Robo advisors have recently gained popularity in Canada, shaking up the financial world with this new automated, digital approach to investing. Though the phenomenon promises low-cost, simple solutions for investors who want to grow their portfolio but don’t have a lot of time to devote to research and making hands-on changes, it may not be the ideal solution for their long-term financial health. Learn more about what robo advisor can do — and more importantly, what they can’t.
How Robo Advisors Work:
Robo advisors are a technology-based way to invest your money. They consist of software that uses mathematical algorithms to determine how you should invest. To start, you set up an account online, input your details, and then go through a basic questionnaire that asks generic questions about your investing time frame, risk tolerance, etc. Based on your answers, it spits out an asset allocation or model portfolio that consists of passively invested exchange traded funds (ETFs). Your money sits in your account and flows with the market, until you decide to take it out. There is no human interaction.
Robo Advisor Pros:
Because an algorithm designs and develops the portfolio, there is no service element or personalized advice. As such, robo advisors are touted as low cost. Young people are often very computer savvy and like to do things online, and robo advisors let clients check on accounts online or with a phone app. If you’re young and your portfolio is very simple, you might consider using a robo-advisor, especially if you have a small amount to invest and don’t have a lot of questions or need personalized advice.
Depending on the robo advisor you choose, you may have the option to chat, email or phone the institution for answers to simple questions or basic instructions and guidance.
Robo Advisor Cons:
While it might make sense when you’re first starting out with investing to consider robo advisors, they offer no customized, personalized advice like you’d get with a wealth advisor. Very early in your investment career, you’re going to start asking questions. I want buy a house or a condo; should I put my money into my RSP or should I put it towards the mortgage? Should I invest in my tax-free savings account or my RSP? How much should I be saving now if I plan to buy a home in a few years? Can I afford to take a year off work to travel? Investors at pretty much every level beyond the most basic will need the advice of a trusted expert. The more money you have and the later on in life you go, the more complex your financial issues become.
The minute you start experiencing major life events (changing jobs, buying property, getting married, having a family, getting divorced, caring for aging parents, etc.), you’ll need someone who’s knowledgeable to talk to you through it. You’ll want an advisor who understands your entire life situation — not just the basic financial info you filled out in an online questionnaire — who you can consult with when your situation changes. It’s comparable to needing a family doctor: instead of going to the ER every time you’re sick, you’ll want to talk to someone who knows your entire medical history and has an existing relationship with you. You’ll need wise counsel that is customized and personalized to your unique situation, no matter what stage of life you're at. And the more wealth you have, the more expert, personalized advice you will need.
Another thing to note is that many wealth advisors are all-around experts. They don’t just guide you on investments; they have a holistic view of all of your assets and devise strategies for your entire financial health, which can include estate planning, taxes, insurance, retirement, property ownership, etc. They can help you navigate a crisis and plan for worst-case scenarios. Who is going to do that if you're just interacting with a computer program?
The Market Meltdown Mystery:
Because robo advisors are relatively new, we have yet to see their performance during a drastic downturn in the market. If we see a drop like we did in 2008, a wealth advisor will guide you through the slump and prevent you from selling in a panic. Think of advisors like personal trainers: when you’re working out, it helps to have a trainer push you to do five more push ups or three more minutes of cardio, because left to your own devices, you're more likely to quit. The same is true with investing. You need someone to hold your hand and motivate you. It’s human nature to see the market go down and want to run the other way. An advisor will keep you disciplined and focused on your true goals, and not let you be emotionally reactive. With a robo-advisor, you’ll log into your system, see minus signs everywhere, and be more likely to sell in a panic and potentially lose lots of money instead of staying the course or even investing more, because there is no one there to advise you. And once you’re out of the market, you’ll likely be gun-shy to jump back in. As we like to say, the market always climbs the wall of worry.
The Real Cost of Robo Advisors:
Robo advisors tend to appeal to people with less money to invest, because people with more wealth tend to understand and respect the value an expert advisor. Unfortunately, the people who are most attracted to robo-advisors are the ones who can least afford to lose their money. If you've got $5 million dollars and you lose 25%, it may not materially affect your life. But if you only have $50,000 and you lose 25% because you didn’t get the right advice, it could drastically change your situation. Therefore less-savy investors may need even more contact, advice and discipline, while the robo-advisors that target them offer less.
Also, we should challenge the idea that robo-advisors don’t cost anything. There is still a fee to use them. You have to compare the incremental costs involved with getting the bare bones product that software offers, and the cost of the holistic advice a wealth advisor provides. Typically, an advisor would charge 1% a year for advice that encompasses your entire financial life, not just your investments, and that fee is usually tax-deductible. How much is that worth to you, versus the possibility that you could press the button at the wrong time, and lose a portion of your portfolio because you didn’t have a professional to guide you?
The more complicated the markets become and the more complex your situation gets, the more you require personalized advice from someone who will hold your hand through your major life events and devise an overall financial and estate strategy. We like to say: as the world gets more high tech, wealth advisors get more high touch.