Why trust an algorithm?

October, 21 2015 | Prashant Mehta

Flier_Gears-300x246Over last 20 to 30 years we have all grown to rely more and more on computer programs or “algorithms” of many types to help simplify our lives. Some are simple to understand and set up such as our calendars, heating, air-conditioning or security systems for our homes, or scheduling utility, mortgage and auto payments.

We also conduct a great deal of commerce over the Internet using algorithms. Consumers place orders, make payments, and schedule deliveries. Sellers process orders, confirm payments and send packages to their customers. We have been doing these functions for centuries. What is new is the speed and efficiency we gain by using computer programs to streamline the process. Now we can deliver goods of all sorts within days, hours and minutes – something that may have taken weeks or months before. Commerce conducted over the Internet now totals several hundred billion dollars.

We are seeing similar transformations in the financial products we consume. Computer algorithms have been used in financial applications since the 1980’s. They were first used by large banks and brokers, who created proprietary algorithms to increase their trading profits. Today, trillions of dollars are invested and traded through mutual funds, banks and large investment advisory firms thanks to the use of algorithms. It would be almost impossible to manage these assets without them.

For example, when a financial advisor is creating an investment plan for a client, he or she takes number of steps that actually use a series of algorithms. One algorithm asks a number of questions that can be used to understand the client’s risk tolerance. Based on that risk tolerance, another algorithm can create an appropriate asset allocation. A third algorithm can then be used to create a set of portfolios. This process could take significant time if done manually and would not be optimal for the advisor or for the client from a cost and return perspective.

While algorithms have been around for decades, we are now seeing their positive impact in our financial lives through the use of new technology put at the service of ordinary investors. Algorithms similar to those that were once used only by large institutions have been made available to independent advisors and consumers to manage their finances. The result is greatly improved efficiency, high quality service, and meaningful savings. These savings could end up paying off an investor’s mortgage over 20 to 30 years.