, what would you say are some examples of nudges that could be incorporated into trading software, and which would tilt investors towards more long-term thinking? Do you think The Big Picture could supplement trading apps so that they are more focused on the long-term horizon?

Jasmin: Brokers should be redesigning at least some types of nudges to further the long-term best interests of investors. For example, incorporating or linking the Big Picture software into their user interface would show users the potential for their money to compound over time. I like that the Big Picture also allows investors to explore interactive graphs to learn about how different types of portfolios, such as varying mixtures of large-cap, small-cap and international stocks, and fixed income instruments, have performed over particular lengths of time – including the decades-long periods relevant to retirement planning. This feature would be especially useful in a robo-advisor app, where a robo-advisor offering a conservative retirement portfolio could show investors how a portfolio with the same conservative types of holdings performed in the past. The types of portfolios and risk levels that you showed us in Exhibit 1 could be lined up alongside robo portfolios that consist of similar holdings.

Additionally, apps can be designed to coach investors not to overreact to volatility if they want to build long-term wealth. The robo-advisor Betterment incorporated a nudge called a “just in time notification” into its app. The notification discourages overtrading by reminding investors of the tax consequences of each trade. Other behavioral cues could provide a similar cooling effect in other situations, such as reminding investors that the market tends to rise at a slow, steady pace in the long run before they panic sell or buy risky assets due to fear of missing out.

Ryan: Are trading apps required by regulations to present a more long-term perspective to their clients?

Jasmin: Under SEC regulations, Regulation Best Interest (BI) in particular, it does seem like they are required to present long-term considerations to their clients. The SEC could consider nudges to trade as recommendations to trade. They could consider defaulting or making it too easy for customers to use margin or options accounts as recommendations to trade on the margin or to trade options. Trading apps should prepare for this possibility by making sure they are screening their customers for risk tolerance and making the proper risk disclosures.

Aside from those requirements, it’s in brokers’ self-interest to redesign their platforms to encourage more prudent investor behavior. If shortsighted gamification causes the SEC to clamp down with broad prohibitions, brokers and the public will lose a valuable tool for attracting and educating new investors. Trading apps need to show the SEC that they can self-regulate and harness the power of gamification in a way that’s consistent with their fiduciary duties.

The key is to show regulators that brokers are watching out for their clients’ long-term financial interests.

Ryan: Agreed. How about the prospect of more stringent trading app regulations? Does the SEC distinguish gamification that encourages short-term investing from gamification oriented towards long-term investing?

Jasmin: Its focus has been on gamification features like notifications, data displays, or default settings that nudge investors toward frequent trading – which is a short-term approach. If you look at the business models for many of these trading apps, substantial portions of their revenues are coming from selling large volumes of their customers’ orders to trading venues and market makers. There’s a conflict of interest that may not be obvious to traders, as trading apps stand to make money by nudging investors to trade more often. As long as brokers are profiting from order flow, any gamification that looks like it’s intended to increase trading frequency would be more likely to catch regulators’ attention.

Ryan: Correct. And when it comes to clients’ long-term financial interests, few factors matter more than investment fees. The Big Picture software can be used to examine the impact of expenses on historical investment outcomes. The results are often startling – let me show you.

I simulated a diversified portfolio at various expense ratios to see how each affected SWRs over 20-year horizons. When I set the expense ratio to only 0.1%, 5.4 % could be withdrawn without making the portfolio insolvent in most historical cases. When I increased the expense ratio to 3%, the safe withdrawal rate dropped to 4.1%. This higher expense burden necessitated a significant 23% decrease in spending to ensure solvency. For a portfolio with an initial value of $1 million, that’s a drop of $1,006 in monthly spending, from $4,386 to $3,380.

This pattern played out similarly over 30- and 40-year retirement horizons. By mixing asset classes and lowering your expense ratio, you can build in more leeway for safe withdrawals. The Big Picture program offers 11 major asset classes with which you can experiment. The point is to illustrate the importance of proper asset allocation and expense management.

Jasmin: That is helpful information for investors. It helps jolt them into thinking about concrete questions about their own future, such as how much they will be able to safely withdraw from their bank accounts during retirement. It was great speaking with you about The Big Picture – I have been enjoying using it in my own analysis of how digital platforms can better help investors.

Ryan: Thanks for your insights, Jasmin. It was nice to discuss these issues with you also. I hope that The Big Picture software can be helpful for many people planning their financial futures.

Jasmin Sethi is the CEO of Sethi Clarity Advisers (SCA), a boutique consulting firm providing expert regulatory and business strategic advice to companies in the financial services industry. As a Harvard trained lawyer-economist, she is a thought leader on issues pertaining to how the asset management industry and financial regulation impact ordinary individuals, and particularly, freelancers.

Ryan McLean, is founder of the Big Picture Safe Withdrawal Rate Software and Investments Illustrated.

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