Should you really fear Robo-Advisors?
Reading financial news, you see many posts warning of robo-advisors, telling you how you really need a human advisor, how you can robo-proof your investment business, or how robo-advisors are merely a fad and will die off when everyone realizes how evil they are.
All these posts have it backwards. They are apologists for entrenched firms attempting to protect their turf when individuals need help.
Shift from pensions to 401(k) plans hurt individuals
Last century, many large employers provided pensions as a benefit. These were large portfolios that could hire good advisors and thus performed well. However, by the end of last century, retirement funds had shifted to 401(k) and similar plans, where individuals managed their own portfolios.
Institutional portfolios hire great managers so many are able to beat their various market indices. In contrast, individual investors historically achieve less than half the returns of their related indices.
Poor performance by individuals managing their own retirement funds is a key factor in the current crisis facing Boomers who are under-funded for retirement. (Note to Millennials: don’t just speak to your parents, do your own planning so this doesn’t happen to you!)
Why do individuals invest poorly?
Individual investors are seen as a contrary indicator:
- If they are buying, then the market is near its peak and it is time to sell; and
- If they are selling, the market has reached its bottom and it is time to buy.
Here is a case in point:
We saw the regret and pride response in action beginning in March 2000, the largest purchase of mutual funds in the history of the stock market. Fast forward to 2008, just before the “Great Recession” market downturn, and stock prices were falling, but investors refused to sell at a loss. As the market continued to fall, investors held off until they simply couldn’t take it any longer. Many sold their stock near the bottom and missed the following upswing that began March 2009. Forbes – Why average investors returns are so low.
To summarize, individual investors perform poorly due to these factors:
- Lack of access to good investment advice; and
- Investment psychology. For more on the psychological factors to which individuals fall prey, see Seven deadly sins of investing to avoid.
There is a third factor: High expenses in form of commissions and other fees.
Robo-advisors address all three factors.
- First, automating advice permits good advisors to offer services to small investors. Betterment with automated rebalancing and tax-loss harvesting is a good example.
- Second, automation lowers costs, so fees charged can be reduced. Combine that with use of ETFs and you have dramatically reduced expenses.
- Last, robo-advisors are immune to greed and fear so their performance will not suffer the way performance of individuals may. No robo-advisor would wait until the market hit bottom to sell, as in the case of 2008 summarized above.
Bring on the Robos!
What is my conclusion? Not only are robo-advisors here to stay, they may be just what individual investors need so they can retire well!