Robo-Investing Better for Robots than Humans

As Silicon Valley has waded into financial services recently, a wave of venture-backed “Robo-Advisor” firms has started to attract client assets.  Marketed as simple, easy-to-use and inexpensive, the robo-advisor model has two critical shortcomings, which will wreak havoc on their clients’ portfolios going forward.

To be clear, systematic investing, low-cost products that provide exposures to markets of interest and easy-to-use tools are all strong value propositions.  Many investors who can’t spend the time doing research or whose portfolios aren’t big enough to gain the interest of professional advisors are likely to benefit from these features offered by the robo-advisor space.  However, investors who entrust their long-term investments to such formats are likely to be blindsided by financial market volatility. 

Many of these services have beautiful graphics, depicting the “likely” long-term outcome of an investment made today (of course, “likely” is far different from “guaranteed”).  Many providers also educate clients by illustrating what long-term portfolios may be worth in the case of “below average” performance in markets, and they draw smooth curves which lead from today’s balance to the future’s sizeable nest egg.  Problem one is that there will never be a smooth path to that nest egg. 

We’ve witnessed two drawdowns in equities of greater than 50% in the last 15 years, and as these services cater to a more tech-savvy clientele (read: younger), the portfolios they construct are likely to have relatively higher allocations to equities than other investors might consider.  One group even refuses to offer any allocation to bonds, due to currently low yields - apparently the benefits of negative correlation weren’t coded into their algorithms.  These investors are going to face equity market volatility over their lifetimes, and when they do, the smooth curve that illustrates their hypothetical path to retirement will be proven to be demonstrably misleading.

Problem two, particularly for the clients of robo-advisors on the low-end of the cost spectrum, is that once market volatility has reduced their portfolio’s value significantly and swiftly, they have no one to speak with about it.  Online risk-tolerance questionnaires that are administered in the middle of a raging bull market are likely to elicit different responses than those given by a client who just watched Enron go from the seventh biggest company in the US to $0, or another client whose financials ETF got massacred when Congress’s first vote on TARP didn’t have the votes. 

This is a problem because fear and greed are going to overtake many clients who have no trusted advisor to speak with.  As that happens, terrible decisions will be made (buy the all-time highs, sell the 50% drawdown).  The greatest investors in the world have colleagues and advisors to bounce ideas off of and talk through news and scenarios impacting their book.  The idea that non-professional investors are going to do better in the long run because they are completely alone when markets get turbulent, but they saved 50bps in advisory fees, is unlikely to be true.

The good news is, when their new balances are locked in by unadvised, unadvisable actions like capitulating at the bottom of a market drawdown, the robo-advisors’ software will still be able to draw them a smooth curve to their future retirement.  The bad news is that the curve ends on the investor’s 211th birthday.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.