Robo-advisors are one of the hottest topics in the financial advising business right now.
People are beginning to warm up to the idea of having a computer algorithm manage their money in place of a financial advisor.
And there are tons of different options out there like Robinhood and Betterment that are becoming increasingly popular - but will these services actually help you make smart investing decisions?
Let’s break down how robo-advisors work to determine if it’s the best way to manage your financial portfolio.
What is a Robo-Advisor?
Because bots are new to the world of investing, you might still be wondering what is a robo-advisor. Robo-advisors are apps that diversify your investments according to SEC guidelines.
Typically when you sign up with a robo-advisor you’ll take a test to determine your acceptable risk level and objectives. Depending on your age, income, and savings the computer will determine a strategy and manage your money using modern portfolio theory.
Before we can compare robo-advisors to traditional financial advisors, we need to understand a little bit about modern portfolio theory.
What is Modern Portfolio Theory?
Modern Portfolio Theory (MPT) is the standard money management approach used by 95% of the industry. It says that the cost of a stock and the value of the business are the same. Because MPT assumes that the market always prices stocks correctly, it’s like a casino where the odds of beating it over a long period of time are zero.
MPT also takes a mathematical approach to measure the risk of each stock. Their level of risk depends on how much the stock price fluctuates compared to the index.
The big problem with MPT is that it simply doesn’t believe that you can buy stocks at a price lower than their real cost.
Now, as Rule #1 investors we know this is not true - just look at Warren Buffett, Charlie Muger, or the hundreds of Rule #1 students we’ve worked with over the years.
The reality is that MPT simply won’t let you beat the market.
Robo-Advisors vs. Financial Advisors
While financial advisors offer more personalized human service and investment management, most of them ultimately take the same MPT approach toward your accounts. And if you’re looking for portfolio performance that’ll knock your socks off, MPT is not the way to go.
At the end of the day, the only difference between bots and human advisors who buy into MPT is in the fees that they charge.
The effect of modern portfolio theory is that you don’t need a financial advisor who will manage your money based on mathematical equations and automatic rebalancing of your portfolio.
The only benefit from a robo-advisor is that they save you some serious bucks in fees, because a robo-advisor can build an MPT portfolio as well as any human and deliver the same run-of-the-mill returns.
If what you want is a portfolio with decent returns -- and who doesn’t? -- then robo-advisor performance just won’t cut it.
So, Are Robo-Advisors Worth It?
Alright, so we’ve established that if you had to pick between the two, you might as well go with a robo-advisor over a financial advisor. But does that mean a robo-advisor is actually the right move for you?
The short answer to this question is: No, you should never use a robo-advisor.
Robo-advisors offer impersonal, automated service and cookie-cutter portfolios with a short track record.
But despite these drawbacks, a lot of people still choose robo-advisors. Let’s take a look at why.
Pros and Cons of Robo-Advisors
Robo-advisors advisors are not for everyone. Choosing them to manage your portfolio depends on your personal circumstances and investment goals.
Take a look at these pros and cons of robo-advisors to make the best decision for yourself:
Lower investment minimums
Unbiased investment decisions
Mediocre rates of return
Not focused on financial planning
Not enough to retire
Lack of flexibility
Automated investment decisions
Incomplete picture of who you are
No human interaction
If you think about it, there’s no reason to pay any type of advisor fees for a portfolio that barely matches market returns.
In that case, you might as well just buy a few indexes. These will save you more on fees and give you the same overall return as the index you choose. Plus, at least you’ll be able to invest the extra money that you would have paid the robo-advisor in fees.
But don’t take my word for it. Check out what some of the most successful investors in history have to say about it.
Robo-Advisor Reviews from Investing Experts
Buffett teaches that risk is not mathematically determinable; that risk comes from not understanding the business. And the best way to minimize risk is by investing in stable companies that have good leadership and are priced below their value.
Buffet teaches that price and value are often very different. Price is just what you paid and it doesn’t always reflect the company’s worth. Value is what you got in exchange for your money.
The reason price can differ from value is that fear and greed, rather than rational thinking, often dominate the market in the short term. If we buy when investors are fearful, we’ll get lower prices and greater value. When we sell greed, we achieve greater gains with lower risk.
This is very different from the results that wall street traders and robo-advisors get when using modern portfolio theory. Here’s what Charlie Munger recently said about this:
“Warren and I would just roll our eyes. People were actually making decisions about how much risk to take, based on the application of correct math, based on an assumption that wasn’t true. And by the way, people gradually knew it wasn’t true. But by that time they had gotten so acculturated to the math and they were so good at it they couldn’t give it up.”
“If smart people were not often so stupid, we would not be so rich.”
Why You Should Never Use a Robo-Advisor
If your investment goal is to grow your wealth and shave a couple of decades off of your retirement dates, you don’t need a robo-advisor. You need to take the bull by the horns and gain control of your own hard-earned money. When you know how to identify value stocks and companies that offer gains, you don’t find yourself wondering if robo-advisors are a good idea or paying unnecessary fees.
If you're new to the stock market and looking for a free resource, check out my Transformational Investing Webinar. It's a 45-minute training that will teach you everything you need to start investing on your own.