Can You Trust Robo-Advisors to Create a Solid Diversification Strategy?

Among the trending digital transformation concepts, robo-advisors have emerged as one of the strongest phenomena. By providing easy access and execution to investors, and a low-cost way of combining passive and active portfolio management, robo-advisors are transforming the asset management industry. As per Statista, the assets under management (AUM) in the robo-advisor sphere are likely to increase to $937,109 million in 2021. However, despite such strong growth, robo-advisors are yet to become the one-all solution for investors, especially when it comes to portfolio diversification.

Typically, a robo-advisor only collects general information from investors via an online survey and deploys the data to generate automated, algorithm-driven financial planning services. There is little or no human interaction involved. Even though robo-advisors work on an algorithm that creates a diversified portfolio and offers timely rebalancing of securities, the diversification is still not absolute. Moreover, due to the sheer lack of human involvement, the portfolio is more standard rather than optimized and ideal. Further, the reliance on conventional parameters and investment theories makes the robo-advisor-generated portfolios more prone to risk during uncertain events like the COVID-19 pandemic.

That said, robo-advisors will likely gain a strong place in the investment management industry in the coming years. But the algorithms are still naïve and need to be improved upon for solid diversification. Moreover, when opted for in a solo capacity, these robo-advisors are less likely to equal or surpass your investment portfolio expectations.

Here is what you need to know about robo-advisors and if you can trust them to create a solid diversification strategy:

What is a Robo-Advisor? How do they work?

Robo-advisors use advanced computer algorithms to create an investment strategy that optimally aligns with your financial objectives and risk appetite. These digital platforms offer automated investment advice with little or no human interaction. Typically, when you sign up for a robo-advisory service, the platform requires you to fill a basic online questionnaire regarding your investment goals, life stage, risk preference, and more. Once you provide the information to the robo-advisor, the platform runs the standard computer algorithm to create an optimum asset allocation and build a portfolio that adequately meets your specific financial goals.

After the portfolio is set, the robo-advisor monitors the investments at a predefined frequency and automatically rebalances the portfolio to align it with your targets and specified risk tolerance.

That said, robo-advisors deploy a standard formula to automate the investment management process. The objective of robo-advisors is to offer adequate investment advice at a low cost. However, adequate advice might not be ideal for you always and may not work in your best interest.

What services do robo-advisors offer?

At most, robo-advisors can do the following for you:

• Create an investment portfolio according to your pre-defined requirements.
• Assess and regularly rebalance your investment portfolio, automatically or at a specific frequency.
• Offer financial planning tools like retirement calculators.
• Use tax-loss harvesting or other comparable tactics on taxable accounts.

Even though robo-advisors offer these services, they are not equipped to provide comprehensive financial services like estate planning, inheritance handling, etc. Moreover, complex strategies like tax-loss harvesting may only be offered by a few robo-advisors, who might charge more than a human financial advisor.

How do robo-advisors create, diversify, and rebalance portfolios?

As mentioned above, robo-advisors gather your investment preferences, risk tolerance, and other related information through an online questionnaire. This data is run through an algorithm to create an investment portfolio that optimally aligns with your specified requirements. These advisors then monitor and rebalance your asset allocation as per your defined criteria and risk appetite. For instance, if you wish to create a portfolio to save for retirement, the robo-advisor will likely recommend investing in an IRA (Individual Retirement Account) that holds a portfolio of ETFs (Exchange-Traded Funds) for long-term growth. The robo-advisor will not place your funds in a taxable account, even if it offers higher benefits. This is because, during retirement, the aim is to preserve capital rather than garner high returns. But, if in case your financial objective is to save for a down payment for a house, the robo-advisor might recommend a taxable account with a balanced ETF portfolio for short-term growth.

It is important to note that, in the case of a robo-advisor, you do not choose your securities and ETFs that form your portfolio. Instead, the robo-advisor pre-selects low-cost index fund ETFs and other investments like mutual funds for you. Generally, ETFs chosen by robo-advisors include investments in U.S. stocks, foreign stocks, bonds, and real estate investment trusts (REITs). Robo-advisors frequently use the Modern Portfolio Theory (MPT) or a similar principle to form a passive, indexed portfolio.

Further, they assign a specific weight and a tolerance range to each asset or individual security in a portfolio and continue to monitor and rebalance your portfolio to ensure that the asset weightage is as per your preferences.

Can you trust robo-advisors to create a solid diversified portfolio?

Robo-Advisors have a primary advantage because they help create an optimally diversified portfolio at a low cost. However, as mentioned, these advisors only create an ‘optimally diversified portfolio’ and not one that is ideal as per your specific financial needs, objectives, life stage, and risk tolerance. An optimally diversified portfolio is likely to offer only moderately good returns and not maximize your returns.

Moreover, robo-advisors rely on the MPT theory or a similar principle to create an investment portfolio. And even though the MPT theory has been widely used as an investment foundation, it has been severely criticized by financial experts and professionals. The theory caters to risk-averse investors, enabling them to build a portfolio that aims to generate returns while reducing risk or maintaining a specific level of risk. Generally, portfolios based on the MPT reduce risk to attain a specific level of return.

Further, the MPT mitigates risk by diversifying into uncorrelated asset classes. However, unless the correlation between these classes is predictable or known, the mitigation of risk is lost. As an investor, you expect returns as per the level of risk you are undertaking in a particular market. But market situations like the one induced by COVID-19 have established that the correlation of asset classes varies unpredictably and without any warning. This makes the very basis of MPT questionable and also clearly highlights the flaws in the theory.

Another critical drawback in the theory is that MPT assumes that an investor is always rational and risk-averse. When a robo-advisor uses the MPT theory to create a portfolio, the advisor is assuming your risk appetite is low. Hence, the securities they choose are low-risk, which ultimately generates low returns. This is highly disadvantageous in situations where your goal is not to minimize risk but to maximize revenue. For instance, you wish to buy a home in the future and want to invest to afford it. You go ahead with robo-advisor services and the platform runs a standard algorithm to structure a portfolio with the right options as per your need. But the advisor assumes that you are a low-risk investor, and hence your asset allocation is focused on secured returns rather than rewarding returns. In this case, you stand to lose out on lucrative market opportunities while only earning mediocre but safe returns. Eventually, in the long run, your savings can be insufficient to pay for the house of your dreams.

In all, the advantages of a robo-advisor only benefit a limited number of investors with a defined goal. Whereas, in reality, the market reacts differently. To tap the market well, it is advisable to opt for a professional financial advisor who understands your concerns thoroughly and creates a diversified yet profitable portfolio matching your requirements.

What are the pros of using a Robo-Advisor?

Key benefits of using robo-advisors include:

• Low fees: Robo-advisors are efficient and offer low-cost investment management services to investors. In comparison to a professional financial advisor, robo-advisors are more suitable for a cost-conscious investor.
• Proven investment models:Robo-Advisors use algorithms based on the modern portfolio theory (MPT). MPT is a commonly used theory that predominantly caters to risk-averse investors. The theory enables risk-averse investors to build portfolios that aim to maximize portfolio earnings at a defined level of risk.
• Market expansion for financial advice: Owing to their cost-effectiveness, robo-advisorsare more affordable and accessible for first-time or young investors. Robo-Advisors charge a low fee for offering professional financial management services. This allows more investors to get expert advice, allowing them to attain better returns as compared to a DIY model.
• Low minimum balance obligation:Robo-Advisors allow investors with low investments worth between $1,000 and $5,000 to get professional financial services. Most robo-advisors offer zero account balance functionality. Many other robo-advisors also offer services with no minimum balance requirement.
• 24/7 availability and efficiency:Robo-Advisors are available 24/7, provided you have a good internet connection. This allows you to get access to investment expertise anytime and tap lucrative opportunities well in time. That said, robo-advisors are also highly efficient. If you wish to execute a trade or transaction, all you need to do is instruct the robo-advisor and you will get access within a few clicks.

What are the cons of using a Robo-Advisor?

Some disadvantages of using robo-advisors include:

• Their services are not 100% personalized: robo-advisors are not 100% personalized.They operate on a fixed algorithm, which is beneficial for an investor who has ordinary investment requirements. However, not all investors are the same. Your needs are different, your goals are not alike, your long-term and short-term vision can alter consistently, and many other factors can affect your investment decisions. Moreover, even though robo-advisors allow you to list your preferences and edit your requirements time and again, the process is not as efficient or holistic. There are many important aspects where the need for professional human advisory services is unparalleled. Further, during extreme market situations like the drop induced by COVID-19, robo-advisors fail to provide the much-needed comfort or insight, unlike a human financial advisor. Your financial advisor can guide you, ease your fears, give you confidence, and deploy pragmatic strategies to ensure your portfolio remains strong even during such critical times. Human advisors work with you more closely and comprehensively than a robo-advisor. Moreover, in complicated matters like estate planning, inheritance planning, succession planning, tax management, etc., a human advisor proves more useful than a robo-advisor because the latter lacks the expertise in such matters. Even experts believe that robo-advisors use algorithms that cannot always answer all your investment concerns accurately. Hence, engaging with a human advisor might prove beneficial in most cases.
• Their expenses are competitive with many human financial advisors: A major reasonfuelling the growth of robo-advisors is their low fees. However, many human advisors also charge as low as robo-advisors. Even if they charge slightly more, they offer a much broader array of services than robo-advisors. Some human advisors charge as low as 1% of the assets under management (AUM) for their services. In most cases, these charges are equivalent to an average robo-advisor fee. Further, human advisors use different methods to charge for their services. There are also pay models where you can pay on an hourly basis or pay for a specific service. In this manner, you can consciously cut down your advisory costs. This allows you to choose to pay consciously only for the service you want.
• They involve no personal contact or human interaction:Robo-Advisors are driven by computer programs and algorithms. There is no personal contact or any human interaction. This does not work well for all situations, especially during highly volatile market situations or times where you are undergoing a personal change in your life, such as marriage, divorce, etc.

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To conclude

In all, robo-advisors work best for you if you want easy, automated, and low-cost advice. However, when compared with human financial advisors, these advantages fall short. Apart from offering skilled financial advice, human advisors also actively manage your emotions and portfolio and adjust strategies as per your requirements. Financial matters are extremely personal and individualized hence a professional financial advisor may be a better choice to help secure your financial future.