Robo-advisors: Money-maker or Investment Mistake?
Tuesday, November 24th, 2015
We have heard the term RoboCop and “robo this” and “robo that,” and now gaining popularity is the Robo-financial advisor. Wall Street has always been great at coming up with ways to make money from investors and don't really care if investors make any money or not, because they will come up with something new and exciting when the current fad fades away.
If you're unfamiliar with the term Robo-advisor, it is a class of financial advisor that provides portfolio management online with minimal human intervention. Now some may think that this is a good idea, but I will explain many reasons why it is not.
Here is how it works: Investors fill out a risk tolerance form, the formula is plugged into the computer and then out comes a portfolio recommendation. The Robo-advisor uses algorithms such as modern portfolio theory to come up with an investment solution, or an allocation between different asset classes such as international stocks, large-cap stocks, bonds and commodities etc.
All these terms sound fancy, like algorithms, which is just a big word for nothing more than a procedure or formula for solving a problem. Everything these days seems to have an algorithm. Maybe I am just getting old, but to me using the old words to say I have a way of doing something or a procedure just sounds more understandable than words that sounds big and fancy.
The word is not new- it is derived from the name of a mathematician who was part of the royal court in Baghdad and lived from about 780 to 850. The word has been around for roughly 1200 years, so don't be fooled thinking you are getting something new and exciting.
The Robo-advisor uses tools that are very similar to what advisors use in portfolio management software. Investors used to have to go through financial advisors to get the portfolio management software, but now they are able to get it on their own. The younger investors seem to favor this type of investment as opposed to human interaction. There are a number of things wrong with this, which I will explain.
First off, it is a set formula to have allocations set up a certain way no matter what the current circumstances. With interest rates as low as they are, it makes no sense to have any of your portfolio in bonds.
The human smart investment advisor understands that interest rates will go up and the value of bonds will decline. The portfolio management software that is used by the Robo-advisers will not understand that, and depending on your risk tolerance could put a large portion of your money into bonds.
Investors need to understand that they are investors, and should understand to some degree what they're investing into as opposed just going along for the ride. The Robo-advisor does not look at the valuations of stocks and can miss some great opportunities when stocks are on sale because the market is in corrections mode.
It can also cause investors to lose money on stocks by insisting on buying stocks even when the valuation ratios are very high, a move that has cost investors plenty of money over the years.
The Robo-advisor cannot take advantage of certain circumstances, such as a market correction with stocks when low valuation ratios are flashing a buying opportunity.
An investor may panic and liquidate their portfolio because the computer does not understand emotions. A good investment advisor who understands the investments can have an intelligent conversation with the investor and help them understand why they should not liquidate their investments.
Investment firms are lining up to offer you their own Robo-platforms; they can be found at your smaller independent firms all the way up to your big firms like Merrill Lynch.
It is expected by the year 2020 there could be as much as $255 billion invested with Robo-advisers. In December 2014 the total was around $19 billion. So you can see this is a trend that seems like it will continue for years to come.
Myself and my firm Wilsey Asset Management will not be using any form of Robo-advising. We would much rather take the time to read and understand the financial statements and the investments, and to make a decision based on all the information, not just some allocation that the computer says is good for you because of some form you filled out.
We will also take the time to educate our clients about their investments and investing in general, and this helps reduce a lot of stress for the investors.
Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!
Wilsey is a financial analyst for Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.
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