Rise Of The Machines

The rise of the robo advisor in recent years, and particularly the increase in visibility of these new automated offerings in the past few months, has created quite a stir among financial advisors. We’ve even heard news recently that our own broker/dealer, LPL Financial, which boasts the largest fleet of independent financial advisors in the US, will be rolling out a robo advisor in an effort to ‘keep up with the joneses’. All of this attention has sparked a robust debate in the industry about the long-term effectiveness of the robo advisor versus the traditional financial advisor. While we believe that the two don’t necessarily need to live at odds with one another, that’s the narrative which has emerged, due both to the way the robo-advisors have been marketed, and the resulting over-reaction of the traditional advisor community.

The argument for the supporters of the robo model goes essentially like this: Why pay 1% to an advisor to build an asset allocation and invest in a basket of mutual funds or ETFS, when a sophisticated computer program (the robo model is based on science and the underlyingtechnology, and is predicated on modern portfolio theory, i.e., efficient markets and the rational investor) can do the same thing for next to nothing? The question is a good one, and the argument is essentially accurate in its basic premise, provided that two things are true-first, that an accurate gauge of an investor’s risk tolerance can be ascertained through the technology, and second, that an investor will act rationally throughout all market cycles.

Selective Amnesia

The timing of the aggressive rollout of the robo advisor in the past few years has been ideal. The unprecedented run-up of the markets since the bottom of the last recession in March 2009, has caused a bout of selective amnesia among investors, and helped to create a perfect environment for these new technology-based investment options. Those of us who have been through multiple recessions in the past, however, understand the psychology of the other side, especially the difficulty clients have fending off the ceaseless negativity that surrounds them in a prolonged downturn. The idea that clients with automated investment solutions will be able to just tune out the noise and stick to the program in such times seems optimistic at best. We remember what it was like in March 2009, trying to calm clients down and get them to stick to their plan.

Even modest corrections cause some clients to over-react, as we have been seeing recently. As September statements came out, many portfolios showed declines of anywhere from 2% to 5%, prompting quite a few nervous emails and phone calls to our office. This, despite our constant reminders over the past few years, i.e. that corrections and recessions are a natural, even necessary part of market cycles, and will be coming at some point. In a recent blog post http://td-wm.com/blog/even-mr-spock-could-use-financial-plan, we discussed the fallacy of the ‘rational investor’, the point being that, behavioral finance is real, and when the chaos of the next market downturn reaches a fever pitch, many robo advisor clients will undoubtedly find themselves longing for some experienced guidance. We mean guidance of the sort that might keep them from making an emotional decision which could well end upbeing calamitous to their investment portfolio.

Risk Tolerance

One thing we’ve noticed over the past few years is that when the market goes essentially straight up for multiple years in a row, every new client that walks in the door characterizes his or her tolerance for market risk as Moderate/Aggressive to Aggressive. Similarly, in the immediate aftermath of the so called ‘lost decade’ and the two major recessions within it, most new clients were coming in Moderate/Conservative to Moderate. The reality is that a client’s true appetite for risk is most often a moving target, and is very hard to gauge from a 10-question form, or even an hour-long conversation. To effectively ascertain a client’s risk tolerance takes time. In our experience, actually seeing how a person reacts to different market conditions, is the only way to get a true sense of his or her ability to stomach risk. If we assume, therefore, that many of the risk tolerance profiles associated with clients using automated allocation software are not entirely accurate, our sense would be that this greatly increases the likelihood of negative emotional responses in times of extreme volatility. A kind of snowball effect, where the combination of inaccurate risk profiles and the lack of experienced, human guidance, could potentially result in a wave of adverse outcomes for individual investors.

Can’t We All Just Get Along?

In sum, what’s being lost in the narrative about the robo advisor is that a good financial advisor should provide much more than portfolio performance. In fact, it would be fair to say that in our practice, we consider the performance of the investment portfolios to be a secondary concern. We believe that if we are providing all of the myriad functions a good advisor should, the investments, given time, will do what they are supposed to do, and provide a vehicle to attain the important financial goals set out by the client. Advisors themselves bear some of the responsibility for the investment performance narrative, as it is we ourselves who need to more clearly articulate what we do, so that clients can fully understand what they are trading in for their apparent 1% savings.

The truth is that the technology and algorithms that have been developed and allow the robo advisors to offer what they do is impressive. For behavioral finance and investing geeks like us, the idea of fully automated technology that can help take the emotion and prognostication out of the investment process is very attractive. In fact, it is our belief that at the end of the day, the robo technology will likely end up being leveraged more as a tool for advisors, than as a stand-alone alternative to them.

Perhaps then, it really isn’t robo-advisor versus financial advisor, but rather, robo-advisor and financial advisor.

 

 

This article was originally published on NerdWallet.com