Robo-advisors Are They That Smart?
Robo-Advisors are a hot topic that has come up many times lately, and I think I (as a former programmer and current IT person) have a unique perspective on this topic (having a journeyman’s understanding of financial matters as well). Are Robo-Advisors something new, or just old tricks wrapped in technology?
A simple explanation of this investing vehicle from Wikipedia is:
What qualifies as a Robo-advisor? Pretty much anything is a very loose set of heuristics and ideas, along with some technical flimflammery. My first piece of advice is if anyone says they have a Robo-Advisor taking care of their investments, ask them if they understand what they are using. Handing your money over to an (allegedly) automated system you don’t understand is just as bad as handing it to a Human Advisor with little or no talent in investing. A task is poorly done by technology, or a human is still a task poorly done.
An important thing to remember is the Robo-advisor simply does what it is programmed to do. It “decides” based on what it is told to do (it does not learn or diverge from its programming). Many marketing blurbs speak of expensive algorithms that assure maximum investment performance, but I am skeptical.
A key thing to understand in this area is the investing philosophy the Robo-advisor will follow. Here is a simple philosophy and method to go with it.
Passive Investing with Quarterly Balancing
Philosophy: set up a diverse portfolio with the following configuration:
- 25% Canadian Index Fund
- 25% US S&P 500 Index Fund
- 25% International Index Fund
- 25% Canadian Bond Fund
You recognize that as a simple couch potato configuration. Buy low mgmt fee ETFs or Index Funds.
Algorithm: Every three months, compare holdings percentages, and if any position is greater than 5% off 25% (plus or minus) rebalance using existing funds.
This is what a Robo-Advisor might do for you (note you can do this as well, you are simply automating it). From a simple point of view, this seems like a relatively good way of doing things, or does it?
What the philosophy doesn’t say:
- What funds or ETFs should be used, so what stops the programmer of the Robo-Advisor to have you buy funds with a company that might pay them a fee? This kind of “buying bias” is already being seen in the marketplace.
- What stops the program from suddenly changing funds and churning your money (i.e. losing it to purchase fees and such)?
- How much are you going to pay for the service? Are you paying for something you could just as easily do yourself (yes, I realize many folks don’t want to do this, but that does not mean they should be paying through the nose for the privilege either).
These are just some very simple questions to ask.
I’d really like to see some kind of regulation or standards in the area of Robo-Advisors, but I suspect specific regulation may not occur until there is a scandal of some sort (in the area).