By, Barbara A. Friedberg, MBA
To create long term wealth and passive income, investing in financial investments is crucial. If you begin investing early enough, stock and bond market investments can grow into a nest egg that will provide financial freedom. What was once a harrowing task of choosing funds and creating your own portfolio or paying through the nose for a financial advisor, is much easier with the advent of robo-advisors.
Robo-advisors are a class of automated, computer driven investment platforms that make investing for your future easy and affordable. Not all the same, robo-advisor fees range from zero up to approximately .80% of assets managed. The management fees compare favorably with those of human investment advisors that usually charge 1.00% to 1.5% of AUM.
Robo-advisor investment styles also vary. This Betterment Review analyzes one of the oldest and largest robo-advisors, explains the fund choices and goal based approach for this legacy robo-advisory platform. For a management fee of .25% you getmany tools to help you plan for the future. One creative feature is access to texting with financial advisors.
Betterment and it’s robo-advisory brethren make up a class of low fee computer driven investment managers, so what could go wrong?
Now, don’t misunderstand, I am a proponent of robo-advisor investing. These new-ish platforms offer enough variety for most investors. But, they aren’t perfect. And if you’re considering using a digital money manager, first view a robo-advisor comparison chart and next be aware of the robo-advisor risks as well.
Risks of Robo-Advisors
1. Security Issues
Your sign up and money management takes place online. So, your personal information is stored in an online database. Although unlikely, it’s not impossible for your personal information to become compromised or hacked.
Even government systemshave been hacked. Although, a robo-advisor might not be any more susceptible to hacking than a securities brokerage firm or bank, hackers have broken into many types of systems.
2. Inability to Measure Risk Tolerance Accurately
Risk tolerance is simply how much of a drop in your investment value you can stand. If you will go crazy and are tempted to sell if your investment portfolio drops 10%, then you are a conservative investor. If you can withstand a large decline in your investments – approximately 40% or so, then you’re an aggressive investor.
Based on a few questions, the robo-advisor assigns you a risk tolerance level between conservative and aggressive. The aggressive portfolios have greater proportions of stock investments and the conservative ones lean towards bond investments. But, the robo-advisory questionnaire might not be elaborate enough to accurately determine your true risk tolerance. Also, some robo’s lean towards an aggressive allocation. This can set you up for more stress than you’re willing to handle, leading to the possibility that you will panic and pull out of the market during a decline – a bad decision.
3. Effectiveness of Robo – Advisors Are Not Yet Established
Robo-advisors are new and not yet established. Most have launched during the last five to ten years. During that time, except for the market decline at the beginning of 2018, these digital platforms haven’t weathered a bear market. During the market tumult at the beginning of 2018, there wasn’t too much upheaval among the robo-advisors. But, they’ve yet to experience a prolonged bear market.As such, their effectiveness in handling a long term market decline hasn’t been proven.There’s no empirical data to support robo-advisors’ efficiency during a recession.
4. The Lack of Human Interaction
The lack of human touch is a con for many robo-advisors, especially for people who want to talk a person who will understand their financial goals. Although, the hybrid model of robo-advisor combining automated and human advice is becoming more popular, most robo-advisors lack the human touch.
Without contact with a financial planner, there are no conversations about how to build your personal investment portfolio. Instead, clients must trust the robo-advisory algorithm. With a robo-advisor, you run the risk of having your financial questions unanswered and your portfolio mismatched with your personal goals, risk profile and time horizon.
5. Not Understanding What You’re Investing In
The ease of sending money to invest through an app on your phone could make investing too easy. That’s right, without understanding what type of funds you are investing in and the risks involved, those with no financial education could be unprepared to handle market volatility. Although, most robo-advisors offer a blog and educational resources, it is up to the investor to read and understand the material.
Many 30-year-olds are slotted into aggressive 90% stock – 10% bond portfolios due to their decades until retirement. Younger investors might be disheartened to find that five years after beginning to invest, the markets take a dive and the money slotted for their home downpayment is worth 15% less than they expected.
Robo-advisors are low-fee, cost-efficient investment managers with a lot going for them. But, they aren’t an investment panacea. Be aware of the risks of robo-advisors as well as their advantages.
Barbara A. Friedberg, MBA, Former portfolio manager, university investments instructor and Owner Robo-advisor Pros.com.