What You Need to Know About This ‘New’ Investment Strategy

Oct 29, 2021

This week I want to talk about one of the most popular trends in the world of investing and personal finance.

I’m referring to the rise of so-called robo-advisers.

If you’re not familiar, robo-advisers are similar to traditional investment advisers or money managers. However, as the name implies, they rely on computer algorithms, rather than humans, to make investment decisions on your behalf.

As a result, robo-advisers promise to provide the benefits of working with a professional money manager without the hefty fees that typically come with them.

That’s certainly a compelling proposition. So, it’s little wonder robo-advisers have become so popular with individual investors.

But before you consider investing in one of these services, there are a couple of things you need to understand about their cost and expected performance.

Let’s start with cost.

Now, it’s true that robo-advisers generally cost less than traditional financial advisers.

Most have no or low minimum investment requirements. And most charge total annual fees of 0.5% or less, versus the 1% or more (potentially much more) you would typically pay to an adviser.

They’re also generally less expensive than passively investing in the high-fee target date mutual funds offered in many retirement accounts.

Regular Money Talks readers know why minimizing fees is so important. As I explained when we discussed mutual funds, even relatively small differences in fees can add up to hundreds of thousands — even millions — of dollars over time.

So, if you’re currently paying high fees to a traditional adviser, or worse, to a cookie-cutter mutual fund, then switching to a lower-fee robo-adviser might be a great decision.

But it’s also important to understand how robo-advisers are able to charge these lower fees.

You see, there’s nothing magical about these services. The lower fees are primarily the result of two simple factors.

First, they generally invest in low-cost index funds and exchange-traded funds (ETFs) instead of more expensive mutual funds.

Second, they have significantly lower overhead because they rely on computers rather than human employees to guide their investment decisions.

Now, many of these services tout proprietary algorithms they use to make those decisions. But in my experience, most of these algorithms are based on the same basic portfolio approach recommended by traditional advisers for decades.

This approach involves splitting your investment portfolio between a mix of stocks and bonds. And as I explained in my series on “portfolio thinking” in April, the traditional recommended mix is roughly 60% in stocks and 40% in bonds. This is commonly known as the “60/40 portfolio.”

However, in practice, many advisers recommend a higher percentage in stocks for younger or more aggressive investors and a higher percentage in bonds for older or more conservative investors.

This is the same general approach most robo-advisers use as well. In fact, a quick Google search for “robo-adviser performance” will turn up the actual portfolio allocations for many of these services.

This means that most individual investors could easily follow this approach themselves with a mix of the same low-cost stock-and-bond index funds these robo-advisers use. And it would cost even less than what these services charge.

That brings me to performance.

Robo-advisers also have an advantage over traditional money managers and mutual funds in this category. But that’s only because most managers and mutual funds underperform their benchmarks!

Underperformance isn’t a major concern with robo-advisers. Because they generally hold low-cost index funds, they should perform similarly to the various indexes those funds track (before fees).

But, by definition, this type of portfolio will never beat the market, either. And because robo-advisers typically follow a buy-and-hold approach, these portfolios can still experience significant volatility and big drawdowns during bear markets.

Again, if you’re currently investing with an adviser or fund that’s underperforming the market, then switching to a robo-adviser could be a good idea. It could save you money and improve your returns.

But most folks could do much better.

Our research here at TradeSmith shows that simply using trailing stop-losses — or better yet, our proprietary smart trailing stops — can dramatically outperform a buy-and-hold approach.

And while many TradeSmith subscribers prefer to own individual stocks and assets, these tools can just as easily be used with the mix of low-cost funds I mentioned earlier.

Finally, one additional selling point for these services is that they offer automatic rebalancing and tax-loss harvesting. But again, these strategies generally aren’t proprietary and aren’t all that complicated to follow yourself.

Rebalancing simply means adjusting the size of each position in your portfolio back to its original percentage weighting at the end of each month or quarter. You’ll sell some of the funds that have grown above their original size and buy some of those that have fallen below.

This can easily be done manually — or with just a few clicks of your mouse with the help of TradeStops.

Likewise, “tax-loss harvesting” sounds complicated but is relatively simple in practice. At the end of each month or quarter, the robo-adviser sells any funds showing a loss and replaces them with a different fund that tracks the same index.

This strategy allows you to recognize losses for tax purposes while still maintaining exposure to the same indexes. And it doesn’t require any special tools or software at all.

In other words, for just the cost of an affordable TradeStops subscription and a few minutes a month, I believe just about anyone could dramatically outperform the best robo-advisers out there.

Have you used a robo-adviser? I’d love to know if you agree. You can email me directly at [email protected]. As always, I can’t personally respond to every email, but I promise to read them all.