Here’s a look at the pros and cons of robo-advisors

Robo-advisors “promise” an easy route to investing.

You complete an online questionnaire set up to measure each person’s needs. Your response is designed to supply all the robo-advisor needs to know about you as an investor. For instance:

• Age
• Amount to be invested
• Time horizon of your investment
• Your risk profile.

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The robo-advisor then supplies a portfolio that fills those needs. The assertion is that each company’s proprietary algorithm claims to take the emotion out of investing and will grant the investor better returns at a lower cost than traditional financial advisors.

It is possible that this might work adequately in a few cases, say, for younger investors just getting started, usually with a relatively small amount to invest and an entry level knowledge of investing.

But for more mature investors who are shepherding their investments to meet their financial goals before and after retirement, serious doubts arise. First, you have little chance of getting a portfolio that is tailored precisely to you, in spite of the questionnaire. When you sit down with human beings to build a portfolio, the results are very different.

The mechanics behind automated investing

Robo-advisors typically aim to build what they see as well-diversified portfolios covering all the main asset categories. Each robo-advisor generally has five to 10 standard portfolios composed of ETFs that vary mainly by the amount of market risk that they carry, covering a spectrum from very conservative to very aggressive.

Each set portfolio usually includes asset categories that include investment-grade bonds, stocks (Canadian, U.S. and global) and sometimes also other asset categories such as real estate investment trusts, emerging markets equities and high-yield bonds.

Each portfolio is subsequently rebalanced automatically as needed whenever actual balances diverge significantly from their target allocations. But you are still getting a pre-packaged product. Essentially, you are getting an asset allocation model, or rather one of a series of asset allocation models.

Asset allocation stems from Modern Portfolio Theory, which grew out of a 1952 paper by a U.S. economist. He developed a mathematical model that emphasized the reduction of volatility by combining investments with different types of returns (i.e., stocks, bonds, cash).

The investment industry seized upon this and subsequent academic research on the subject. It quickly transformed it into a sales pitch for investment products carrying higher fees than so-called “plain vanilla” stocks and bonds.

Financial firms developed asset allocation funds–mutual funds that can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers are convinced the bond market is depressed and due for an upswing, they may invest heavily in fixed-income investments for a few months to take advantage of the change.

All of this is based on reading the markets, not serving the interests of individual investors. And since we know that the vast majority of fund managers fail to match market indexes, let alone beat them, this is not the best advertisement for future gains.

What’s more, you could just as easily acquire these investments on your own. Robo-advisors usually invest in index funds and ETFs. You could buy these investments and save the robo-advisor fee that is added on to the underlying fees for the fund or ETF.

Still, there are two arguments that could be made by the promoters of robo-advisors

1. The fees are lower than those you would typically pay for an asset allocation fund. This is true: they compare favourably to the low MERs you would pay for most ETFs.  The question, of course, is whether you will get the best possible results for the fee (keeping in mind you could buy the ETFs yourself).
2. Robo-advisors do not force you to stick to the original profile you entered. You can edit your goals using their financial planning software.

However, you can’t talk to anyone who makes investment decisions for you. You are dealing with an algorithm, and an algorithm will never ask you whether you are anxious, optimistic, or pessimistic, or whether you feel there’s a particular concern you’d like to get off your chest.

It will always make decisions based on the enormous bank of data it is processing, not your personal concerns.

Perhaps someday artificial intelligence will create a robo-advisor that can sympathize with your anxiety about housing prices tapering off in your neighbourhood or an unexpected expense that has just cropped up. Or share your joy when you get a big boost in your returns.

But there’s an even bigger point to be made here. The investments fed to you by a robo-advisor will always be an approximation of your personal needs and goals. It will always be a model that cannot match the hopes, fears and dreams of each individual investor.

For that, you must talk to a human being. A human being who can respond by making specific decisions that will improve your portfolio, month by month and year by year. Someone who understands not only what your goals are, but what those goals actually mean to you.

Have you used a robo-advisor? What was your experience like?