A robo-advisory may be better than a bad broker, but there are still downfalls

A robo-advisory involves automated, Internet-based advice and portfolio management services.

A robo-advisory may offer beginning investors a more efficient, lower-cost investment approach, compared to what’s now open to them. Unfortunately, robo-advisors are likely to focus on the less reliable of the two main investment approaches.

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Will robo-advisory services be valuable to individual investors seeking ETFs?

The bottom-up approach, also known as descriptive finance, focuses on building a diversified, balanced portfolio of high quality investments. This is part of our Successful Investor method (although there’s more to it than this simple description). This approach is generally the more consistent and more profitable of the two main ways to tackle the job, but only over long periods. That’s why experienced, successful investors tend to favour the bottom-up approach. However, bottom-up doesn’t lend itself to automation, which is at the heart of the robo-advisor concept. That’s because bottom-up investors tend to look at an extremely wide range of information and analysis.

Robo-advisors are better suited to following the top-down approach, also known as predictive finance. Top-down advisors mostly try to profit by predicting what will happen next in the market. They mostly do that by zeroing in on a handful of economic or market indicators. They try to tie these indicators together in an algorithm or formula that generates trading recommendations. These recommendations may work for a time, if only because successful predictions tend to occur in bunches. Unfortunately, a few failed predictions can quickly wipe out gains from a series of successful predictions.

That’s why, in any given year, the top-performing advisor may follow the top-down approach. Over longer periods, however, the top-performing advisor is generally from the bottom-up school.

Robo-advisory services will probably use a low-key version of the top-down approach. For example, they may apply fixed rules about portfolio-rebalancing. That’s when you sell stocks (or mutual funds, ETFs, derivatives or whatever) that have gone up, and buy more of alternatives that have dropped in price. However, this is essentially a prediction that a portfolio-rebalancing approach that worked in the past will work in the future. When the formula inevitably quits working, results will suffer.

The robo-advisor may lose business as a result. This may prompt the firm to tinker with the formula. This could improve results, or hurt them all the more. As long as changes to the formula are gradual and modest, damage will be slight. Investors will be better served this way than they would be with a full-service broker who makes speculative or high-fee recommendations.

Avoid robo-advisory services for ETFs—but don’t use this method instead

Some investors decide to buy an ETF with the help of technical analysis.

Technical analysis is a useful tool, but only if you recognize it as one of many tools. Before making any recommendations or transactions in client accounts, we always look at a chart. However, we don’t look at the chart for a prediction on what’s going to happen. We look to see if the pattern on the chart seems to support the view we’ve formed of the stock, based on its finances and other fundamental factors.

We find it encouraging if the two seem congruent, and they usually do. But sometimes one contradicts the other, and that’s when we know we have to dig deeper, and perhaps wait until the situation clarifies itself.

After all, there’s a large random element in all stock price changes, even ETFs, especially in the short term. When you focus on timing buy and sell decisions to improve your investment results, you are trying to come up with a system that can outguess a random factor. But a random factor is something you can’t outguess.

When investing in ETFs, simple is better

The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”

Our view: simple is better. If you want to invest in something like emerging-economy stocks, limit your stake to a point where you can accept the associated foreign exchange risk. If you buy an ETF, choose a “plain vanilla” unhedged version.

Or, to adapt yet another old investor saying, “If the foreign-exchange risk on your emerging-market investments keeps you awake at night, sell down to the sleeping point.”

Has a discount broker ever offered you robo-advice? Were you turned off, or just accept it as the next generation of machine learning and data delivery?