Rebecca Lake U.S.News & World Report

Technology is turning the way investment advice is delivered on its head. Robo advisors are redefining the traditional financial advisor model by leveraging algorithm-based strategies for portfolio construction — whether it’s for stocks, mutual funds or exchange-traded funds.

“Cost, convenience and technology are the most attractive features for the younger generation flocking to robo advisors,” says Tony Drake, CEO and founder of Drake & Associates in Waukesha, Wisconsin. “Millennials are much more comfortable working with an app and avoiding human interaction.”

Regardless of age, robo advisors can fill certain needs when building a portfolio. Namely, the need for simplified investing as part of a hands-off, low-cost approach.

Gregory Lawrence, certified financial planner and founder of Lawrence Legacy Group in Estero, Florida, says robo advisors eliminate the middle man, along with the higher fees personal advisors may charge. He says investing through a robo platform can make life simpler for investors when markets behave well.

Those characteristics work in robo advisors’ favor, but they aren’t without certain flaws. Experts say there are three important reasons to think twice before investing with a robo advisor.

— Automatic rebalancing isn’t perfect.

— Robo advisors can be tax inefficient.

— There’s no personal touch.

Automatic Rebalancing Isn’t Perfect

Asset allocation isn’t designed to be fixed; it’s intended to shift and evolve along with an investor’s risk tolerance and time horizon. Robo advisors attempt to make managing asset allocation easier through automatic rebalancing, but there are problems with that strategy. The first is the potential for returns to underwhelm.

“Robo investing makes your portfolio performance average, rarely giving you superlative returns relative to the market,” Lawrence says.

That type of outcome may be more likely when a robo advisor changes the balance more frequently, which may go against the grain for an investor who favors a buy-and-holdapproach.

“Hyper, periodic rebalancing can force portfolios to sell winners into growing markets and not realize the holding periods required for investment participation,” says Adam Holt, CEO and founder of Philadelphia-based Asset-Map.

There’s also a cost component to consider. Drake says changing the balance automatically can get expensive if it triggers transaction fees or taxable events. He also notes that automatic rebalancing models have yet to be tested against a large market correction.

The possibility of a correction aside, automatic rebalancing can make it harder to create a customized portfolio.

“The investments made by robo advisors are often based on a risk tolerance score but don’t necessarily account for other pieces of a financial plan,” says Matt Schulte, head of financial planning at eMoney Advisor. “Automatic rebalancing may not produce the best outcomes for clients because their other assets, investments and overall financial goals are not taken into consideration.”

That could be a serious issue for someone whose assets aren’t centralized at a single robo advisor platform. Drake says that type of scenario calls for extra caution on the part of investors.

“An automatic rebalance from a robo advisor could make you overweighted in a certain sector if it doesn’t take into account all of your assets,” he says. “Diversification should look at all assets in your portfolio; one hand needs to know what the other hand is doing.”

They Can Be Tax Inefficient

A handful of robo advisors include automatic tax-loss harvesting within their scope of services. This strategy involves offsetting investment gains, and subsequently capital gains tax by selling under-performing investments at a loss.

In a taxable investment account, tax-loss harvesting can work to an investor’s advantage. The problem with allowing a robo advisor to harvest losses automatically is that it could result in tax inefficiency if the wash-sale rule is triggered.

The wash-sale rule specifies that for a tax loss to offset a gain, an investor can’t purchase the same or substantially identical investment within 30 days before or after the sale. Robo advisors can violate this rule without being aware of it if investors are harvesting losses on their own in other investment accounts.

Bill Van Sant, senior vice president and managing director at Girard says the main problem is tunnel vision with regard to what’s happening outside the platform.

“Robo advisors focus narrowly on the portfolio that is managed on the platform,” Van Sant says. “While the intention is good, it may not be overly tax efficient if not considering personal situations.”

Like automatic rebalancing, tax-loss harvesting could shortchange returns if it’s done by a robo advisor without taking the bigger picture into account.

“If you have a long-term time horizon, reacting to short-term market volatility can be detrimental,” Drake says.

There’s No Personal Touch

Robo advisors eliminate the need to schedule in-person meetings with a financial advisor. While that may be a time saver, it leaves little room for an investor to receive personalized advice, which Drake says is the biggest downside of robo advisors.

He says younger investors may not mind not having a personal connection but as investors get older, investing tends to become more emotional with retirement accounts. “Retirees go from making money to spending money and their biggest fear is going broke,” Drake says. “There are so many things to take into account as you plan for the future and it’s important to work with a fiduciary who can help you through that process.”

While robo advisors may come with certain automatic features, such as rebalancing, they don’t automatically adjust to accommodate life changes, Schulte says.

“There’s no relationship, you need a person for that,” he says. “Advisors build relationships and create financial plans and investment recommendations tailored to individual clients.”

Those relationships become vital during periods of market volatility.

“In times of uncertainty, most people will seek certainty in a credible human who can provide that confidence,” Holt says. “Very often, a human advisor’s role is to help an investor from being their worst enemy by making emotional decisions at the wrong times with respect to their portfolio.”

While robo advisors can employ advanced algorithms to make investment decisions, they can’t see the future. Traditional human advisors don’t come with a crystal ball either, but they may be better equipped to forecast market movements and trends.

Lawrence says a robo advisor may best service someone with an uncomplicated portfolio who’s bullish on the market. “But if you want experience, tax and financial planning, then the human advisor is more than likely your best choice,” he says.

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