Are Robo-Advisors the Wave of the Future?

The Rise of Financial Machines

Technology has a long history of disrupting industries by replacing human labor with machines and software. In most instances, technology can provide scalability, lower costs over time, and productivity gains.
The financial services industry is no different, and improvements in technology have lowered costs for investors over the past two decades.

 
For example, back in the 1980s and 1990s, individual investors who were not already incredibly wealthy really only had high-cost mutual funds at their disposal to diversify their nest eggs. Today, thanks partly due to technology, these same investors can access a level of service that has existed for large institutional investors for decades.

 
The most recent advent in the investment arena that has gained a tremendous amount of attention from financial advisors and investors alike are “Robo-Advisors.”

 
A robo-advisor is a web-based wealth management service that provides automated portfolio management advice with little to no interaction from financial advisors. These online tools use the same software as traditional advisors, and some even offer attractive services such as tax harvesting and reinvesting dividends.

 
These technologies are typically low cost and require smaller account minimums, which leads many to believe that they could disrupt the financial advisor industry for good, where humans are replaced entirely with machines.

 The Good with the Bad

On paper this movement makes a lot of sense. There’s no question that advisor fees impact performance, so why pay a human more for something that a computer can replace at a fraction of the cost?

 
To be completely honest, many of these robo-advisors use the same financial concepts and theories as human advisors. Furthermore, a large cohort of investors out there don’t need complex advice and/or services, so they will likely find little value in the higher cost of a human overseeing their investments versus a computer.

 
Robo-advisors were mostly created to meet the demands for those who (1) are younger and have a long runway for their financial future, and (2) have rather simplistic investment needs.

 
For example, a 25 year-old earning enough to put away a few thousand dollars each year into a retirement fund may benefit from a robo-advisor. This investor has rather simplistic needs and can weather any volatility that comes from recessions and bubbles like those endured in 2000 and 2008. If this portfolio dropped 15 – 30% in a year, there’s plenty of time to recover any losses.
However, a retiree who needs income to pay bills, cannot stomach the volatility in the investments that robo-advisors select, and/or is afraid of outliving a nest egg has a much harder time investing in these strategies.

 
Those who have complex financial needs will also find little value in these automated solutions. No computer will ever truly know an investor as well as another human who has spent time learning about the intricacies of an investor’s personality and financial needs.

 
Simply put, while these robo-advisors make sense for Millenials because of their time-horizon and basic investment needs, these tools could prove far too risky for those who are close to retirement or already living off their nest egg.

Robo-Advisors Can’t Manage Emotions

I firmly believe that most important service that a financial advisor performs is managing investor emotions. Going further, keeping investors level-headed during times of market volatility is simply the most critical task of any seasoned advisor because fear, panic, and greed lose money almost every time.

 
The chart below shows the number of big dips in the S&P 500 since 1950, along with the average size of the drop and frequency of big dips (aka “crashes”).

S&P 500 Dips of 10% or More Since 1950

Total Occurances:                28 Times

Average Dip:                          1.6%

Median Dip:                          -16.5%

Average Length:                    7.8 Months

Greater Than 20% Dip:        9 Times

Greater Than 30% Dip :       5 Times

These numbers may appear frightening upon first glance, but let’s consider the following three key conclusions:

 
1. Big Dips Happen: The S&P 500 has experienced 28 dips greater than 10% (also known as a “correction”) since 1950, so these dips are expected from time to time.
2. Losses Don’t Last: The average recovery time from a correction was less than eight months. Hence, paper losses rarely persist for more than a year and highlight the inherent dangers within panic selling.
3. Large Losses are the Exception: The S&P 500 has only seen five drops greater than 30% in 65 years, or roughly once every 13 years. Furthermore, more than two-thirds of corrections fail to develop into a 20% or more loss.

The net result of this analysis is that investors lose money when they assume that the market is crashing every time it falls. The reality is that crashes are very rare, and when they do occur they usually persist for a short period of time.
My point can be summarized using a single question to investors. If panic selling, not volatility, is the reason why investors lose money when the market dips, then how will a computer program prevent an investor from selling into panic?
The bottom line is that robo-advisors have their place in the investment community but for only a small subset of investors. Financial advisors offer far more than just financial advice, and their true value will never be replicated by software.