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Is it safe to invest with a robo-advisor? Are there risks involved?

Is it safe to invest with a robo-advisor? Are there risks involved?
Asked by
Jane Goodwin categorie-icon time-icon4 months ago
1 Answer Answer Question

Sheila Olson
Answered time-icon4 months ago

There are risks with every type of investment—unless you’re holding all your assets in cash, there is some risk involved. That is especially true of stocks. No matter what anyone tells you, there is no “sure thing” when it comes to the market. There is always an element of risk.

That said, when it comes to the mechanism of investing, robo-advisors are pretty safe. These digital investment management platforms use military-grade encryption, and most are heavily invested in data protection. From a security point of view, most experts consider robo-advisors a safe way to invest.

But there are other risks to consider before you invest with a robo-advisor. One of the more obvious is that this is relatively new technology built around a relatively recent trend toward passive investing. Robo-advisors broke onto the scene in 2008; the industry is barely 10 years old.

In addition, although passive investing has been available for decades, it’s only recently become a popular way to invest. In 2000, a mere 10% of mutual fund assets were in passively managed funds; today, that figure is approaching 50%. There has been a stunning outflow from actively managed mutual funds to passively managed index funds and ETFs over the past five years; some $600 billion in 2017 alone moved from active to passively managed funds.

This seems like a perfect storm, since both of these developments have existed exclusively in a bull market. The U.S. stock market is in its 10th year of a sustained bull market, the longest stretch in history. A significant body of evidence demonstrates that actively managed funds outperform their passive counterparts in a bear market. It remains to be seen how robo-advisors, and their clients, will fare when the market enters an inevitable downturn.

Another risk is the manner in which robo-advisors assign clients to portfolios. The online questionnaires vary significantly between the different robo-advisor platforms, suggesting that some may do a better job than others at accurately assessing an investor’s risk tolerance and investment goals, and matching them to an appropriate fund portfolio.

This lack of standardization across platforms points to another risk, which is in the regulatory realm. Although robo-advisors are subject to the same fiduciary rules governing all registered investment advisors under the SEC, there are other regulatory and compliance concerns, specifically related to the algorithms used to build the pre-set portfolios.

The SEC issued regulatory guidance aimed at robo-advisors in 2017, which focused specifically on disclosure rules, the provision of advice based on online questionnaires, and compliance regarding the use of algorithmic codes. It is obvious that robo-advisors will remain under SEC scrutiny as the business model expands.

Another risk relates to the buy-and-hold strategy most robo-advisor portfolios are built around. As mentioned above, index funds are a good choice in a bull market for a buy-and-hold investor. But they may be inferior to individual equities in a range-bound market, where the market as a whole trades in a narrow band, moving very little in either direction. By definition, most index funds will deliver lackluster returns—they aren’t designed to beat the market, merely to track it.

And that points to the final risk with robo-advisors. They only keep pace with the market. If the market takes a beating, so will your portfolio. They are not equipped to utilize sophisticated hedging and risk management strategies designed to limit losses and amplify gains.

Some platforms are expanding their product offering to include more options for investors looking to beat the market. Betterment has a smart beta portfolio that tilts toward a more active approach to achieving gains. Wealthfront is parking a percentage of its investors’ money in a “risk parity” fund, which uses complex derivatives to goose returns. But generally speaking, the robo-advisor business model is built around low-cost, low-fuss, passively managed ETFs, which, despite their current massive popularity, do have disadvantages for investors.

One final thing to keep in mind if you’re thinking of using a robo-advisor: It’s as easy to sell shares in your robo-advisor account as it is to buy them. In other words, there’s no human being managing your investments and executing your trades. If the market suffers a correction and you’re a risk-averse investor, it’s extremely easy to liquidate your position and substantially harm your returns and investment goals. A human advisor would counsel you against a bad financial move.

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