Do Automated Investment Tools Really Work?

August 12, 2015

Connect Member

Founder, Paladin Research & Registry. Author, “Who’s Watching Your Money”

Maybe you have read about some of the new online investment services. They will invest your assets for 75% lower fees than traditional financial advisors. Sounds like a pretty good deal, but services that charge lower fees may not be everything they purport to be.

The foundation for the automated investment tools is the assumption that computer algorithms can do a better job investing your assets than humans can. In fact, the computer programs eliminate the need for layers of expensive professionals, hence the lower fees.

Before you leap, ask yourself two questions: How do the tools work? What am I giving up to reduce my investment expenses?

5 Easy Questions

The automated investment process starts with five questions:

  • How much money do you have to invest?
  • What is the purpose of the money?
  • When will you need your assets or income from your assets?
  • What is your tolerance for risk?
  • What is your rate of return expectation?

Model Portfolios

Your responses are used to plug you into one of five model portfolios:

  • Maximum Growth
  • Growth
  • Growth & Income
  • Income
  • Capital Preservation

The service provider assumes people with the same investment characteristics (higher tolerance for risk, higher return expectations) are invested the same. This way the provider only has to manage five portfolios instead of a different portfolio for each client. This maximizes efficiency and reduces your expense for investment advice and services even more.

Exchange Traded Funds (ETFs)

Each diversified model portfolio invests in several ETFs that cover various segments of the securities markets. For example, one ETF invests in large U.S. companies that pay dividends. Another ETF invests in small U.S. growth companies that do not pay dividends.

The model portfolio’s diversification reduces your risk of large losses.

The role of the ETF is to match the performance of a particular asset class. For example, the S&P 500, a large capitalization index fund, is up 10%. Your ETF that is based on the holdings of this index fund is also up 10%. Model portfolios that invest in ETFs are a lower risk “match the market” strategy versus a higher risk “beat the market” strategy.

Bells & Whistles

Some of the automated investment tools fall into the bells and whistles category. They are nice to have because they can improve your results and reduce your investment risk.

Some of the more important tools include:

  • A diversified portfolio of ETFs based on tolerance for risk
  • Automatic rebalancing to reset a model portfolio’s asset allocations
  • Tax loss harvesting to reduce your payments to the IRS

What’s the Downside?

You may have a personal relationship with a financial advisor who will meet with you face-to-face. The advisor knows you, your family, your goals, and your concerns.

There is no relationship with an online advisory service that uses computer programs to manage your assets. You may receive weekly emails that are spewed out by a CRM program, but you may not be able to talk to a human.

The relationship may not be important when the market is going up every year — like it has since 2009. But, it can be critical in a prolonged down market when your assets are declining in value month after month.

The relationship will help you make rational decisions during the bad times so you benefit during the good times.

Jack Waymire is a member of the DailyWorth Connect program. Read more about the program here.