Debunking Robo-Advisor Myths

Would you invest in 6,574 different stocks by putting $5 in each one of them? How about spreading $4,000 in 13,513 different bonds? What if I told you that for every dollar I lose managing your investment account, you could get 30 cents in tax breaks? Is that a good deal? Backed by a gathering stream of venture capital dollars and thanks to increasingly aggressive marketing campaigns that tout the promise of lower fees, so-called “robo-advisors” have exploded on to the scene in recent years. Of course, underpinning the existence of such offerings is the implicit notion that online, automated investing solutions are just as good – if not better than – working with a trained, real-life human advisor with years of experience.

But is this true? Can a machine really provide the same level of service as a seasoned financial advisor? We think that is a very tough case to make. For proof, consider three robo-advisor myths that every investor should keep in mind:

MYTH 1. Robo-advisors are capable of offering investors individually tailored, customized portfolios.
Most employees of robo-advisor firms are tech engineers and programmers (not financial advisors) working on complex algorithms and software to group clients together in order to provide them with a “customized investment plan.” I don’t know about you, but that doesn’t fit my definition of customization at all.

In a recent article published by MarketWatch, it compares the investment recommendations of 3 robo-advisor firms for a hypothetical client: a 35-year old investor with an average risk tolerance and $40,000 in a retirement account. Their recommendations were very similar: 30% US stocks, 35% international stocks, 15% REITs, and 20% bonds in 7 to 10 different ETFs. In looking a little deeper into the underlying holdings, you get a range of approximately 6,500 to 9,300 different stock holdings and 1,600 to 13,000 different bonds. If you have a chance to customize your portfolio, would you buy 9,300 stocks and 13,000 bonds with a $40,000 investment? The problem with this approach is obvious: over-diversification. Over-diversification is a recipe for mediocre results originated from a lack of conviction in your investment ideas, and it is one of the problems with trusting an automated solution to make critical investment decisions.

MYTH 2. Robo-advisors can increase investors’ returns with tax-loss harvesting.
Tax-loss harvesting is simply selling your losers to offset your present or future realized gains (only applies to taxable accounts). The idea is that the sold security is then replaced with another highly correlated, but different security in order to avoid the wash-sale rule and maintain the optimal asset allocation and expected returns.

Tax-loss harvesting is a tax-deferral strategy, pure and simple. It can be used to defer tax liabilities, not avoid them. However, it is being touted by robo-advisor firms alike as a money making strategy. You must be wondering, “how can losing money make me money?” The answer is in the fine print. In order to generate this so-called “tax-alpha,” two things need to happen:

I) The newly bought security needs to appreciate in value as to recoup the previous loss incurred; and
II) Tax savings created by the loss must be re-invested back into the portfolio.
For further clarity, consider the situation below:

Year 1
Initial Investment: $100,000
Tax-Loss Harvesting: ($10,000)
Investor's Tax Bracket: 40%
Tax Savings: $4,000
Additional Investment: $4,000
Ending Value assuming portfolio recovered 100% of the loss harvested: $104,000
"Tax Alpha": 4%

As you can see, tax-loss harvesting alone does not produce gains. Buying investments that go up in value and adding money to your account do.

MYTH 3. Robo-advisors offer investors lower fees.
Fees are undoubtedly an important consideration when making investment decisions. However, it is impossible to compare fees in a vacuum. Robo-advisor firms may advertise lower fees, but what kind of products and services are clients actually getting for those fees? Do they even compare to what most full-service firms can offer? The answer is no.

Coming up with a financial plan requires more than inputing some numbers into a computer and producing an algorithm. It is about establishing a human connection and understanding the unique needs of each individual client. An automated asset allocation program cannot do that.

Most clients are looking for much more than asset allocation strategies from their financial professionals, and for an all-inclusive fee of 1 percent, that’s what real advisors deliver – much more. Whether clients have questions about markets, buying a home, refinancing an existing mortgage, buying or leasing a car, setting up a will or a living trust, when to exercise stock options, insurance needs, reducing tax liabilities and much, much more, a GK advisor is here to help. That sounds like a much better value proposition to me, and for a very reasonable cost.

By Danilo Kawasaki
Vice President & COO
Gerber Kawasaki Wealth Management

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.

Gerber Kawasaki, 2716 Ocean Park Blvd. #2022 Santa Monica, CA 90405. Contact us at (310) 441-9393.