The Problems with Robo-Investing

Investing using robo-advisors is a product of the digital age and emerging fintech industry. Fintech is the merging of financial services with technology to create large-scale financial solutions that can be utilized by anyone carrying a mobile device. It also incorporates complex algorithmic formulas to perform financial functions at a superhuman level, giving robo-advisors, which only exist online, the capacity to analyze a person’s financial objectives and risk tolerance to generate an investment strategy.

With that, a robo-advisor will recommend specific, low-cost investment vehicles such as exchange-traded funds and index funds. It can also help investors monitor and rebalance their investments to help them stay on track to meet their goals.

All this is done for a relatively small fee, typically around 0.50% or less of the assets under management. That compares very favorably to the 1.0% or more charged by fee-based advisors and much more favorably to the management fees charged by mutual funds, which can run as high as 3.0%. Robo-advisors can charge less because they rely on technology rather than pricey humans to guide their clients.

The Upside of Robo-Investing

Just as the health industry has utilized technology to expand health care to people who can’t afford good health insurance (think virtual medicine), the financial industry is harnessing technology to expand advisory services to people who can’t afford to or don’t want to pay financial advisors.

Generally, it’s a good thing if more people have access to affordable health care and, for people who want it, more affordable advisory services. The more people can receive sound financial advice, the better it is for society.

Robo-advice is a huge winner for people who can’t afford a financial advisor. It’s also a big winner for the younger generations, who generally don’t trust the financial industry. Many lost trust from watching their parents suffer through the financial crisis and its impact on their 401(k) plans or home values.

Others don’t see the value in paying a financial advisor for information they can get online. They’re used to finding what they need when they need it and getting it on demand. Traditional means of dispensing advice or managing money seem outdated and untrustworthy to tech-savvy millennials, who have little desire to interact face-to-face with a financial advisor.

Even if they wanted to work with a traditional financial advisor, many investors can’t have access due to the high barriers to entry. The best financial advisors tend to have very high minimums of $250,000 or more. However, for them, a robo-advisor may be just what they need to start a serious investment plan.

The Downside of Robo-Investing

While robo-investing has gained popularity and offers certain advantages, this approach has potential challenges and drawbacks. Here are some problems that investors and financial advisors may encounter with robo-investing:

Lack of Human Interaction: While people with fewer assets may be okay not interacting with a human, people with substantial assets have more complex circumstances and needs that require a more nuanced approach only a well-qualified, competent human advisor can provide. Plus, studies show that most people want to be able to interact with a human advisor in discussing the more critical aspects of their financial lives.

Limited Customization: Robo-advisors often follow standardized models or algorithms for asset allocation, which may not fully account for an individual’s unique circumstances, risk tolerance, or investment preferences. Investors with specific goals or complex financial situations may find that their needs are not adequately addressed through a one-size-fits-all approach.

Inability to Navigate Complex Financial Situations: Robo-advisors generally excel at managing straightforward investment portfolios with a long-term perspective. But they tend to struggle in addressing complex financial planning needs, such as tax optimization, estate planning, or retirement income strategies. These situations often require a human financial advisor’s expertise and personalized advice.

Limited Emotional Guidance: During periods of market volatility or significant life events, investors may experience heightened emotions and be tempted to make impulsive decisions. Robo-advisors lack the ability to provide emotional guidance and behavioral coaching, which can be valuable in helping investors stay disciplined and avoid irrational investment decisions.

Overreliance on Historical Data: Robo-advisors typically base their investment strategies on historical performance data and algorithms. However, historical data may not accurately predict future market conditions or account for unforeseen events. This can pose challenges during periods of economic uncertainty or rapidly changing market dynamics.

It’s important to note that these problems may not apply universally, and some investors may find robo-advisors to be a suitable solution for their investment needs. However, it’s essential to consider the limitations and potential drawbacks before relying solely on a robo-advisory platform, particularly if you have complex financial goals or prefer a more personalized approach to your financial planning.