Robo advisors have been around for a long time but may seem like a recent phenomenon. This is the case because robo advisors are a relatively new technology for retail investors.
Institutional investors have been using some form of robo advisors for the past forty to fifty years. However, this technology has only been available for retail investors for the past fifteen years. Even though its been available it has just recently become more popular in the past five years.
The idea of robo advisors for retail investors is a good thing. However, most have major flaws.
This article defines what a robo advisor is, the pros and cons of robo advisors, and additional details you need to know about them before using them.
What Is A Robo Advisor?
A robo advisor is software developed by investment management firms that makes the investment process more efficient. In short, they take tasks that require expensive experts to manage and automate them.
Robo advisors automate these tasks. Therefore, you as a consumer save a ton of money in fees!
In addition, robo advisors help automate mundane tasks such as account opening, transferring assets, auto-deposits, etc… Again, being able to automate these small tasks saves you a ton of money.
One item a robo advisor can do is to automate the selection of investments in your portfolio. For example, target date funds use robo-advisors to select investments. This specific feature I’m not a huge fan of. I explain more about this below.
Why Robo Advisors Are Good
Robo Advisors are good for one reason. They save you a ton of money.
Let’s say you were investing $1,000 a month over a forty-year span. In addition, you earned 6% annual returns.
Using robo advisors saves you on fees. Therefore, you can reinvest more money. In this example, you’d have $465,000 more!
There are two additional benefits that often go overlooked:
- Rebalancing: Not only do you end up with more money but you do so with less risk. The reason being is that rebalancing consistently realigns your investments with your risk tolerance.
- Tax loss harvesting: The $465,000 above doesn’t include this. Factor this in, the benefit is even greater than $465k!
As I mentioned above, automating tasks such as account opening, rebalancing, and tax loss harvesting is a major benefit to you!
Why Robo Advisors Are Bad
After going through the benefits of a robo advisor, you may be thinking it is a no brainer. However, there are some major flaws with robo advisors you need to be aware of.
Flaw #1: Risk Tolerance Based On Academic Theory
There are two components investment professionals look at when it comes to investments: Risk vs Return. Risk is then broken up into your willingness to take risk and your ability to take it.
There is a ton of academic research on this topic. Unfortunately, most of that research gets blown up in the real world. However, people still use it to make real world decisions.
One example of this is the most popular investment choice in 401(k)s/403(b)s: Target date funds.
Target date funds don’t actually care about your willingness to take risk or ability to take risk. Instead they tale academic research that says “your young therefore you can take a lot of risk.” (Yes, I’m paraphrasing).
Therefore, target date funds are often misaligned with the individuals willingness and ability to take risk.
Personally, its astonishing because human investment advisors have to thoroughly document both willingness and ability to take risk for each of their clients. Target date funds, specifically those in 401ks virtually ignore it!
Flaw #2: Risk Tolerance Focused On Willingness (Questionnaires)
Robo advisors outside of employer retirement plans take into account risk. However, it is incomplete in two ways because of the questionnaires used.
Most of these questionnaires are used simply to check a box for compliance purposes. Below I detail their flaws.
Willingness To Take Risk
Most of the questionnaires focus on your willingness to take risk. However, this doesn’t make any since because you are going to answer those questions differently on any given day.
For example, they may ask, “How do you feel if your account goes down 20%?”
This question is flawed two ways:
- If you have $1,000 invested and the account goes down $200 you might not care. However, over the years if you build up your account and its worth $100,000 you might think differently about a $20,000 downturn. Retail investors don’t necessarily care about the percentage they care about the dollar amount of the ups and downs and they are more concerned about the dollar magnitudes down than up! In short, there is a behavior aspect that is completely ignored by these questionnaires.
- They ignore or largely ignore your ability to take risk. I know this because most of them don’t ask anything about your education (this greatly impacts the risk to your income), debt, family status, and the list goes on and on. For young people, they basically look at age to determine ability.
One easy way to see how this can affect you is recent inflation. Robo advisors are still telling young people to put like 90% in stocks because they have a long investment time horizon.
That is great academic theory but reality is if inflation keeps going the way it has been, you may need your money in 1 – 3 years simply to buy groceries and pay for utilities. Therefore, you do not have the ability to take risk!
Not only this, but your willingness to take risk might change simply based on your mood today!
This is why we launched our hybrid robo advisor at FitBUX. Your FitBUX profile and FitBUX Score incorporates your ability to take risk and your behavior.
Therefore, our robo-advisor selects your asset allocation based on your ability to take risk. Then for willingness, we let you decide if you want to take more risk or not.
Flaw #3: Portfolio Investments
The last flaw of robo advisors deals with the actual investments. Again, academic theories are used in this by many robo advisors.
Specifically, they use modern portfolio theory. I’m not going to go into all the flaws with modern portfolio theory.
The key to understand is that its not realistic in the real world because of two major flaws. The first being that it doesn’t take behavior into account. Second, it produces a lot of unnecessary churn, i.e. buying and selling.
Instead, a simplified approach using passive ETFs is best for most people. For example, FitBUX’s hybrid robo advisor focuses on income producing assets. We do this because the reinvestment of the income produces a great return on investment while reducing risk. In short, it provides better risk vs return metrics in the real world!
Flaw #4: Black Box
Robo advisors are a black box. That means you have no idea about how they are managed but more importantly you have no one to speak to.
Most robo advisors have answered this complaint by giving users the ability to speak with a financial professional. However, they charge a massive fee to do so.
We do not think there should be a massive fee. That is why you can speak to a FitBUX Coach. They will answer your questions and there is no additional cost!
Robo Advisor vs Financial Advisor
Robo Advisors are way more efficient than a financial advisor especially if you are just getting started.
In fact, most financial advisors take your money then put it into a robo advisor. They just charge a massive fee to do so.
You may be thinking that you have enough money that they do not do that. That instead you will get a personalized portfolio. In this article, I detail why that is not the case.
Therefore, in my opinion most people do not need a financial advisor. THIS IS ESPECIALLY TRUE FOR YOUNGER PEOPLE.
The only ones that do are those that have a complex financial picture because of the type of assets they hold. In these cases, a financial planner that specializes in estate planning is needed.
However, robo advisors are also tremendously flawed. I’m obviously biased but that is why our hybrid robo advisor is awesome for young professionals. It removes the flaws of robo advisors plus you have access to a FitBUX Coach to answer your questions.
Are Robo Advisors Worth It?
Absolutely. Especially if you have a simple understanding of investments or you don’t want to be extremely hands on with your investments. In short, if you don’t want to spend hours a day learning about and doing your own investments, they are great.
As you saw earlier, robo advisors give you the ability to generate a lot of money relative to using a financial advisor simply do to the lower fees.
In todays world, there is no reason for you to pay a person to do rebalancing, tax loss harvesting, deposits, transfers, etc.
Robo Advisor Fees
Robo advisors typically charge between .25% and .50% of assets under management. Financial advisors typically charge between 1% to 2%.
What does this mean in real dollars?
If you have $100,000 invested with a robo advisor, it would cost between $250 and $500 a year.
A financial advisor would cost you between $1,000 and $2,000 a year. That adds up to being a lot of money in the long run.
In this example, I tell a story about how a relative of mine was paying their advisor $30,000 a year in fees! The advisor was simply turning around and putting her money into a robo advisor. Absolutely ridiculous!
How does a robo-advisor work?
It is simple. You complete a questionnaire or a profile which should take between 5 – 10 minutes. Then you either deposit, transfer, or rollover your funds to the robo advisor. From their make sure you update your account.
Investment Help Is Here
We know most of you want to do the right thing with your investments but you do not want to have to become and expert in finance to do so.
We also understand you don’t want to be charged a ton of money for a bad service.
Therefore, FitBUX recently launched our hybrid robo advisor just for you. Check it out and let us know if you have questions.
We’ve helped young professionals manage $2.2 billion in assets and debt and we look forward to helping you.
By Joseph Reinke, CFA