Can robots replace humans in giving sound financial advice?

Robo-advisers are bringing financial advice to the masses by charging low management fees for customized asset allocation and automatic portfolio rebalancing.

More and more investors are turning to “robo-advisers” as a cheaper and more efficient alternative to traditional financial investment firms that require substantial investment sums and charge up to 1 percent to 2 percent annual portfolio management fees.

“Sophisticated portfolio management used to be reserved for the wealthiest investors. Not anymore,” according to Charles Schwab’s Intelligent Portfolios, the online “robo-arm” of the financial services giant.

Robo-advisers — what Bloomberg News calls “the most investor-friendly financial innovation since the index fund” — can automatically build and rebalance portfolios of exchange-traded funds or similar investments without the use and added expense of human financial planners.  

In the past, investors had two choices: either they employed a do-it-yourself investment strategy to build or manage their portfolios or hired a financial investment advisor such as a stockbroker, investment advisor, private banker, or financial planner.

The 200 or so companies offering digital portfolio management range from complete automation — robo-advisors in the true sense of the word — to more expensive hybrids that pair computer algorithms with dedicated financial advisors.

Warren Buffett recently said that hedge funds and investment consultants are usually a “huge minus” for anyone who follows their advice.According to a recent article in The Wall Street Journal, “[Buffett] has long argued that most investors are better off sticking their money in a low-fee S&P 500 index fund instead of trying to beat the market by employing professional stockbrokers.”

Automated investment services use passive investing, such as tracking the stocks of the S&P 500 index, as a benchmark for investing. They take the emotion out of trading.

Born Out of Market Volatility 

The first robo-advisers launched during the market volatility of the Great Recession when risk-averse investors and investors wanting lower fees and limited investment requirements created market demand for a new financial management business model.   

“Market conditions with zero-interest-rate policies and very low investment returns have made investors much more aware of costs. When you get 1percent to 3 percent on your investment, a 1 percent advisory fee can eat up 33percent to 50 percent of your returns,” said Bill Snider, a local CFA and retired domestic and international banking executive.

Robo-advisers also appeal to young investors who are tech-savvy and comfortable relying on technology for banking services, bills, photos and social interaction.

The industry as a whole has grown substantially over the past couple of years, hitting $53 billion in assets at the end of 2015, according to the Aite Research Group. The industry figure doesn’t include existing brokerage firms that have added a robo arm, such as Charles Schwab’s Intelligent Portfolios and Vanguard’s Personal Advisor Services. Both of those services combine robo algorithms with flesh-and-blood advisers.

“The well-known robo-advisers are Betterment, Wealthfront, Charles Schwab, Vanguard and ETrade. Fidelity, Ally and others have announced they will offer such services soon,” Snider said.

Another sign that the rapid growth of robo-advisers is gaining traction in the financial world is that the CFA Institute, the largest worldwide society of investment professionals, featured sessions on robo-advisers at its annual conference in May.

Slashing Fees

Robo-advisers generally charge 0.5 percent or less to manage your investment portfolio and typically charge no advisory fees, account service fees or commissions.

These companies differ based on the scope of the advice they deliver, the products they recommend or provide, and the way they deliver their service — online, email, advisers and service representatives. Some robos factor bank accounts, mortgages, and spending history into their automated analysis.

Fidelity Investments is test-piloting Fidelity Go, an automated robo-investing service that will charge annual fees of 0.35 percent to 0.39 percent versus the 1 percent to 2 percent fees of traditional management firms.

If you can afford a $50,000 investment, Schwab’s robo-adviser offers “tax-loss harvesting,” which garners any losses to offset capital gains, a service once only available to the wealthiest investors.   

When You Don’t Have $2 Million to Invest

Robo-investment services are reducing financial barriers by requiring low or no minimum balances to invest. The greater level of personalized service, the higher the minimum initial investment.

The online investment adviser Betterment has no minimum balance requirement, tailoring its services to young investors and the middle and working classes. This has put the pressure on traditional investment firms that offer dedicated financial advisers to clients after a substantial investment of $250,000 or more.

“Surveys show over 80 percent of individual investors still want flesh-and-blood investment advice, but the traditional high-dollar investment requirements and portfolio management fees are out of reach of many, if not most,” Snider said.

Traditional investment firms may also require client portfolios to have high cash allocations. For example, a $500,000 investment may require a minimum of 6 percent allocated to cash. This can translate into opportunity losses on investments. The drag on returns and the loss of gains in the market can be dramatic over time.  

Can an Algorithm Serve as Your Best Fiduciary, Serving Your Best Interests?   

Robo-advisers are required to act as fiduciaries, the legal term meaning they must put a customer’s financial interests ahead of all else.

But the fine print of some robo agreements state that the client is responsible for determining what’s in his or her best interest, which is like saying a sick patient is responsible for knowing what’s wrong and how to fix it. The key with robo-advisers is whether they are collecting enough information on customers.

According to a recent Bloomberg article, the Securities and Exchange Commission and the Financial Industry Regulatory Authority cautioned that robo-advisers might not provide the best advice, which is a cornerstone of the fiduciary standard.  

Most robo-advisers are confined to investment management. They do not address estate planning, most tax issues, insurance, home finance, debt management or other aspects of a comprehensive financial plan.

“Traditional advisers are expected to remain with investors over the $2 million investment level where estate planning, trusts, more complicated tax issues and charitable giving become important,” Snider said. 

Flesh-and-blood financial advisers can also give guidance to the asset allocation best for you based upon unquantifiable factors, such as your child’s college expenses, your aging parent’s financial needs, or assets held elsewhere, such as an IRA or 401(k). 

Another disadvantage of robo-advisers is that they don’t offer the choice of investments you may want to avoid, such as stocks from companies with questionable environmental practices.

Are human advice and encouragement important when the going gets tough? A bear market would be the ultimate test of just how crucial, or irrelevant, working with actual humans is to good, long-term investing. 

“During the best of times, while markets rise, rules-based models can work very effectively. In the worst of times, there is the need for a steady human hand,” said Jim MacLeod, president and COO of CoastalStates Bank.