Robo-Advisors may be just what we need!

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:

  1. Lack of access to good investment advice; and
  2. 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!

5 Things Every Young Person Should Know About Retirement – You’ve got time, so use that time well!

If you are young, you’ve got time, and if you use that time well, you may even make up for the possibility of no pension and no Social Security benefits.

1. You won’t have what your parents had – no pension and no social security. Millennials are the first post-war generation to face retirement with virtually no pension. Fewer than 7% of Fortune 500 companies offer pension plans to new hires. Also, the way that the Social Security system is currently funded, there will be no reserves by 2033. Social security benefits are paid to retirees from the tax withholdings of the current workforce and also from the Social Security Reserves. Once the reserves are depleted, it is estimated the tax revenues the collected at that time will only be enough to pay out three quarters of the scheduled benefits. There are measures Congress could take to head off this eventual depletion, like changing the benefit formulas, raising payroll taxes or increasing the cap on taxable wage income. Until any changes are actually implemented, don’t count on any benefits!

2. Learn how to save and spend – now! It’s never too late to adopt good spending and saving habits, and the sooner you do it, the better. The more you can set aside that is invested now, the better off you will be. Also, avoid accruing any high interest rate debts. You can make your coffee at home if that is what allows you to max-out contributions to your 401(k) plan, especially if your employer matches what you contribute. If you do not have employer-sponsored plan, open a Roth IRA or even a traditional IRA. It’s a lot easier to put money aside now than it is to play catch-up in your 40s. And you can set up auto-debits so the investments are made as soon as your paycheck hits your bank account – keeping it out of your shopping slush fund!

3. We’re living longer, healthier lives. Longer, healthier lives are good, but they also require more investments at retirement. If you hit the Social Security full retirement of 67 now, the Center for Disease Control estimates you will live to around 86. That’s 19 years of retirement that you need to fund. But, if you are younger, living a longer, healthier life, then you will likely live longer, requiring more funds, unless you choose to work later in your life.

4. The good news is you have time. The Center for Retirement Research at Boston College suggests that, by setting aside money at age 25, you will need to save only about 10% of your annual income to retire at 65. If you wait to save, the percentage you need each year increases. If you wait ten years, starting at age 35, your target savings increases to 15%. Wait until you’re 45 and you’ll need to save 27% of your annual income. Imagine if you were 55 today and wanted to retire at age 67? The message is: don’t wait!

5. You also have great resources. With smartphone apps and do-it-yourself trading services, investing is more accessible and less costly than ever. Also, there are more affordable investment products available like ETFs (see our post), so you avoid high fund manager fees. Saving on fees means more to grow for your retirement. Over the course of 40 years, those fund manager fees add up to real money.

In sum, start saving now. Set up a simple portfolio and adjust it as you go along. The time you’ve got now will reward you later!