Trying Automated Investing? Understand the Pros and Cons First

By Sophia Lin | Feb. 10, 2018, 2:59 p.m. | General

Automated investing, also known as robo-advisors, has become one of the fastest growing sectors within fintech in the last few years. Robo-advisors allow small net worth individuals to take advantage of some of the benefits of a traditional financial advisor, minus the expensive commission and possible conflicts of interest. They use computer algorithms to manage portfolios, allocating and rebalancing investments without the need of human intervention.

As individuals become more accustomed to new technology, they are able to bypass the traditional method of financial advisory and take control of their investments using these services. Increased transparency and options allow investors to choose the exact type of investment strategy they would like to take on. Simply answer a few questions regarding your investment goals, risk appetite and time horizon, and the algorithm will recommend investment ideas for you. Today, I’ll be covering some of the pros and cons of automated investing to help you decide whether it is right for you.

The Pros:

Guidance:

Robo-advisors can give guidance to beginners who are interested in the stock market. Studies have shown that most individual investors underperform the market. Those who do not have the time to learn about investing (or do not want to) can take advantage of the modern portfolio theory and efficient market hypothesis used by automated investing. Not only will robo-advisors plan your portfolio, but they will also allocate assets, assess risks and offer tax-loss harvesting services. It gives beginners access to powerful tools traditionally only available to financial advisors.

Cost:

Low overhead cost allows companies to offer automated investing services at low prices. Average financial advisors have a minimum required investment of $50,000 and commission fees of around 1%. On the other hand, robo-advisors typically require around $1,000 to get started, with some companies like Betterment and Hedgeable offering services with no minimum balance. Commissions are much lower than the 1% typically charged by financial advisors. It should be noted that you would still be required to pay certain underlying management fees paid directly to mutual funds and ETFs.

Transparency:

The iconic 2015 blockbuster movie The Big Short starts out with a brief explanation of the way banks operated for the past few decades; bankers were salesmen working for commission. Market performance of their products and client interests didn’t matter. They were motivated to push and sell as many products as possible, simply to make more money. However, the increased distrust of banks after the 2009 financial crisis and the advancement of technology gave rise to robo-advisors and bucked the trend. Robo-advisors make recommendations based on market performance and the changing environment, oftentimes giving buy and hold recommendations. They have given investors the power to cut out the middleman, whose interest may not be aligned with that of the clients.

The Cons:

Simplicity:

One of the drawbacks of robo-advisors is their simplicity. Unlike the personal oversight and recommendations made by traditional financial advisors, robo-advisors categorize investors based on the questionnaires they answer. Some of these questions may be oversimplified and ambiguous, which may fail to take into consideration individual-based needs.

Robo-advisors don’t offer specialized services like estate and retirement planning. Services are limited to basic investment tools, and the advice is usually based on one simple investment goal. They do not account for different factors that may affect individual financial needs; contributions/withdrawals from the account, plans to buy a new house, and tax situations are not considered. In addition, algorithms are written with certain assumptions and lack the ability to anticipate changes in market conditions. Unexpected events such as the recent Brexit and rate hike by the Feds may negatively impact investment performances.

Loss of Human Interaction:

Another limitation of robo-advisors is the loss of human interaction that comes with a traditional financial advisor. Financial advisors can look at your various investment goals, assets, and the overall market environment to determine a personalized investment strategy for you. They can make specific recommendations and tweak your strategy as needed. Also, investors may call up their advisors for reassurance when markets turn sour and seek advice on how to proceed. This prevents jittery investors from panic selling and making bad investment decisions.

Returns:

A big trade off for the low price and ease of use is the low return rate. Robo-advisors mainly trade ETFs, a method of passive investing aimed at tracking and matching the overall market performance. Active investing has the advantage in that analysis are done on stocks that are often overlooked by ETFs, which may provide significantly more returns and outperform the market. However, it should be noted that many fund managers fail to outperform the market. According to the Wall Street Journal, “of the 20 best-performing actively managed U.S. stock funds for 10-year returns as of 2005, only seven were better than average over the next decade.” As active investors fail to generate alpha, more people are continuing to invest in passive stock funds. The real test lies in the way robo-advisors will perform in a long-term bear market. Active investors have the ability to adjust exposure and change strategies based on the market environment. A knowledgeable investor may find ways to make money that are overlooked by algorithms.

Summing it up:

Different robo-advisors offer different services, with some offering hybrid services that utilize both automated investing and traditional financial advisors. Nonetheless, it’s hard to determine a one-size-fits-all strategy when it comes to investing. Everybody has different investment goals and robo-advisors may be enough to fulfill simple ones for young professionals looking to start investing. The convenience of having direct control over your investment through the internet may be another appeal. For high net worth individuals who desire specialized, personal services at a higher premium, traditional financial advisors may be the better option.

I believe that an ideal method of investing is to take advantage of all the options that are available to you. Based on your risk appetite, invest a portion of your money into large-cap ETFs managed by robo-advisors to gain exposure to the overall market performance, while simultaneously investing in small to mid-cap active stock funds to gain some alpha.

 

 


Mark is Keel's Research Intern.

Mark developed an interest in investing when he placed top 10 in the school-sponsored stock trading challenge.

Following his service in the Air Force after his sophomore year, he worked as a Sales & Trading Intern at UBS before returning to school. He is a growth, contrarian investor, specializing in the consumer goods sector. He also writes writes as a contributor on Seeking Alpha. When markets are closed, he enjoys working out at the gym and watching the UFC with a cold IPA.

Mark is currently a junior economics major, minoring in business, at Cornell University.

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