Robots already do serious work in manufacturing, construction, and an increasing number of other fields. And now, "robo advisors" are invading financial services. Within the next decade, these automated portfolio managers are expected to be handling trillions of dollars in assets.
But are robo advisors an upgrade over their human counterparts? The jury is still out on that question, so let's take a closer look.
How do robo advisors work? It's not like R2-D2 sets up a face-to-face meeting at his office and devises a financial plan for your future. Instead, you input critical data—including your age, risk tolerance, assets, and goals—into a software package, which then spits out an investment "asset allocation" based on an algorithm. So, the technology does all of the grunt work.
Typically, the allocation will rely heavily on exchange-traded funds (ETFs) holding a mix of domestic and international stocks and bonds. Although robo advisors vary, normally the algorithms that determine which ETFs to hold are based on modern portfolio theory or a version of it.
Although you may be attracted by the idea of a portfolio automatically tailored to your needs, robo advisors have certain shortcomings. For one thing, they haven't been sufficiently tested during a range of market conditions such as the sustained downturn that began in 2008-2009.
In addition, there's the fact that a faceless, mechanical robo advisor won't react in the same way as a human advisor. Who is responsible if your investments go south? You can't consult with the tech experts who provided the coding for the software (nor are they likely to know much about managing your investments). In some cases, there is an 800 number you can call, but the software still drives the final decisions.
Furthermore, a robo advisor operates in a virtual vacuum. It doesn't have a complete financial picture or know you personally. If there's a call center for a particular robo advisor, you'll likely speak to a different person every time you call. In other words, the methodology behind these technological marvels won't take into account all of the factors influencing your life.
Finally, proponents of robo advisors claim that they are less expensive than human advisors, but that's not always the case. In any event, you may find that the services of a trusted personal advisor are well worth the cost in the long run. Despite the latest technological advancements, humans can still play a valuable role in guiding your investment decisions.
This article was written by a professional financial journalist for McCarthy Asset Management, Inc and is not intended as legal or investment advice.