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The recent rise of the robo-advisor has created quite a stir among financial advisors and raised questions among consumers about whether this type of automated solution is truly a viable alternative to human advice.
Robo-advisors are computer-based investment programs that design and maintain portfolios for consumers according to assessments of their risk tolerance. Fees to use a robo-advisor are a fraction of the roughly 1% of assets under management that human advisors charge. Initially, this service was only offered by startups, but now some large firms are offering robo-platforms, including my firm’s broker/dealer, LPL Financial.
All of this attention has sparked a robust debate about the long-term effectiveness of robo-advice versus traditional advice. The two are often presented as being at odds with each other, but they don’t have to be.
The argument for the robo-model raises the question: Why pay 1% to an advisor to build an asset allocation and invest in a basket of mutual funds or ETFs when a sophisticated computer program can do the same thing for next to nothing? It’s a good question, but the value proposition of robo-advice depends on two things: investors acting rationally through all market cycles and technology’s ability to accurately gauge an investor’s risk tolerance.
The unprecedented run-up of the markets since the bottom of the last recession in March 2009 has caused selective amnesia among many investors, helping to create a perfect environment for robo-advice. Those of us who have been through multiple recessions understand the psychology of a downturn, especially the difficulty investors have fending off the ceaseless negativity that surrounds them during those periods. The idea that clients with automated investment solutions will be able to just tune out the noise and stick to the program during such tough times seems optimistic at best.
Even modest corrections cause some investors to overreact. When September statements came out, many portfolios showed declines of 2% to 5%, prompting quite a few nervous emails and phone calls to my office, despite constant reminders that corrections and recessions are natural, even necessary, parts of market cycles.
When the chaos of the next market downturn reaches a fever pitch, many robo-advisor clients will undoubtedly find themselves longing for experienced guidance that might keep them from making emotional decisions that could well ruin their portfolios.
Over the past few years, I’ve noticed that when the market goes essentially straight up for multiple years in a row, investors tend to overstate their risk tolerance. The reality is that a client’s true appetite for risk is often a moving target and is very hard to gauge from a 10-question form or even an hourlong conversation. Learning an investor’s risk tolerance takes seeing how she reacts to different market conditions, so it’s unlikely that many of the risk-tolerance profiles used by robo-advisors are entirely accurate.
This inaccuracy increases the likelihood of negative emotional responses by these investors in times of extreme market volatility. Combined with a lack of experienced, human guidance, it could result in adverse outcomes for individual investors who may make rash decisions.
Can’t we all just get along?
What’s lost in the narrative about robo-advisors is that a good advisor should provide much more than portfolio performance. In my practice, I consider the performance of the investment portfolios to be a secondary concern. If advisors are doing their jobs right, investments will in time do what they’re supposed to. Advisors need to more clearly articulate what we do so that clients can fully understand what they’re missing if they use a robo-advisor: expert guidance, customized advice and, importantly, an accurate evaluation of the client’s risk tolerance.
I believe that eventually, robo-technology will end up being more of a tool for traditional advisors than a stand-alone alternative to them.
Perhaps then it won’t be robo-advisor versus human advisor, but rather, robo-advisor and human advisor.
Image via iStock.