Written by: Corey Janoff
This post was originally published on our previous blog website on August 15, 2017 and has since not been revised and/or updated.
An increasingly popular way people can invest their money is through digital wealth managers. Sometimes referred to as “robot-advisors,” these are hybrid investment platforms that are in between managing your own investments and paying a financial advisor to oversee them for you. In a nutshell, you select an investment portfolio and a computer algorithm manages the portfolio for you. As with anything, there are pros and cons to using these online money managers, which we will dive into here.
How They Work
There are plenty to choose from, but they all operate similarly. You go to a website, fill out a short questionnaire about your investment risk tolerance and time horizon of the investment, and the program recommends a portfolio based on the answers to those questions. You could elect to proceed with the recommend portfolio, or choose a different one. Your money then gets invested into the portfolio selected and you’re off to the races.
Compared to meeting with a real financial advisor to discuss your goals and the appropriate investment strategy to reach them, which could take several hours over multiple meetings, this process is consolidated into a matter of minutes. Also, because you are removing the human advisor from the equation, the costs are considerably less (often half or even a fourth as expensive, depending on the size of your portfolio).
Save on cost, save on time – sounds great, right? Not so fast. The struggle most investors have with using digital investment manager is most investors don’t even know where to begin.
Some Drawbacks to Digital Investment Managers
- The risk tolerance questionnaire. These are often presented as multiple choice questions with option A being the least extreme, option C being the most extreme, and option B being in between the two. What do you think most investors choose? If you guessed option B you are correct.
This is similar to the way most people order the Grande (medium) size at Starbucks. If you order the small, you feel like a child. If you order the large, the barista will think you’re a glutton. So you order the medium size. Not too big, not too small, but just right.
This psychology translates to most aspects of life. We are social animals that don’t want to deviate from the herd. So without knowing any better, when presented with three to five choices, we will often select one somewhere in the middle.
The way people answer these questionnaires results in many people being placed in a portfolio that isn’t the most appropriate for their financial goals. For example, if you are a young investor and are directed into a moderate-risk portfolio with an equal mix of stocks and bonds, you will likely need to invest a lot more, or work a lot longer than someone who selects a more aggressive portfolio. Or if you are within a decade of retirement and haven’t done a good job saving, you might need to be more aggressive to give yourself a fighting chance at being able to retire on time. So there is sometimes a disconnect in those programs between the portfolio you get paired with and what is actually needed to reach your goals.
- They can’t really provide you with advice. For all intents and purposes, these are self-directed investment strategies where the investor controls which portfolio to use. The only thing you are paying for is the portfolio management. If you have questions, you can call a 1-800 number, wait on hold, and then speak with someone in a call center to answer questions you have about the portfolio or how to use the website. But they can’t really provide you with investment advice. They aren’t going to get a comprehensive look at your financial picture and give you specific recommendations on how to achieve your goals.
Now, some of these companies offer the option for an enhanced service (for an additional fee, of course) where you can speak with a licensed financial professional to get actual advice once per year, or as needed, depending on what you are willing to pay for. However, it will often be a different person each time and it is difficult to establish a connection with someone who has to service thousands of people per year.
3. The third drawback is You. You are your own worst enemy when it comes to investing. Money can be an emotional topic, especially when it’s your money. It doesn’t matter what portfolio you invest in, there will come a time when it doesn’t perform as well as expected. We enter a recession, global equities (stocks) decline by 25%, and your $100,000 portfolio drops to $75,000. What will you do when that happens?
Will you call the 1-800 number to get some answers and see what is going on? Get in line and prepare for a long hold time. Will you want to change to a different portfolio that didn’t decline by as much? If so, will that better enable you to reach your financial goals? If so, why didn’t you select that portfolio to begin with? What should you do, if anything, to stay on track to reaching your goals? These are the questions a computer program cannot easily answer for you.
Who Should Use a Digital Investment Manager?
If you have advanced investment knowledge and an understanding of portfolio construction and allocation, then it should be pretty easy for you to find the most appropriate portfolio for your particular goals.
If you are capable of creating your own savings and investment strategy and have the discipline to stick with it over time, then this could be an appropriate avenue for you to pursue.
If you are working with a financial advisor and he or she is helping you devise an investment strategy and select the appropriate portfolio(s) to use, then a digital investment manager could be appropriate.
Who Should Use a Financial Advisor?
If the answer is “no” to any of the above statements, then you should work with a financial advisor to help you with your investment strategy and portfolio oversight.
Digital investment managers can be great. There are a lot of financial advisors out there who use them to help manage their clients’ portfolios. They can offer efficiencies and streamline an investment process. However, a financial advisor knows how to use these portfolios and which ones to use as part of an overall investment and financial strategy.
You really only have one shot in this game called life. Yes, you can make changes and course corrections as life throws obstacles at you, but you can’t go back and redo things from the beginning. If you aren’t 100% sure what to do, talk to a financial advisor.
