Robo-advisors have been great for getting more people to dip their toes in the stock market through low-cost, automated investing. What you get with a robo-advisor is a portfolio made with your needs in mind. And you have 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.
Here’s what to keep in mind when going robo.
- Robo-advisors are fiduciaries. But clients should still be sure to understand how these algorithms work.
- Your risk tolerance can be factored into a robo-advisor's actions, but it may not be precise. Also, methods vary by company.
- Robo-advisors are not able to help you diversify your portfolio; they only offer a small set of assets.
- Robo-advisors may react automatically during market downturns. That means it's up to you to veer from any default actions.
What Do Fans and Critics Say?
There’s a lot of good in the robo-advisor model. “It’s democratized the investment management market,” says Will Trout. Trout is the author of the 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 is a director at Cerulli Associates, a research firm that specializes in global asset management and distribution analytics. Smith says it’s not so much that robo-advisors are generally wrong. But they may simply 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.”
Are Robo-Advisors Really Fiduciaries?
There’s an ongoing debate of whether robo-advisors can really act as fiduciaries. In other words, what are their legal obligations to act in their clients’ best interests?
Generally, there have been two standards for financial advice:
- A lower standard: suitability. This allows brokers (for instance) to sell you a financial product that’s merely suitable for your needs.
- A higher standard: fiduciary advice. Not only is the advice suitable, but it’s also in your best interest.
The Securities and Exchange Commission (SEC) recognizes robo-advisors as fiduciaries. But it also urges them to be transparent with how their algorithms make recommendations.
Most companies use will use a questionnaire to help calibrate their robo-advisor to your financial goals. To adhere to the fiduciary standard, the SEC also stresses the importance of these questionnaires. They can be used as a tool for companies to really get to know their customers.
As a consumer, “try to understand the investment philosophy or methodology that’s underneath the hood,” says Sylvia Kwan. Kwan is the 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 is developed by people—the algorithm is reflective of the firm.”
How Do Robo-Advisors Manage Risk?
Are you looking to buy a car in the next five years? A house in 10? Or are you thinking more long-term? Maybe you have retirement and your children’s educations in mind.
No matter your goal, you can get started in the same way. First, identify your goal and time horizon. That's because what you want to accomplish with your money—and when—should go into determining your risk profile and strategy. This will also help you answer your robo’s questionnaire.
Most robo-advisors will take these needs into account. Then, they may 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.
“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?’”
Betterment originally launched as a pure robo-advisor in 2008; since then, it has added human advisors to its offerings.
Are Robo-Advisors Enough?
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 robos provide exposure to the broad stock market, you’re at risk of losing money. This is true even with rebalancing and tax-loss harvesting.
That’s why you want to diversify your types of investments across different asset classes. That means also having your money in cash, real estate, and perhaps commodities.
How Do Robo-Advisors Respond During Market Volatility?
In 2016, Betterment suspended trading during the Brexit market volatility. This was done in order to prevent its customers from making impulsive decisions with their money. Betterment CEO Jon Stein went on record saying this was a good move to make.
For the most part, robos are self-driving cars that allow you to grab the wheel when you want to steer it yourself. 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 different providers will handle these situations in different ways.
“The strategy we’ve taken is more reactive than proactive,” explains Holeman, the CFP. “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.”
When markets are reeling, some advisors will send out blanket emails or calls. This could be true of both human and robo-advisors alike. Others don’t, thinking that this sort of communication can backfire if some clients weren’t nervous in the first place.
The ways many robo-advisors (including Betterment) mitigate downturns is something to consider, as well. When the market falls, many robos 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.
How Do Robo-Advisors Understand Your Financial Picture?
How well a robo gets to know you and your risk tolerance will determine how personalized your portfolio will be. That's why it's important to answer its questionnaire.
“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. Path is an automated feature that lets customers think about 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.”
While it may sound counterintuitive, think of answering the questions emotionally, rather than logically. For instance, let's say the market goes down. On one hand, you might understand it’s a buying opportunity. But if the thought of the market going down gets your heart pumping (and not in a good way), then that’s something you need to address.