Why not use a robo-advisor?

Robot

So as I mentioned in my last post, my day job started offering a 401(k) recently. Finally!

It’s been very relieving, as it allows me to put more tax-advantaged money away for retirement, which, as you might imagine, is pretty important to me (and should be to you too, if I may be so bold). I mean, I could manage without it, but I’d rather put my 15% away in a 401(k) than in a standard taxable account. Wouldn’t you?

I was curious what provider the company had chosen, and was surprised to find that it was … a robo-advisor.

A robo-advisor, if you didn’t know, is a service that allocates a portfolio for you based on your specific desires and an algorithm. It’s Silicon Valley’s answer to the democratization of financial advice.

In other words, it’s basically the Uber of financial advisors.

Oops, you can probably see where I’m going with this. Blog post fail.

Advantages

So you’re like most people, and you have absolutely no idea what to invest in. Mutual funds? ETFs? Stocks? Bonds? Real estate? Gold? Bitcoin?

The robo-advisor asks you questions about your current situation, risk-tolerance, and future goals, and then inputs these characteristics into an algorithm, where it outputs a financial prescription, which is a mixture of a number of different products, all of which are designed to maximize return and minimize loss.

This sounds excellent. You take people who aren’t experts, and allow them to get the advice of an expert without having the shell out the high fees of working with an expert.

I mean, I can relate. At the moment, I don’t even use a human expert (although that’s likely to change soon, so stay tuned), and I think about this stuff a lot more than most people.

Unfortunately, the sales pitch of the robo-advisor isn’t compelling enough for me, and I’m not willing to wait around to test out the service and see how well it performs.

All you need to know about the concerns

Believe it or not, the most telling paragraph about robo-advisors that I’ve found so far comes from Investopedia.

Check this:

The investment strategies and portfolios robo-advisors offer are based on Modern Portfolio Theory and the Efficient Market Hypothesis. They use a process to determine exactly how to invest on your behalf. You sign up and take a short survey to provide answers to a few investment-related questions. The robot plugs your answers into an algorithm that determines the kind of portfolio and asset allocation that’s appropriate for your age, risk tolerance and time horizon.

You can read more about the Modern Portfolio Theory and the Efficient Market Hypothesis if you want, but you don’t need to. The former basically advocates for diversification for risk reduction (fine), and the latter states that current prices reflect all information, and that nothing is hidden.

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All prices accurately reflect what is going on in a company?

Were all ratings agencies accurate when they were rating subprime mortgage bonds back before the mortgage crisis?

The EMH is, as even Investopedia notes, “a cornerstone of modern financial theory“, though it is also “highly controversial and often disputed“.

So we’re trusting our portfolios to a controversial theory. Okay.

But even if you trust the theory, and there are reasons to do so, the next part should give you pause.

The robo-advisors ask you questions about your risk tolerance and goals, and derive a portfolio based on this.

I’ve argued before that people are no good at assessing their own risk tolerance, and in fact, the majority of us don’t have the luxury of being risk-averse.

If you tell the robo-people that you’re looking for a low-risk portfolio, that’s exactly what you’re going to get. And you’ll have entirely false confidence here, because the robo-advisor has granted a portfolio based on your desires, but that will not get you the results you will likely need.

A robo-advisor that takes cues from us might not be the smartest move.

Be wary

I’m not saying that robo-advisors have no place, or that they are all bad. My robo-advisor through my company’s 401(k) actually prescribed a situation very similar to what I would have picked on my own. I would have been pleased enough had I had to use their recommendations.

But I’m not paying for the robo-advisor. And for most people, especially if you’re just starting out, one or a few target-date funds or broad-based index funds will be all the diversification you need. You won’t need to pay a robo-advisor anything to do this.

Risk without return doesn’t exist. And diversification can happen without experts. Robo-advisors can help you, but it’s important to do your research and weigh the benefits against the risks.

But if you’re going to do all that, why not just do the investing yourself?

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