Are Robo-Advisors Really As Effective As Human Advisors?
A robo-advisor is a form of investment management which relies on algorithms to automate portfolio management and avoids all human interaction in the portfolio construction and rebalancing process. This automated process has given rise to a more affordable investment management option for the masses. But are robo-advisors really as effective as human advisors? What are the shortfalls of robo-advisors that investors need to know?
Investing Through Human Advisors
When you choose to invest through a human advisor, you would meet with the investment advisor/portfolio manager at his or her office (or in these days, video calls are also an option). He or she will ask questions to help them understand your financial situation including your financial objectives, risk tolerance and time horizon, develop an investment strategy, and use that strategy to decide how to allocate your portfolio among investments, while continuously monitoring the portfolio’s overall performance to reach your financial objectives and goals.
Investing Through Robo-Advisors
When you choose to invest with a robo-advisor, on the other hand, you would access an automated investment platform where you will be prompted to answer standard questions, typically starting with your goals and tolerance for risk. The computer or robo-advisor will then pair your responses with a model portfolio that matches your needs and preferences, and computer-based algorithms will rebalance your portfolio to reallocate funds across investments as prices of portfolio holdings change based on a rules-based methodology.
How Robo-Advisors Construct And Rebalance Portfolios
The lack of human intervention means that robo-advisors are much cheaper than human advisors and, as proponents of robo-advisors emphasize, may reduce human bias and error. Depending on which side of the fence you are on, removing human intervention can also be negative. Let’s take a look at how robo-advisors construct and balance portfolios to see why.
To explain a robo-advisor’s computer algorithm in an easily digestible manner, an algorithm is a fancy word for the process a computer takes to solve a problem, in this case, the steps it takes to construct your investment portfolio after integrating your responses from predefined questions.
Most robo-advisors employ what is called modern portfolio theory (MPT) to design portfolios. MPT argues that you can design an ideal portfolio that will provide you maximum returns by taking on the optimal amount of risk.
Robo-advisors offer several “model” portfolios according to MPT and a particular model portfolio is suggested for you based on the answers you have input into its platform. Your holdings are rebalanced regularly to align with the model portfolio.
However, this one-size fits-all MPT approach of constructing model portfolios comes with shortfalls.
Shortfalls of Robo-Advisors Investors Need To Understand
1. While risk is an important consideration for portfolio construction, risk is not well understood by the everyday investor. Moreover, with robo-advisors, unique personal circumstances are not taken into account in determining your risk tolerance. If you are dealing with complex issues such as an inheritance, retirement-income planning, tax strategies, legacy planning, or have other financial needs such as cash-flow planning in addition to portfolio management, then a robo-advisor may not be right for you.
2. The robo-advisor is going to interpret the answers you have input as the truth and nothing but the truth. But the whole truth is that your tolerance for risk is rarely a static measurement, let alone quantifiable on a set scale of let’s say, “1-6” or “low to high”.
Has your risk tolerance changed pre-Covid-19 and post-Covid-19? A robo-advisor is going to say, okay, the answers you have input are the correct answers, whereas human investment managers might delve deeper into your answers with more specific questions to your responses to get a more detailed picture of your risk tolerance and other aspects of your financial situations.
3. Lastly, most robo-advisors assign a risk rating based on predefined answers that range on a qualitative set scale. For instance, the difference between “aggressive” and “very aggressive” is quite subtle and subjective, and without human interaction, it is difficult for a robo-advisor to truly understand the investor.
The Bottom Line
Robo-advisors have risen to prominence, aiming to democratize financial advice and bring investment management services to the broader population, including more active involvement from younger investors. However, they have limitations and may not be for everyone, especially investors with more complex financial situations and those looking for more guidance.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.