You Can’t Code Away The Gray
Robo Advisors – A Great Idea… A Ways To Perfection…
At a glance of the title, it may seem like I’m bashing Robo advisors… Keep reading and you’ll see that I’m not. Rather, my stance is we are in the first stage of the online investment management revolution and there are some real kinks that will need to be worked out over time before the service is in its optimum state… There is real merit in using the current robo style platform for certain investors at a reduced fee. Specifically those individuals with a strong background in finance but a lack of time, energy, and interest to manage their own accounts are ideally suited for an automated system.
For everyone else – those not comfortable or educated in the process of investing or financial planning, I argue that the process should NOT be purely automated. I’ve spent a great deal of my time analyzing robo advisor sites and the pros and cons of each as they are a direct competitor to my business. I’ve been in financial services five years and worked with a variety of people: young to old, inexperienced to very savvy investors and everything in between. It has always troubled me that young people are often neglected by traditional advisors because the small accounts they hold don’t generate fees larger enough to justify the time needed to responsibly service them on a 1-2-1 basis.
The robo advisor model has exploded on the scene to address this issue… BUT it is far from perfect. Aside from highlighting some obvious holes below, I’ll also give my two cents on what to look for if you do go the robo route:
1.) The Next Bear Market Will Be The Real Test: None of the robo advisor firms (to my knowledge) had a significant client following using the online investing model in the pre-2008 world. As such, these “online clients” haven’t had the experience of dealing with an automated service in a real bear market… which is exactly the time you’ll really want to talk to a human to calm your nerves and make logical decisions through the rough patch. The major robo companies were founded in 2008 and later. Food for thought: The market has provided positive returns every year since 2008.
SIX straight years of positive returns on equities (2009-2014) is somewhat rare. In fact, 22% of years (since 1970 on the S&P500) have been negative. It’s the nature of investing… you are going to lose sometimes. Of course, if you see your account going up every year the rational is… who cares about being able to talk to someone? Ask yourself, “Would you have felt that way if you woke up in the spring of 2009 and saw your account down 58% with no one to call (yes that’s how much the S&P dropped from top to bottom in about 14 months)?
2.) Regulation: After the 2008 financial crisis, regulators further developed the “Know Your Customer Rule” (KYC) for investment advisors. Basically it requires financial advisors to document conversations about risk tolerance, the client’s prior investment experience, income/expenses, assets & liabilities, etc. before making recommendations and charging a fee for that advice. “Registered Investment Advisors” (all Robos fall in this category) are held to the fiduciary standard meaning they must recommend not only what’s suitable, but what’s in your best interest at all times. The automated sites claim they can responsibly satisfy the KYC rule and the fiduciary standard in about 3-4 questions and voila… you’re “ready” to open an account. This is hunky dory in an up market (like we have had since 2009) but what about a 25% down year on the S&P?
3.) Reliance Solely On Machines & Algorithms Can Create A False Notion That The Market Follows a Rigid Set of Rules… News Flash – It Doesn’t: Trust me, an 80-90% stock portfolio (the commonly recommended allocation for the 40 and under crowd on robo sites) can easily lose 20-40% in a bad year if not more. Just because a set of algorithms is managing your portfolio does not mean you are insulated you from these losses and you have to be braced for them. That said, if you’re in the minority – a person who can handle that kind of stress without human support, the Robo model might be right for you for at least a portion of your assets.
• But First Imagine This Scenario: every seasoned advisor in the industry has seen investors destroy their wealth jumping out of the market in 20+% declines only failing to benefit from the sharp rebounds that tend to follow. What client will be more likely to stay the course? We have Client A – in a state of panic they get a call center and a blog to calm their fears? Or, Client B, who has a strong relationship with an advisor and real trust in their advice, integrity, and process. Maybe even an advisor holding the same types of securities they recommend their clients! How we react to major market swings (both up and down) is the single most important factor in long-term performance…. not saving 20-75 bips on your fees.
4.) Financial Planning Questions: it’s my stance that whomever you work with should have a sophisticated and holistic understanding of finance – not just investing. This involves budgeting, taxes, insurance, retirement planning, employee benefits, etc. Having someone to leverage when you have questions about these things (we all do every year) is the real value of working with a financial advisor… not just managing a portfolio.
So I’m poking all these holes in the robo advisor model… man I’m a hater. Actually it’s quite the contrary. I think they are doing something great. Helping young people invest and follow a programmatic process with low fees.
***But, the current services have gone too aggressively down the road of automation which will likely hurt many new investors who need education on the front end to truly understand what they are getting into. Those pulled down the robo path will go years without any personal guidance and may miss financial planning opportunities along the way.
Key Takeaway: The merits of any financial decision can be argued multiple ways and the right advisor should help you see things with a more balanced perspective. Finance is not a black and white field. Every decision has its pros and cons to be reviewed before you pull the trigger (investment or otherwise). It’s difficult to code away the gray.
Conclusion: we need a middle ground that’s still cost-effective, convenient, and online but layered into an experience that allows for periodic human interaction between the client and advisor. This middle ground could be offered somewhere in between – say 0.50-0.75%/yr and be far more effective over the long-term for the young investor. Take a look at the fees below. Ask yourself, is the extra $135/yr worth the comfort of having some actual guidance from a living breathing human who can help you not only invest but make better financial decisions? $135 won’t get you very far if you are paying for worthwhile guidance on an hourly basis… An hour if you’re lucky.
• $25,000 Account X 0.20% fee = ~$50/yr
• $25,000 Account X 0.75% fee = ~$185/yr
• $25,000 Account X 1.50% fee = ~$375/yr
*** Maybe you see right through me… our firm is in the development stages of offering this middle ground service online within 6-12 months.
Still Going the Robo Route? Here’s What I Would Look For:
• Which site gives me access to periodically talk with an expert…no, not a customer service staff member but an actual licensed & credentialed financial expert?
• What in-take process asks the most effective questions to get to know me, my risk tolerance, and my investing style?
• Which site has the best library of financial planning content that’s easy to navigate?
• What are the fee differences? The fees on all of the robo sites are so low. Picking the one based on absolutely the lowest fees shouldn’t be your primary consideration. 0.10-0.20% is not a huge difference in the long run vs. these other factors affecting the quality of the service they provide.