Robo-advisors are reshaping the way investors approach their portfolios, and they’ve gained traction as a low-cost alternative to traditional wealth management. While relying on a computer algorithm to guide investment choices can eliminate the potential for human error, investors shouldn’t assume robo-advisors are foolproof. In fact, there are certain situations in which relying on automated investing advice can backfire.
You’re Being Pushed Outside Your Comfort Zone
While individual robo-advisors differ in their approach, investors who use them typically have multiple asset allocations to choose from, which vary in their degree of risk. When you create an account, the robo-advisor uses the information you provide about your finances, age and long-term goals to select the most appropriate portfolio. Investors who prefer a passive approach may find the prospect of letting a computer make investment decisions appealing, but it can also be problematic.
Let’s say, for example, the robo-advisor selects a portfolio that’s concentrated heavily in emerging market funds. While there’s the possibility of earning higher returns, you’re exposing yourself to an increased level of volatility. If the risk isn’t being balanced out with safer investments, such as bonds, you stand to lose big if the market tanks.
With a traditional investment advisor, it’s easier to communicate what you are and aren’t comfortable with in terms of risk. The lack of a human element is one area where robo-advisors have the potential to fall short. The lesson here? Don’t be afraid to trust your gut if your robo-advisor’s recommendations require you to stretch yourself beyond the boundaries of your risk tolerance.
Your Advisor Is Playing It Too Safe
Taking too much of a gamble with your investments can lead to big losses if your robo-advisor gets it wrong. By the same token, you should also reconsider your robo-advisor’s advice when it seems to be encouraging you to err too much on the side of caution.
Because robo-advisors use a computer program to create a broad investment strategy, there’s often a tendency for them to behave rather like a target date fund. That means your portfolio is automatically rebalanced periodically to ensure that your risk level decreases appropriately as you age and you don’t have the ability to pick and choose individual investments.
While rebalancing is necessary to make sure you have the right allocation, you don’t want to sell off profitable assets before it’s time. If your robo-advisor is suggesting that you cash out of a particular stock or mutual fund based on a preset timeframe for retirement, you could be shortchanging your profits in the long run. Don't be reluctant to veto that move.
An Investment’s Returns Don’t Justify the Fees
In general, robo-advisors cost investors less than working with a brokerage or an individual investment advisor. Instead of paying 1% to 3% a year in management fees, robo-advisory services are usually a fraction of the cost. That doesn’t mean, however, that the investments in your portfolio will be low-cost or that your assets will generate substantially higher returns.
The fees that robo-advisors advertise only cover the cost of managing your account. They don’t include the expense ratio or other management fees for the underlying investments themselves. While robo-advisors often veer towards low-cost, tax-efficient investments such as exchange-traded funds (ETFs), there are some that incorporate actively managed funds into investor portfolios.
Actively managed funds are often sold to investors based on the premise that they can beat the market, but there’s a catch: They come with higher fees. In terms of performance, a 2015 Morningstar study found that actively managed funds lagged nearly every passive asset class between 2004 and 2014. Overall, the study found that the higher the fees, the worse the fund performed.
If your robo-advisor is recommending an asset allocation that includes actively managed funds or other pricey securities, look carefully at the investment’s historical track record to determine whether the increased cost is likely to yield more value for your portfolio.
The Bottom Line
Robo-advisors can be a great choice for investors who want a hands-off approach and are comfortable forgoing the benefits that a human advisor can offer. While they can streamline the way you invest, it’s important to remember that they’re not infallible. If you get the sense that your investment strategy is being steered off-course, it may be time to reconsider the moves your robo-advisor is making.