How Your Robo-Advisor Could Steer You Wrong
Robo-advisors have been great for getting more people to dip their toes in the stock market through low-cost, automated investment opportunities. What you get with a robo-advisor is a portfolio assembled with your needs in mind, but with an algorithm at the wheel. Granted, those algorithms were built by, and are managed by, financial professionals. But it’s the computer intervention that allows you access to professional advice for so much less.
There’s a lot of good in this model. “It’s democratized the investment management market,” says Will Trout, author of the new report, Looking Under the Hood: Robo Advice, Portfolio Risk and Regulation. “You no longer need to have $5 million to get the attention of a market advisor—you can be a millennial with $10,000.”
But you can also become a lemming at risk of marching off a cliff. “With these baskets of market-tracking instruments—as long as the markets keep going up—they’re good,” says Trout. “The question, then, is: What happens if you have a sufficient market crisis and these pots drop in value? How do the robo-advisors keep their clients afloat, or prevent them from making rash moves with their money?”
Scott Smith, a director at Cerulli Associates, a research firm that specializes in global asset management and distribution analytics, says it’s not so much that robo-advisors are generally wrong, but that they may be wrong for you. “If there are mismatches in expectations, it’s not that the robo did anything wrong—that investor shouldn’t have been with a robo in first place.”
Here’s what to keep in mind when going robo.
They Are Fiduciaries of a Different Color
There’s an ongoing debate of whether robo-advisors can really act as fiduciaries—that is to say, what their legal obligations are to act in their clients’ best interests.
Historically, there have been two different standards for financial advice:
- A lower standard, suitability, which allows brokers (for example) to sell you a financial product that’s merely suitable for your needs.
- Then there’s fiduciary advice, which comes with higher standards. Not only is the advice suitable, but it’s also in your best interest.
The Securities and Exchange Commission recognizes robo-advisors as fiduciaries, but it also urges them to be transparent with how their algorithms recommend portfolios. And it stresses the importance of them really getting to know their customers through their questionnaires.
As a consumer, “try to understand the investment philosophy or methodology that’s underneath the hood,” says Sylvia Kwan, chief investment officer at Ellevest, a digital investment platform for women. “In many cases, automated can be a great strategy, but because all robo-advisors are driven with an algorithm—which are developed by people—the algorithm is reflective of the firm.”
They All Manage Risk a Little Differently
Are you looking to buy a car in the next five years? A house in ten? Or are you thinking more long-term, with retirement and your children’s educations in mind? Identify your goal and time horizon, because what you want to accomplish with your money, and when, should go into determining how conservative or aggressive your risk profile is—and how you answer your robo’s questionnaire.
Most robo-advisors will take these needs into account, and attempt to nudge you to make the right asset allocation decisions for your needs. But they don’t all do it in exactly the same way. “If you’re saving for your kid’s college, we’ll give you a recommendation—we call them risk tolerance bands—and you can deviate a few points up or down,” says Nick Holeman, a CFP with Betterment (which originally launched as a pure robo-advisor, but has since added humans to its offerings). “If we recommend 50% stock and you choose 55%, because you’re riskier, we’ll let you.
If you start to deviate a lot, like to 80%, we’ll push back a little harder: ‘Hey it looks like you’re taking on too much risk. Are you sure you still want to do this?’”
They’re Not One-size-fits-all Solutions
Trout says the limited range of assets offered by robo-advisors, in general, is reason enough to be sure you’re not keeping all of your eggs in the robo-basket. “You want to spread your assets across different types of investments, not just the stocks and securities held with robo-advisors,” he says. “The diversification provided by robo-advisors isn’t super powerful.” While robo-advisors provide exposure to the broad stock market, even with rebalancing and tax-loss harvesting, you’re at risk of losing money.
That’s why you want to diversify your types of investments across different asset classes, which means also having your money in cash, real estate and perhaps commodities.
They May Take Rash Action in Times of Turmoil Without Telling You
Last year, Betterment suspended trading during the “Brexit” market volatility to prevent its customers from making impulsive decisions with their money—a move CEO Jon Stein went on record saying was a good one to make. For the most part, robos are self-driving vehicles that allow you to grab the wheel when you want to steer it in a different direction. With this move, Betterment deployed the airbags, completely immobilizing their investors. “Communication could have been clearer,” says Betterment spokesperson Arielle Sobel.
“We stand behind it—our customers were really happy with what happened.”
Perhaps. But consider that different providers will handle these situations in different ways. When markets are reeling, some advisors—human or robo—will send out blanket emails or calls. Others don’t, thinking that this sort of communication can backfire if some clients weren’t nervous in the first place. “The strategy we’ve taken is more reactive than proactive,” explains Holeman. “If you were to log in during a Brexit, for example, you’ll see a notification, but if you don’t log in, you won’t see it.”
The ways many robo-advisors (including Betterment) mitigate downturns is something to consider, as well. When the market falls, many robo-advisors will automatically rebalance your portfolio and employ tax loss harvesting. “Those strategies help use downturns to your advantage to correct your portfolio… But there’s no way to prevent losses,” says Holeman. If in these times of market distress you want to engage and give input, then a robo might not be the right tool for you.
They May Have a Limited View of Your Financial Picture
At the risk of stating the obvious: How well a robo gets to know you and your risk tolerance via its questionnaire will determine how personalized your portfolio will be. “If you go through and fill out a five-question questionnaire, there is less certainty that that account has been customized for [your individual] wants and needs,” says Smith. “We have to separate financial planning from portfolio management. [Portfolio] management is a part of planning, but it’s just one part.”
That’s why more industry leaders are beginning to offer holistic services for their customers. Robo-advisor Wealthfront, for instance, introduced Path, an automated financial planning feature that lets customers consider questions like:
Do I want someone to just manage my money, or do I want to be able to talk about my money, too? Do I want an investment management tool, or do I want an investment management tool and a financial planning relationship?
For the same reason, Betterment brought human advice back into the mix. “We also realized money is a sensitive topic,” says Sobel. “And in order to trust the firm you’re putting money with… Trust often comes when communicating with a human.”
If You Don't Know Yourself, Neither Can the Robo
Executing on what you want can only be achieved by knowing who you are as an investor. To proactively control what a robo-advisor does with your money, you have to be reflective and truthful when it comes to filling out the questionnaires. “When going through their questionnaires, people really need to think about themselves and make sure they answer what they feel—not what they think the robo or firm wants them to feel.”
It may sound counterintuitive but think of answering the questions emotionally, rather than logically. For example, if the market goes down, you might understand it’s a buying opportunity, but if the thought of the market going down gets your adrenaline pumping (and not in a good way), then that’s something you need to address.