From the Mailbag:
What in the world is a “robo-advisor”? These services claim they can manage my money cheaper than a human financial advisor. I’m skeptical, but have considered giving one a shot with a small chunk of my retirement portfolio. How do robo-advisors work and are they ever a good solution for investors?
Just a few years ago, investors had only two options when it came to managing their money: hiring a professional advisor or going it alone. Today, investors have a third option with a more ominous-sounding name: the robo-advisor.
The term robo-advisor invokes the image of a muscular cyborg managing your investments. Of course, that is not quite the case. Robo-advisors are not mechanical aliens. They are just computer programs that use algorithms and technology to build and manage investment portfolios. Outside of the person who performed the coding, there is nothing human about them.
The portfolios constructed by robo-advisors are usually similar to the ones built by human ones. But robo-firms claim their fees are just a fraction of those charged by traditional firms. Depending on the balance of the account, robo-firms charge an annual management fee of 0.15% to 0.50%, compared to the traditional 1% or more demanded by human advisors.
All robo-firms say they achieve higher returns than do-it-yourself (DIY) investors. Of course, that’s not saying much. Most everyone has seen the data showing that average investors underperform nearly every asset class over the long term. So how do robo-advisors do it?
First, the investor opens an account and goes online to complete a questionnaire. This survey helps the robo-advisor establish the investor’s risk tolerance and ideal allocation. After that, one of two computer programs kick in, depending on the firm.
Some use a formula based on modern portfolio theory, which centers on risk tolerance. These programs invest in exchange-traded funds (ETFs) and are usually rebalanced quarterly.
Others use a program based on tactical asset allocation. Portfolios constructed using this theorem also invest in alternative asset classes, like gold, private equity or even Bitcoin. Supposedly these portfolios focus on risk management and downside protection.
- To eliminate behavioral biases from portfolio management.
A computer is not tempted to liquidate a position because it hears something scary about the markets on television.
- To automate tax efficiency.
Robo-advisors are programmed to automate tax-loss harvesting, invest in tax-efficient funds and rebalance portfolios in the most tax-efficient way.
- Faster and cheaper hands-off trading.
Most offer automatic trading and dividend reinvestment as well as the opportunity to invest in fractional shares. Trades can cost as little as pennies per share.
What could go wrong, right? At first glance, hiring a robo-advisor sounds like a great alternative to paying the ridiculous fees human advisors demand. And the advantages that come with the time you will save using their hands-off approach should be well worth the price.
But, as usual, I am more than a bit skeptical. The regulators, the Securities and Exchange Commission, and the Financial Industry Regulatory Authority have their concerns, too.
Robo-advisors have a lot of limitations. They simply cannot help you with 100% of your retirement planning. If you choose to try one out, even with a small portion of your assets, don’t fall for their promise of “set it and forget it.” You really can’t.
Robo-advisors fail to see your full investment profile. It is impossible for them to know what you have in your 401(k) or any of your other accounts held outside of the robo-firm. Therefore, they can’t truly execute tax-loss harvesting properly. They are making decisions for you based on just one slice of your investment pie.
Then there is the dreaded conflict of interest. It’s too difficult to determine if their automated investments offer only products from a related firm. These products may carry fees that are higher than the ones you would select yourself.
The scariest part about the robo-advisor strategy is that it remains untested. The most mature robo-firm has been managing money for just five years. During this time, we have experienced one of the longest bull market runs of all time.
No ETF investor has needed a human advisor to generate these sorts of returns. They haven’t needed a robot one either. But what happens when the market turns south? Potential clients of robo-advisors just don’t know. These automated portfolios have experienced just part of a full market cycle.
And ultimately, clients are still human. And they can still choose to get out when things get bad. When they do, they will lose money. Robo-advisors cannot truly mitigate behavioral bias from any investor’s process. That’s a false promise.
Keep in mind, the term “robo-advisor” is misleading. It’s not really an advisor at all – it’s a computer program. They aren’t even cyborgs. Robo-advisors can’t tell if your investment profile has changed or if it is time to make changes. Only you are privy to that information, and therefore are better off going it alone. Financial goals can change quickly. We decide to buy a home, send a child to college, etc. It makes no sense to pay to automate a process we are ultimately going to have to manually update.
Although robo-advisors can provide a starting point for building a balanced portfolio, individual investors can find a plethora of information regarding asset allocation and diversification online. There are dozens (if not more) of sample portfolios. The Oxford Wealth Pyramid is a great resource. Why pay an advisor, robo or human, for something you can do on your own?
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