In the simplest context, a robo advisor is a way for financial institutions to cut costs by removing the personal element from their side of the client relationship. In any service-centric business, the expense of human capital is both very large and very risky as employees (unlike software) are prone to high medical costs, theft, incompetence, and myriad other liabilities.
From the perspective of the corporation, ponying up the cash to replace humans with a computer could be a smart fiscal decision, provided the application can perform the tasks at least as well as, and cheaper than, the people it deposes. The balance of this post will be dedicated to an assessment of what computers can and cannot be expected to do in a manner sufficient to safely navigate the complex and nuanced investment landscape.
I’ll start with a brief description of what a robo advisor is and what they typically do for those choosing to utilize one.
In the most general sense, we can think of these tools as an algorithmic engine with a clean, easy to navigate user interface. Mathematically, nothing about the programs are any more sophisticated than my trusty HP-12C handheld financial calculator. What makes them useful, however, is the ability to seamlessly bring many different variables into a cohesive, somewhat comprehensive recommendation for an ideal investment allocation mix.
The user experience typically starts with a basic survey about age, time-horizon, starting asset values, planned periodic saving amounts, and income goals after attaining the target date of the objective. From there, things usually progress to a question-based assessment of personal risk tolerance, the results of which will produce a generalized recommendation for a portfolio with (what should be) a comfortable volatility profile.
Based on the investment allocation ultimately chosen, the program may also provide the statistical likelihood of reaching the stated objectives. If the user doesn’t like the results, they can back up and alter the initial assumptions, tweaking the variables until arriving at a manageable and realistic scenario.
From a longer-term perspective, programs integrated directly with custodial accounts may perform tasks such as automatic rebalancing and auto-adjusting allocations as age progresses.
It should be noted that none of the functions listed above are beyond the scope of what any competent and qualified advisor can and should be performing with every client. However, not every client needs to be paying someone to do it.
Should I Use a Robo Advisor?
For someone new to investing and without a lot of money to work with, using a robo advisor can be a cost-effective and time saving alternative to seeking out and employing a human professional. Though ranges will vary, most advisors aren’t looking for clients with less than around $100,000 in investable assets. Granted, I’ve been hired by a handful of smaller clients, but I do the work because I love the people, not for the income.
Even if one can find an advisor willing to bring an investing neophyte into the firm, they will typically need to charge a proportionally larger fee relative to the size of the investment to make it worth their time. Additionally, basic needs will likely require little more than a basic strategy, which can often be accomplished in adequate measure by automated software applications.
The second, and more important, reason why robo advisors work better with smaller investors is because a lot less is at stake should they fall through some of the cracks in the effectiveness of non-human advice.
Are Robo Advisors Dangerous?
Generally speaking, no, robo advisors are not dangerous– provided the user understands what they are and are not getting from the service. If needs are limited to basic mathematical calculations and general allocation advice, robo is the way to go. But it’s also important that consumers know what these services will never be able to do, as discovering the inherent shortcomings can be an expensive lesson to learn the hard way.
Specifically, there is no way a computer program can understand the many facets that make a person … a person. At least, not to the degree another human can.
A robo advisor can learn facts about an individual and, within the bounds of statistical reliability, offer glimpses of what their financial future may have in store, but it will never be able to understand the way someone thinks about and reacts to external, unpredictable factors. It can’t consider personal biases and philosophies about life and money that may color the decision-making process. Nor can it weigh the significance of a person’s lifelong dreams, aspirations, and fears.
Most competent advisors with enough of experience under their belts have learned to quickly discover things about human nature that could never be revealed by a ten-question electronic survey. A good advisor recognizes factors that cause people to skew their perceptions of risk in various phases of the economic cycle and stages of life, coaching clients to a better understanding of who they really are and how they really feel about various aspects of the investment process.
As presumptuous as it may sound, human advisors who have mastered their craft often become astonishingly skilled at knowing people much better than they know themselves; at least insofar as it relates to money. This key difference between a computer and a qualified advisor in the investor’s corner has the potential to be the single biggest factor in determining long-term success or failure and its value should never be underestimated.
Are Financial Advisors Dangerous?
I’ll be fair and address this question, too. Again, generally speaking, no. However, the shortcomings of an un- or under-qualified “professional” have the potential to be extremely dangerous.
By and large, most advisors care deeply about the success of their clients, and they do their best to help everyone they can. Unfortunately, the price of inexperience and/or incompetence can be devastating to both advisors and their clientele. The challenge for the investing public is attempting to figure out who knows what they’re doing and who is flying by the seat of their pants. After all, it’s not like anyone is going to advertise their lack of ability.
In summary, if you are just getting started and want to dip your toe into the world of advisory services, robo advisors may be a good jumping-off point. If nothing else, you’ll get a better feel for the different considerations and planning aspects a personal advisor will employ when you make that evolution down the road.
If, on the other hand, you’ve got more on the line than you feel comfortable trusting to a computer or have planning needs more complex than the typically narrow scope of the robo platforms, enlisting the help of a qualified human professional may prove to be the more prudent decision.