At The Money: Automate Your Investing

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1:12Have you taken full advantage of automating your investments? You can improve your returns, reduce emotional decision-making, and generally end up with better results simply by putting your investing on autopilot. To help us figure out how, let's bring in Jeffrey Patak. He's managing director at Morningstar. Previously, he was the chief rating officer there. He's been with Morningstar since 2002. And his research has shown features like auto enrollment or contribution increases, default investments, and target date funds enable investors to bypass common pitfalls of market timing and emotional trading.

1:57So, Jeffrey, let's define the automation features you're discussing in your research. Things like steady paycheck deductions and regular rebalancing. How can an investor set that up? Sure. Sure. So, you know, it's relatively straightforward if you're working with a brokerage platform to enable those types of features in some other contexts, like a retirement plan. It might be standard plan features. In fact, you might be defaulted into them. And so away you go. And so it's well within our reach as investors, either to switch these features on at our own election or to be opted into them as we would be in a retirement plan.

2:37So explain to me the difference between auto-enrollment and auto-escalation. For sure. Yeah. So auto-enrollment, the notion is you're auto-enrolled, you become a participant in the retirement plan. Auto-escalation is you're in the plan and then your contribution rate is steadily increased at a predetermined level. And so one is about being in, participating. The second is about the extent to which you are participating, both valuable. So your research has found automatic investing reduces bad investor outcomes, reduces behavioral errors, promotes consistency. Sounds a little too good to be true.

3:21What sort of data have you found that supports automation leading to improved investor returns? Yeah, real good question. So it's a bit inferential because we're not a brokerage platform. And so we don't have sort of the tick data. Nevertheless, we can look at the types of funds and where they tend to be used and whether automation is common in those settings, you know, and draw some conclusions. And one of the more striking findings from our research, this is the mind the gap study that we conduct, is that investors in allocation funds, the most popular version of which are target date funds, they do the best job of capturing their funds total returns, that is, they experience the fewest frictions related to the timing and magnitude of their transactions over time.

4:05And what do we know about target date funds? We know that people are commonly defaulted into them, that they regularly invest in them just as part of their regular payroll deduction that takes place. And so they're kind of the signal example of automation. Then take some other examples of fund types that you wouldn't find in a retirement plan, like maybe the quintessential example would be something like a sector fund or a thematic fund. You're typically not going to find those in a plan lineup. We found those have some of the widest gaps. And why is that? They're not used within that gilded cage of a retirement plan.

4:40Furthermore, they might be more subject to discretionary ad hoc off-cycle trading decisions where there might be a greater propensity to trade on a motion than would be the case with something like a target date fund. And it sounds like the key advantage of automation is it tends to reduce unnecessary trading, and it also reduces the emotional responses to just ordinary market volatility. It does. Yeah. Basically, it's the best kind of inertia, I would say. We know that market bobbles can be unnerving to investors and left to their own devices, they might make a change to their allocation, they could elect to remove capital from the markets, and we know how harmful that can be to their long-term compounding power.

5:29Whereas in these settings, because they just continue to mechanically add to their investments and those investments in turn, you know, take care of some of the mundane tasks like rebalancing and adjusting the asset mix, they just get on with it. And I think that works to their benefit over the long term. And certainly our research seems to bear that out. So we talked about the investor gap between their actual performance and their funds performance. When we're looking at automated target date funds or automated allocation funds, how measurable is the gap between those and people who kind of self-manage that allocation?

6:08Yeah. So with allocation funds, the largest subset of which are target date funds, we found almost no gap. It was basically 0.1 percentage points per year. Then when you focus on every other type of fund, we found that the gap was around 1.2 percentage points per year. Now, yes, among those other types of funds, it is quite possible that some are using them in an automated fashion. Maybe they have some sort of investment plan that they've set up or they've otherwise mechanized the process. But I think it stands to reason that for a fairly large subset of that capital, it's being invested in a more discretionary fashion.

6:44And so you can see the difference between the two of those. It amounts to around 1.1 percentage points annually of return that's being foregone effectively. So what are the automation features that have consistently good benefits for investors? So I would say that probably the biggie is auto enrollment. We don't have as much data that we collect, but there are others like Vanguard. Vanguard puts out a terrific annual study called How America Saves. In the most recent edition, they reported that 61 % of the plans they service as clients had auto-enrollment, and two-thirds of those plans that offered auto-enrollment also offered auto-escalation.

7:27And then of those that auto-enroll, 98 % of them are defaulted into a target date. And strikingly, the average participant holds only two funds. So that gives a sense of the reach of automation in our retirement system. If I had to choose between the two of those, auto-enrollment versus auto-escalation. It's a bit of a false binary, but all the same. I would say auto-enrollment is far, far more important. Why is that? It's because we want people participating so that they can compound their wealth. Even if they were to experience a return gap, we would rather that they get some, if not all, of their funds' returns and auto-enrollment and cease to that.

8:04Yeah. Before the default settings, there were stories were rife about people working at places for years and the money just piled up in cash and did nothing. It's kind of crazy. But that leads to an obvious question. How widespread has the adoption of automation been in the various retirement ecosystems that are out there? It's become very widespread. As I might've mentioned before, you're talking about two thirds of plans that offer auto enrollment and then also a very significant number, auto escalation as well. And, you know, I think that one other thing from the Vanguard study that I mentioned before that I found quite telling, they found that 1 % of target date fund investors transacted last year, that'd be 2024, compared to 11 % of investors in other types of funds.

8:56And so it just gives a sense not only the breadth of automation that's taking place here, but also some of the benefits it confers and tapping down transacting that we see within these plans. Any particular demographic groups stand to benefit more or less from automating these strategies? That is a great question. It was one of the most eye-opening findings from that study. they found that auto-enrollment disproportionately benefited younger and lower earning participants. So you were really talking about a quantum among those cohorts. And I think that's critical, because we want to get those folks into plans.

9:35In some senses, you're talking about socioeconomic demographics that may be more vulnerable, that otherwise wouldn't have the opportunity to compound wealth in the way we'd like to see auto enrollment has helped to ensure that those gaps get closed. And so I think that that's a really, really telling and encouraging finding from their study. What about non-qualified plans, portfolios outside of 401ks or IRAs? What can we do to automate those sort of holdings? Yeah. So I think that one thing that you can do is you can set up sort of an auto investment plan, very similar to the kind of setup that you would find in a retirement plan, put that on autopilot.

10:20And then I would say to the extent that you can automate your investments. I may have mentioned in other settings that it's important to have a plan, first of all. But then once you've got that plan, you know, maybe it's an allocation fund, a target day fund, or a target risk fund, where you're fixing the percentage of equity, fixed income on other asset classes. And that obviates the need for you to go in and make adjustments on your own. Automate, automate, automate. I think those are the key things to ensure that we capture as much of our funds total returns and compound as we can. So there are a lot of new digital investing tools and AI is starting to have an impact on various strategies.

10:58What do you think is going to have a powerful impact on both automation and future investor outcomes. Yep. And so I think, you know, I'm an avid user of AI. I know how beneficial it's been in my own work, making me more productive. I think that it can further the same sorts of benefits to investors, you know, maybe helping them to formulate a plan, maybe figuring out the optimal way for them to allocate their assets, you know, and otherwise sort of keeping them to, you know, sort of the goals that they've set consistent with their risk parameters. You know, the other side of it is it can engender overconfidence.

11:38You know, maybe we feel like we've got the capacity to make trading decisions that maybe really are outside of our circle of competence. And so we just want to make sure like so many of these other tools and resources we have available to us, we use it in a way that advances our goals and we don't get carried away in an overconfident way, sort of an impulse that we're maybe all likely to succumb to from time to time. And for either an individual investor or perhaps a financial advisor, if they're seeking to automate investments, what are the most important factors they should be thinking about when they're either selecting a platform or a tool to use to help automate?

12:20That's a great question. So, So, you know, one of the corollaries to automating, at least in a retirement plan context, is it is a little bit of an all in one decision. So typically the target date fund is going to be offered by a single provider. And so what what what that means is that we want to make sure that, you know, we're feeling very confident about that organization's culture, about its staying power, about its overall investor centricity. Those aren't necessarily easy things to tease out, but I think a little bit of research can tell you whether or not this is a firm that has a certain kind of pedigree, a certain kind of reputation.

12:56Look at the fees that it levies. Fees speak volumes about organizational fiber, so to speak. And I think if you can go through and satisfy yourself that this is an organization that has my best interests at heart, that is levying a fair fee and is likely to be around for the years to come over which I'm looking to compound. Those are all good facts. And I think that they portend well for you to succeed in capturing your funds return and compound some real wealth over time. So to wrap up, there are lots of automated tools that you could use, platforms, specific allocation funds, other things you can do to improve your returns, reduce emotional decision making, and generally end up with better performance simply by putting your investments on autopilot.

13:44I'm Barry Ritholtz. You're listening to Bloomberg's At The Money.

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