The term “robo-advisor” is a catch-all term used to describe investment management software that automates the investment portfolio process. Robo-advisors measure a potential investor’s risk tolerance through a short questionnaire before generating a portfolio deemed appropriate (on an expected risk/reward basis) for that individual’s profile. Robo-advisors have become the latest trend in the financial services industry but it is important for investors to understand the benefits, drawbacks and costs of these new autonomous advisors before relying on them to manage their funds.
The biggest issue with technology-driven financial advice is that it relies on a very small amount of information provided by the client when they sign-up. Everyone’s risk profile is different and constantly changing due to different factors in everyday life (job, income, marriage, children, major purchases, retirement, etc). This cannot be boiled down to a few short questions. Robo-advisors lack the ability to directly communicate with their clients and adapt to changing circumstances. A robo-advisor portfolio is based on a single moment in time which may be heavily influenced by short-term events or emotions. Traditional advisors and experienced investors will adjust investment profiles and strategies over time to match their changing profile instead of relying on static assumptions.
Additionally, investment advisors may meet face-to-face with their clients and help new investors understand their portfolio, long-term financial goals, and how much to save and invest to meet them. This is also one of the benefits of investment clubs, as members can discuss strategies and goals together to develop an appropriately diversified portfolio.
The algorithms these accounts utilize are also based on previous market data and assumptions that may not hold true in the future as financial markets change and evolve with new products. They – and the psychological tenacity of investors who use robo-advisors – have yet to be tested during periods of high volatility and may prove to be inadequate. First-hand experience and human interaction can still provide valuable insights that cannot be found in an electronic circuit.
A major attraction of robo-advisors is the low cost. Wealth managers and financial advisors’ fees have become increasingly difficult to stomach for many investors receiving small or negative returns. Due to automation, robo-advisor firms are able to offer their services for much cheaper than traditional advisors. Robos typically charge between 0.15% to 0.75% of assets under management compared with at least 1% plus expenses for traditional advisors. Many robo-advisors include tax loss strategies as well that have traditionally only been offered to wealthy clients, further increasing annual returns.
Finally, while robo-advisors are based on complex, algorithms and assumptions, they can provide a standardized, diversified portfolio based on an individuals’ basic risk tolerance. Financial advisors, on the other hand, can be bad investors and provide poor or inappropriate advice. Many financial advisors are not fiduciaries, which means they do not have to provide advice in the best interests of their clients. This can lead to an advisor advocating a stock that will increase their commissions but is not suitable for their client’s goals. Robo-advisors, like investment clubs, reduce individual human-error and overall portfolio risk.
As more and more investment firms and companies offer the services of robo-advisors they will be tested and refined further. Robo-advisors are not appropriate for everyone but they may provide benefits that make them a valuable complementary resource for investors.
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