The robo-advisor is considered very useful for attracting more people to dive into the stock market through low-cost automated investing. What you get with a robo-advisor is a portfolio tailored to your needs. You have an algorithm that controls the process. These algorithms were built and managed by financial professionals. But through computational intervention, you can access professional advice at a much lower cost.
What Do Fans and Critics Say?
There are many positive aspects to the robo-advisor model. “It has democratized the investment management market,” according to Will Trot. Trot is the author of the report “Under the Hood: Robo-Advisors, Portfolios, and Regulation.” “You no longer need $5 million to get the attention of a market advisor – you could be a millennial with $10,000.” But you can also become a monkey walking on the edge of a cliff. “With these strains of market-tracking tools – as long as the markets continue to rise – they are good,” says Trot. “The question, then, is: What happens if you have a sufficient market crisis and these pots drop in value? How do robo-advisors keep their clients alive or prevent them from taking hasty steps with their money?”
Are Robo-Advisors Actually Trusted Advisors?
There is an ongoing debate about whether robo-advisors can actually be trusted advisors. In other words, what are their legal obligations to work in their clients’ best interest?
Generally, there have been two standards for financial advice:
- Lower Standard: Suitability. This allows brokers (for example) to sell a financial product that is only suitable for your needs.
- Higher Standard: Fiduciary Duty. Not only is the advice suitable, but it is also in your best interest.
The Securities and Exchange Commission (SEC) recognizes robo-advisors as fiduciaries. However, it also urges them to be transparent about how their algorithms provide recommendations.
Most firms will use a questionnaire to help the robo-advisor calibrate your financial goals. To comply with the fiduciary standard, the SEC also emphasizes the importance of these questionnaires. They can be used as a tool for firms to really get to know their clients.
As a consumer, “try to understand the philosophy or investment methodology that lies under the hood,” according to Sylvia Kwan. Kwan is the Chief Investment Officer at Ellevest, a digital investment platform for women. “In many cases, automatic investing can be a great strategy, but because all robo-advisors operate through an algorithm – which is human development – the algorithm reflects the company.”
How Do Robo-Advisors Handle Risks?
Are you planning to buy a car in the next five years? A house in 10 years? Or are you thinking long-term? Perhaps you have retirement and your children’s education in mind.
Regardless of your goal, you can start the same way. First, define your goal and the timeline. This is because what you want to achieve through your money – and when – should factor into defining your profile and strategy. This will also help you answer the robo-advisor questionnaire.
Most robo-advisors will take these needs into account. They may then try to guide you in making the right decisions about the correct asset allocation for your needs. But they don’t do this in exactly the same way.
“If you are saving for your child’s college, we will give you a recommendation – we call it risk tolerance ranges – and you can deviate a few points up or down,” according to Nick Holman, CFP at Betterment. “If we recommend 50% in stocks and you choose 55% because you are more risk-tolerant, we will allow that. If you start to deviate too much, like 80%, we will push back a bit more: ‘Hey, it seems like you are taking on too much risk. Are you sure you want to continue down that path?’”
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It is important to note that Betterment originally launched as a pure robo-advisor in 2008. Since then, it has added human advisors to its offerings.
Are Robo Advisors Enough?
Trouth says that the limited range of assets offered by robo advisors, in general, is sufficient to ensure that you are not putting all your eggs in the robo basket. “You want to spread your assets across different types of investments, not just stocks and securities held by robo advisors,” he says. “The diversification that robo advisors offer is not very strong.”
While robo advisors provide exposure to broad market equities, you are at risk of losing money. This is true even with rebalancing and tax loss harvesting. For this reason, you want to diversify your types of investments across different asset classes. This also means having your money in cash, real estate, and possibly commodities.
How Do Robo Advisors Respond During Market Fluctuations?
In 2016, Betterment suspended trading during the volatility stemming from the Brexit vote. This was done to prevent its clients from making rash decisions with their money. Betterment’s CEO, Jon Stein, stated that this was a good move to make.
Generally, robo advisors are self-driving vehicles that allow you to take the wheel when you want to steer it yourself. With this move, Betterment deployed air cushions, effectively disrupting investors completely.
“Communication could have been clearer,” according to Betterment spokesperson, Ariel Sobel. “We stand by that – our clients were really happy with what happened.”
Maybe. But different companies will handle these situations in different ways.
“The strategy we took is more reactive than proactive,” explains Holman, CFP. “If you logged in during the Brexit vote, for example, you would see a notification, but if you didn’t log in, you wouldn’t see it.”
Some advisors will send emails or group calls when the markets are in a downturn. This can be true for both human and robo advisors. Others do not do this, assuming that this type of communication could backfire if some clients aren’t concerned in the first place.
How robo advisors (including Betterment) mitigate downturns is also something to consider. Many robo advisors will automatically rebalance your portfolio when the market declines and use tax loss harvesting.
“Those strategies help utilize downturns to your advantage to correct your portfolio. But there is no way to prevent losses,” says Holman.
If you want to engage and provide input during these times of market stress, a robo advisor might not be the right tool for you.
How Do Robo Advisors Understand Your Financial Picture?
How a robo advisor recognizes how well it knows you and your risk tolerance will determine how your portfolio is allocated. That’s why it’s important to answer its questionnaire.
“If you go through the questionnaire and fill out a five-question survey, there is less certainty that this account has been allocated according to your wants and needs,” according to Smith. “We need to separate financial planning from portfolio management. Portfolio management is a part of planning, but it’s just one part.”
For this reason, industry leaders have started offering comprehensive services to their clients. For example, the robo advisor Wealthfront introduced the Path feature. Path is an automated feature that allows clients to consider
Source: https://www.thebalancemoney.com/how-your-robo-advisor-could-steer-you-wrong-4153545
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