Broker Check

Robo-Advisers Can Be Costly

| May 03, 2016
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Recently, robo-advisers have been gaining market share against retail advisers, because they provide a cheap way to invest some money and are fairly easy to interface with.


For those who are unfamiliar with them, a robo-adviser is an investment and portfolio construction service that provides automated, algorithm-based portfolio management advice without the use of human financial planners. Robo-advisers only offer portfolio management and do not get involved in more personal aspects of wealth management, such as taxes, retirement, and estate planning.


Whom do they appeal to, and what are the pros and cons of using these online tools?

    •    Older Americans may not use robo-advisers — instead they are utilizing super-cheap ETF’s (Exchange-Traded Funds) and index funds, but without an actual adviser.

    •    Younger investors, especially Millennials, like them because they themselves are technologically savvy and they either don’t trust Wall Street, or they think that advisers are only selling what is good for their firm. Sometimes it’s difficult for less-experienced investors to understand exactly who is or is not acting in their best interest.

These investors also don’t necessarily know how to measure the value of an adviser or professional advice. They are not alone.

What they do know, and can quantify, is cost and expense. And, with the decline in market volatility since 2009, there has been a movement toward do-it-yourself investing. In fact, robo-advisers are similar to the day trading trend popular in the late 1990s.

I blame the industry for the most part for not educating the consumer better. Most people who call themselves financial advisers just sell investments or products. They provide only “incidental” advice, primarily about the investment or products they are touting.

What the traditional adviser or firm does not do is provide true financial planning advice. They do not provide retirement transition advice, like how to prepare mentally and physically for retirement. And, they are not helping clients figure out answers to these questions:

    •    What will retirement cost?

    •    Where will I live or transition to, and how?

    •    How should I do eldercare planning? Where are some resources?

    •    How should I behave during a bear market sell-off?

    •    Why shouldn’t I take on more risk in a bull market?

    •    How much volatility can I handle before I will do something harmful to my portfolio?

    •    What is the best way to save for college?

    •    How can I protect myself and my estate from sudden loss of income, property, illness, etc.?

Many traditional human advisers don’t give comprehensive advice. No wonder consumers don’t see the value in paying fees to financial advisers and are open to robo-advisers.

Before jumping on this high-tech bandwagon, keep the following in mind:

In the last six weeks, as volatility picked up to levels not seen since the summer of 2011 — but not even close to the levels of the 2007-2008 credit crisis — we have seen investors pull more than $61 billion out of equities or stocks since Dec. 16, 2015. To put that in perspective, in 2012 the net out-flows for the whole year were $132 billion, and in 2008, they were $149 billion. To put it another way, almost half of the amount taken out of equities or stocks in a whole year has already been taken out of the market — in just six weeks!

How much have knee-jerk reactions cost the investing public? A lot, suggests Dalbar, which is the financial community’s independent expert for evaluating, auditing, and rating business practices, customer performance, product quality, and service.

In its 2014 “20th Edition of QAIB Study of Investor Behavior,” Dalbar analysts indicate that the cost is 7.42 percent annually — and only if you look only at equity investments (11.11 percent, S&P 500 return, minus 3.69 percent equity, average investor return).

These are investors who invested 100 percent in stock funds. Dalbar attributes the significant underperformance to investors moving in and out of the market at the wrong times. An individual’s experience will vary, but I say that is a very expensive behavioral finance mistake.

Economic fundamentals haven’t changed that much in the last six weeks. Could those who sold be right to have gotten out of the market? Possibly, but unlikely. Markets do not move rationally in the short-term. Despite average intra-year declines of 14 percent since 1980, annual returns are positive 75 percent of the time.

Get What You Pay for

It is a very good idea to ask what it is you are paying for. If it is just investments that you are paying for, then going to a cheaper option may make sense.

If instead you are paying for financial planning, ongoing coaching, and advice, you are getting a detailed financial plan that is updated regularly. This in-depth financial plan should:

    •    Help you avoid selling investments at the wrong time.

    •    Keep you from taking too much risk and suffering declines from which you cannot recover.

    •    Ensure that sure you rebalance your portfolio regularly.

    •    Help you avoid choosing the wrong planning strategies, which saves you from losing thousands in lost benefits.

    •    Help you protect your assets from unnecessary taxes in retirement or at death.

    •    Help you choose an appropriate withdrawal rate in retirement that sustains your assets throughout.

In fact, clients find the relationship with their adviser added significant value, according to Vanguard, the largest purveyor of low-cost mutual funds. Entitled, Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha, the report concludes:

“For some investors, the value of working with an advisor is peace of mind. … For others, we found that working with an advisor can add ‘about 3 percent’ in net returns when following the Vanguard Advisor’s Alpha framework for wealth management, particularly for taxable investors. This 3 percent increase in potential net returns should not be viewed as an annual value-add, but is likely to be intermittent, as some of the most significant opportunities to add value occur during periods of market duress or euphoria when clients are tempted to abandon their well-thought-out investment plan.”

The bottom line: Be careful whom you hire to give you advice. Make sure that they can and do act in your best interest, preferably as a fiduciary, and make sure they do actual financial planning.

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