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Financial Planning versus the Robo-Advisors
Posted by David on October 31, 2014 ? Leave a Comment
It seems that every day there's another headline or article about the rise of the Robo-Advisors.
And it seems a common myth discussed in these articles is that these online investment advisory services are a growing threat to the business of personal human-provided financial advice.
What it really comes down to is what, exactly, one means by "financial advice".
In an article dated Oct 27, 2014, US News and World Report asked "Financial Advisors vs. Robo-Advisors: Which is Right for You?" and it seems that they got right to the heart of the matter quickly, quoting industry expert Michael Kitces:
Michael Kitces, partner and director of planning research at Pinnacle Advisory Group in Columbia, Maryland, [...] explains that the business of a robo-advisor is very narrow.
"Robo-advisors are basically designed to do one thing: give you an asset-allocated passive strategic portfolio," he says. Wealthfront, for example, has billed itself as "The Automated Investment Service for Everyone."
"That's the scope of what they do, period. If someone wants actual advice about anything beyond 'Give us your money and we'll invest your portfolio in a diversified manner,' you're outside the capabilities of robo-advisors and into working with an actual financial advisor," Kitces says.
In other words, it comes down to what one means by "financial advice". Unfortunately, the most common business models of so-called "financial advisors" only help to make this more confusing, since there isn't actually any clear unambiguous definition of "financial advisor". Anyone may call himself an "financial advisor" - and that may mean someone who sells insurance, someone who sells stocks and bonds (and maybe gets commissions on those sales), someone who manages a portfolio (pretty much what the Robo-advisors do), a financial planner who does comprehensive planning, or, well, pretty much anyone.
There is a formal definition of "registered investment advisor" - which may include people who simply manage portfolios as well as people who, in addition to giving investment advise (i.e., recommending specific investments, possibly even performing those transactions on behalf of a client), are also giving what's more commonly known as "comprehensive financial planning services".
The Robo-advisors -- Wealthfront, Betterment, the like -- including the newly announced robo-advisor services Schwab will be offering -- are "investment advisors" only in the narrowest meaning - they may use a questionnaire to determine a reasonable risk tolerance and target asset allocation, and then they implement that portfolio in accordance with that target allocation, rebalancing as necessary. For all that it's billed as "rocket science" - it's really not. In fact, there have been "balanced funds" and "asset-allocation funds-of-funds" for many years, and with a very few exceptions, it's not clear that these services are adding all that much more than these products which have been in existence for a long time (the main addition is that they help you, via those questionnaires, select your target allocation).
The truth is that often the real added-value that comes from working with a financial planner (who may or may not also be your investment advisor) is not the implementation of the portfolio -- but from the rest of the planning. Constructing a roadmap for your financial life to help you figure out how much you need to save for retirement, how much, if any, you should be putting into college savings plans, optimizing between all the various alphabet soup of retirement savings vehicles (with their differing tax treatments), figuring out how much you can reasonably afford to spend on a home, reviewing your estate plans -- all the things that an individual's unique situation makes exceedingly difficult to model no matter how sophisticated the financial planning software. In fact, while the best financial planners may use software to help model these scenarios, that software is often highly sophisticated, and is only useful to the extent that the operator understands how this all works. The financial plan that comes out is not a fixed, permanent recipe for one's financial future, but rather, a roadmap which requires ongoing refinement as the terrain changes along the way.
Now, many financial planners work only with an assets-under-mangement business model - which requires the client to turn over a substantial portfolio for the planner to manage, and on which the planner collects a fee which is a percentage of those assets. And these Robo-Advisors may be a threat to that business model, particularly for the planners who don't actually do all the planning and simply invest the assets. So some of those advisors will need to modify their business model in order to compete. They'll need to differentiate between the portfolio management side (which may well be able to be replaced with a Robo-Advisor, though not always, especially if working with pre-existing portfolios which cannot simply be sold off to start from scratch) and the financial planning side of their business.
Robo-Advisors do compete with investment advisors who do nothing more than portfolio implementation. But they are no threat at all to financial planners because the Robo-advisors don't do financial planning. In fact, they may be a great complement to the work of a good financial planner.