Why and When Robo-advisors Will Fail You
This article will discuss the difficulties that robo-advisors and their clients may face when markets become volatile to the downside.
Updated and expanded on March 17, 2017
Everyone knows that there are no crystal balls, except in fairy tales. Thus, no one knows what will happen tomorrow, next week or next year. This fact holds especially true with investment markets.
However, history does show that markets and economies go in cycles, up AND down. Think about the technology stock bubble in the 1990s and its subsequent crash starting in early 2000. Think about the subprime mortgage crisis and crashes in real estate and stock markets in 2008 and 2009. Market downturns are inevitable; we just don’t know when one will happen, how long it will last, and what depths it will plumb.
Therefore, despite an impressive six-plus-year run-up in U.S. stock prices, it is safe to say that a violent and/or prolonged downturn in stock prices will occur again. It has been said that history doesn’t repeat itself, but it often rhymes. Semantics aside, anything that “rhymes” with the vicious market downturns of 2000 or 2008 could decimate your portfolio and retirement prospects.
The intent of robo-advisors* is to make investing easier and less expensive by largely automating the process, thereby taking relatively expensive human advisors out of the equation. They typically utilize pre-made portfolios from a limited palette of investing options, usually exchange-traded-funds. An investor answers questions related to age, the potential need for cash, investing horizon, and perceived risk tolerance, among other topics. The investor’s “risk score” is calculated from answers to these questions. This score then matches an investment portfolio to the investor.
There is one obvious issue with this process. There is wide discretion among questionnaires and risk scores with no universally accepted best methodology. Thus, investors must contend with firms marketing varied approaches with no guarantee a particular approach will suit them.
A less obvious issue arises from the results of seemingly similar 60-40 (comprised of 60% equities and 40% fixed income) portfolios from different robo-advisor companies. On January 25, 2017, Investment News published an article showing investment returns over a one-year period from a test conducted by Condor Capital Management. Those returns varied from up 5.55% for a 60-40 Vanguard portfolio to up 10.75% for a 60-40 portfolio from Schwab.
Do those results mean Schwab offers better robo portfolios? No, it simply means that over the one-year period measured the specific Schwab 60-40 portfolio returned more than other 60-40 robo portfolios. There was no mention in the article of the exact asset breakdown, but it is likely that the Schwab portfolio had more U.S. exposure and the Vanguard portfolio had more international exposure. U.S. stocks outperformed international stocks that year, so the Schwab portfolio did better. Had the test run for another year or two, the results could have reversed or, more likely, evened out. There were no risk measures cited.
The point is that seemingly similar approaches can yield significantly different results over any period, but one robo can’t be measured as better than another simply based on returns. So, what is an investor to do? How can one know what is best? You likely need a discussion with a human being who is experienced in such matters to help you determine what is best for you.
A Bigger Problem with Your Robo
Robo-advisors may be good for creating simple portfolios on the cheap, but they cannot help you when investments go wrong or when markets turn bad. Robos are programmed to rebalance portfolios to target allocations at specified intervals. They are not programmed to lessen your risk of financial loss in volatile markets. They are designed for long-turn investing, but short-term risks need to be considered, too. If you go broke in the short-term, or get scared away from investing forever, your portfolio won’t last for the long-term.
Thus, the risk of potential loss must be carefully considered and discussed. Robo-advisors can’t calculate how you will feel when markets go against you. What if the stock market (as measured by the S&P 500) goes down 25% tomorrow? How will you feel? What will you do? A robo-advisor cannot determine the best course of action for you individually.
Most of you will not feel qualified, or have the time, to make buying and selling decisions. You will likely not understand how to alter your portfolio based on potential risks in markets. Unless you are an experienced investor taking full responsibility for your portfolio, you should talk to an experienced human advisor before an inevitable market downturn, because investment decisions will need to be made for you. Your human advisor needs to know you in order to best help you.
As the owner of the registered investment advisor, Bionic Capital LLC, I would never guarantee any type of positive portfolio results. An honest, and knowledgeable, investment professional can’t. However, I do pay close attention to markets and customer portfolios every day. I make decisions for my clients based on many years of Wall Street and investing experience. Humans, like me, sometimes make mistakes, but we also make decisions. Would you prefer an unthinking machine or an experienced human helping you invest? How about a combination of both?
Either way, I can guarantee the machine will not take any responsibility for your portfolio results or your financial future.
When markets turn down, your robo-advisor will inevitably fail you. You need someone who will take responsibility for the risks and results in your portfolio. If that person isn’t you, you must find the right person who can make difficult decisions and take appropriate actions for you. Robo-advisors just can’t do either.
If you have $250,000 or more in investable assets, let’s analyze the risk/reward characteristics of your portfolio. To discuss, call me at 310-734-8500 or email me by clicking here.
Dean Erickson, CFA
CEO, Bionic Capital LLC
*A robo-advisor uses a computer algorithm to determine a client’s asset allocation (which is a questionable, but typical practice). The algorithm normally cannot alter that allocation based on changing market conditions or heightened risks in the economy.
See this post as it originally appeared on Investopedia.com.