Should You Trust Robots To Build Your Portfolio?

If you are reading this article, then you are likely considered a “self-directed investor.” You like to perform your own investment research and make buy, sell and short decisions on your own.

But you should still know about the radical battle being raged for the hearts and minds of investors that entrust wealth building to others.

#-ad_banner-#In one corner, we have traditional financial services firms such as The Charles Schwab Corp. (NYSE: SCHW), Vanguard and Fidelity Investments.

In the other corner, you’ll find industry upstarts with names like Wealthfront, FutureAdvisor, Motif Investing and Betterment. These firms are all scrambling to establish a position in the field of robo-advising, also known as “automated investment services.”

Before weighing in on which firm has built the best mousetrap and if the entire concept holds real appeal, it helps to understand what robo-advisers are and are not.

Robo-advisers ask clients to fill out a quick survey that identifies an investor’s goals. They then create ideal low-cost portfolios that hold a basket of diversified exchange-traded funds.

Total fees often end up at less than 1% of assets under management, compared to fees of 1%-to-2% of assets under management offered by traditional financial advisors. (Robo-adviser upfront fees can be as low as 0.25%, but investors also need to account for the (modest) fees associated with the exchange-traded funds (ETFs) that end up in a portfolio.)

Most traditional financial advisers prefer to work with clients that have six-figure investment portfolios, but the robo-advisers aim to work with the millions of Americans that don’t quite have that much saved for retirement.

The Wall Street Journal created a handy bar chart that highlights the distinctive asset allocations that various firms make. 

My personal take, investors with a longer-term time horizon need considerable exposure to international stocks, and a 30% weighting should be considered a floor, not a ceiling.

How To Use Them
Many of these services are directed at younger investors, mostly millennials and an emerging category known as “Generation Z,” which are those just entering the workforce. People in these demographics have a higher degree of trust in social media-style business models and are more willing to try new things. Older investors are also giving robo-investors a look, but not adopting them in large numbers. Old habits are hard to break.

Of course, older investors have much larger nest eggs with which to invest, which means that the robo-advisers will only become meaningful (in terms of assets under management) as millennials start to hit the sweet spot of their careers.

For a bit of context, the assets under management of all robo-advisers is expected to more than triple this year (to more than $50 billion). Yet the broader United States financial services fund industry manages $1.7 trillion, according to the Investment Company Institute.

Roughly a decade ago, financial services analysts dismissed ETFs as niche category, but they have grown to be wildly popular with investors. To extend that analogy, few of your neighbors are using robo-advisers right now, but many of them will give them serious consideration in coming years.

It may be wise to track these services for several years before making any major commitment. This is a fairly new investment approach, and all of the robo-advisers will be tweaking their services to account for early stage feedback from clients. Moreover, many more financial services firms are likely to enter the field, and that may set the stage for price wars and other financial inducements.

The major firms have begun to resort to paying out hundreds of dollars for people that are willing to open new online trading accounts. These perks haven’t arrived on the robo-adviser scene yet, but they will.

Although it may be tempting to cast your lot with one of the younger upstarts, it’s unclear if they will have staying power. After all, we don’t yet know if these business models are operating profitably, and they may eventually feel the pressure to raise fees or trim the quality of their offerings in order to generate profits.

In contrast, the major financial firms have the financial resources to outspend the upstarts. They may not be innovators, but there isn’t much here that is hard to replicate either. My default advice when it comes to ETFs also applies here: Go with Vanguard. The fund management firm has consistently done right by its clients, and can be counted on to deliver industry-leading value in the area of robo-investing as well.

Vanguard currently has a $100,000 minimum for its personal advisor services, which bring the benefit of a real, live person to aid you in your investment decisions. Vanguard’s advisers, many of whom are certified financial planners, can help with tax strategies and other considerations. (That minimum is expected to drop to $50,000 this summer.) Vanguard charges just 0.3% for its Robo-Adviser service, and if history is any guide, Vanguard will remain a category leader in terms of value proposition.

For investors that are just getting going with fairly small nest eggs, it pays to compare the offerings of Betterment and Wealthfront, as each firm offers low minimums and low expenses, and each firm has strong financial backing (i.e. staying power) from venture capitalists.

Risks To Consider: We still don’t know a lot about the algorithms deployed by the robo-advisers. They may over-emphasize stock market trends from the past half-decade when establishing ideal weightings and as result, may deliver poor results when market conditions change.

For many investors, the one-size-fits-all approach used by automated asset allocation may not be ideal. Tax-planning issues, college funding requirements and other topics usually associated with financial planning may require a more bespoke approach to wealth-building, which most of these robo-advisers can’t provide.

Action To Take –> The real appeal of robo-investing is that it saves investors from their worst enemy — themselves. How many of us have bought and sold stocks over a period of time, only to find out that we now own a high concentration of companies in just a few industries? For that matter, many investors fear the perceived risk associated with international stocks and funds. These robo-advisers can help ensure that our portfolio’s stay globally balanced, with suitable diversification and risk profile.

Investors may also want to consider target date funds, which I discussed in February. These funds automatically adjust their risk exposure with the passage of time, which may be a key consideration for younger investors that have a desire for aggressive growth stock exposure now and more of a value orientation in future decades. These “set it and forget it” portfolios have generally delivered solid returns, and it may be helpful to compare their approach side-by-side with the offerings of the robo-advisers.

Oftentimes the little ideas are the big game changers — something like using algorithms to build investment portfolios. My colleague Andy Obermueller devotes his time to identifying game-changing trends and the companies that should benefit from this. This has led readers to investments that went on to gain triple-digits.


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