Robo-advisors have grown in popularity, but are they right for everyone?

By Daniel Stewart

Introduced in 2008 and using automated algorithms devised by financial professionals, robo-advisors provide financial planning without human intervention. These automated financial advisors advise clients using data collected via online surveys. They then design investment plans based on the data for clients, often using passive index investing strategies.

Since they offer a significantly lower cost, along with automated investing, some financial experts credit robo-advisors with democratizing financial services, allowing more people to enter the market. The algorithms used by robo-advisors create portfolios built with a client’s goals, needs, and risk tolerance in mind. In the past, only the uber-wealthy had easy access to wealth management services. With a robo-advisor, you can now get professional money advice without the need to have millions in investable assets. Many robo-advisors have minimums of $10,000 or less, which is especially appealing to younger investors.

Since the first widely-available services launched in 2010, robo-advice has taken off. Robo-advisors now manage nearly 2 trillion dollars in assets. However, if you’re considering going with a robo-advisor, you should pay careful attention to potential pitfalls.

Can a robo-advisor be a trustworthy fiduciary advisor?

A financial fiduciary has a legal duty to act in the best interest of their clients, putting client needs above their own. When operating in a fiduciary capacity, an advisor must only recommend products and investments that fit their client’s goals and requirements, not those that pay them the most commission or other perks. Having a fiduciary advisor can help you establish a greater bond of trust with the person handling your finances.

A fiduciary is highly desirable for both pre-retirees and retirees. But can a robo-advisor, which is nothing more than a computer algorithm, indeed be a fiduciary? The Securities and Exchange Commission (SEC) says that robo-advisors are fiduciaries and must adhere to those standards. However, whether a robot can be a fiduciary is far from settled, as the law must grapple with adapting legal frameworks designed for traditional businesses to technology-based investing models.

Some regulators express doubts that algorithmic investment advice may be able to meet the current standards for financial advice under the Investment Advisers Act of 1940, the primary legislation governing financial advisors in the United States.

The Act set forth two primary standards for financial advice:

The lower standard of “suitability.” Suitability means brokers and agents may sell you a financial product that is not in your best interest but is suitable. For instance, an agent or advisor could sell you an annuity suitable for your age, income, and goals, but that is also more expensive than similar products.
The second higher standard is “fiduciary advice.” This means that your advisor might still sell you an annuity. Still, they must consider the product’s suitability and whether that annuity meets your best interests.

In addition to the lack of regulatory clarity you find with robo-advisers, you should also look at other potential downsides, such as:

Mass appeal means limited flexibility and personalization. Robo-advisors are “one-algorithm-fits-many,” which limits their flexibility. Robo-advisors base investing decisions on profiles of people similar to you and not on you personally. Your unique attitudes toward money and risk may not factor into the algorithm.
Limited investment choices. Like many work-sponsored plans such as 401ks, Robo-advisors have mostly limited investment options in broad categories, such as “income” or “aggressive growth.” Your robo-advisor may recommend one of these based on the profile you filled out, which you can reject or change for another. What’s harder to do, however, is customize your plan.
There’s no one to talk you down from the ledge. For some people, the fact that robo-advisors don’t have emotions is a plus. After all, the majority of human beings are relatively bad at making money decisions. Let the robot do it and relax. Robo- advisors can be your calm, level-headed companion, making sound decisions without succumbing to emotions. Unfortunately, sentient beings often require a more human touch. When the market dips, your robo-advisor won’t be there to talk you out of panic selling or closing down your account. When you second-guess a purchase and lie awake at night, your robo-advisor can’t reassure you. On the other hand, your human planner understands what you are feeling and considers managing your emotions to be a valuable part of their job. Human intervention sometimes means the difference between success in planning and making terrible money decisions from which you won’t have time to recover.
Robo-advisor customer service may be inconsistent or non-existent. Robot advisories are less expensive than traditional advisories because they don’t need to pay an entire staff of humans to run the company. Often, if you need customer service, you’ll find yourself talking to a low-paid rep operating in a foreign country or even a “chat-bot.” That interaction probably won’t inspire confidence and won’t be anything like talking to an experienced, empathetic human advisor. When you have a robo-advisor, you have moved into a virtual world where humans are as scarce as honest politicians.
Robo-advisors are probably not suitable for technophobes. If you want to try robo-investing, you should be reasonably comfortable with technology. If you are a bit skittish about artificial intelligence managing your money, you may want to stick to a traditional advisor.

Summing it up:

While robo-advisors may be reliable alternatives for some investors, particularly novices, they are not for everyone. A robo-advisor’s fiduciary status remains somewhat unclear, meaning that your robot may not need to put your interests first. Before choosing to use a robo-advisor, it’s prudent to discover how these algorithms work. It’s possible to factor in risk with a robo-advisor, but the results may not align precisely with your feelings about risk.

Robo-advisors can lower the barrier to stock market investing by allowing the less wealthy to gain access to financial expertise. However, this easy access has several limitations, including reduced flexibility, limited human contact, and less diversity due to fewer investment choices. Suppose you prefer greater control over your investments, or you reject cookie-cutter approaches to wealth management. In that case, you may want to stick with a traditional human advisor. Before deciding, do your due diligence and look at all the pros and cons.

This article and all content on this site are for informational and entertainment purposes only. You should not consider any of this information or other material to be legal, tax, investment, financial, or other advice. Nothing contained in this article or on the site should be construed as a solicitation, recommendation, endorsement, or offer by the author, Safe Money Trends, or any third-party provider to buy or sell any financial instruments.