What Robo-Advisors Can and Can't Do for Investors

Robo-advisors can invest and perform basic money management functions for consumers today, at a fraction of the cost that most human advisors charge. But for all that they can do, robo-advisors still have their limitations as there are still some functions in which they cannot replace humans. So here's a breakdown of what robo-advisors can and can't do for you at this point in their development.

When it comes to making logical financial decisions and performing routine money management chores, robo-advisors are excellent tools that can help investors to stay on track and maintain their initial portfolio allocation over time. They can easily perform such actions as dollar-cost averaging, portfolio rebalancing and harvesting tax losses, where the program will sell losing holdings in order to offset the capital gains that are generated from selling appreciated positions.

This type of algorithmic trading has been around for more than a decade, but it really didn't enter the mainstream market until 2008, when platforms such as Betterment and WealthFront entered the arena. These robos allow even novice investors to create a portfolio based on their risk tolerance, time horizon and investment objectives by simply answering a few simple questions posed by the program that tell it what they want to do with their money. Once they have this information, the robo-advisor will select a group of investments that match up with this information. The investor can then monitor the portfolio at any time by logging in to their account.

Most robo-advisors are designed to follow Modern Portfolio Theory, which balances risk with reward. And one of their greatest advantages is that they can perform all of these functions at a very economical cost. Most programs only charge a fraction of a percent for their services and in some cases are even free, depending on factors such as the amount and investor puts into their account.. (For more, see: Robo-Advisors and a Human Touch: Better Together?)

Robo-advisors do present some limitations for users, despite their technological sophistication. Of course, the most critical element that they lack is human interaction, and there is no substitute for this in some cases. A robo-advisor can create a portfolio based on the information that the customer inputs into the program. But what if the customer sustains a loss and decides to change the entire portfolio based on that single event? This is where a human advisor can convince the client to stay the course in the current portfolio and not go off track in their overall investment plan.

And although they can create personalized portfolios, robo-advisors cannot necessarily provide personalized advice based on an investor's preferences or life situation if they can't input those factors into the service. And these programs may also not be able to screen out certain types of investments that go against a client's beliefs, such as alcohol or tobacco stocks, or fossil fuel stocks. Robo-advisors typically cannot sense when a client may be confused about what they want, or is unable to answer the questions it poses because he or she is unsure of what answer to give. They are ultimately unable to sway clients in their decisions like human advisors can and are unable to spot or contest bad decisions or uncertainty by the client. 

Robo-advisors also lack the ability to do complex financial planning that brings together estate planning, tax planning, retirement planning, insurance needs and general budgeting and savings goals. While there are computer programs that can provide financial planning, they generally still require data entry from a professional who understands exactly how to input the numbers so that the program can make the necessary calculations to produce an accurate plan. This is generally not possible with robo-advisors, which can only make generalized decisions regarding portfolio allocation. They cannot dispense tax or legal advice and also won't keep their clients updated on the latest tax information or estate planning strategies. (For more, see: Pros & Cons of Using a Robo-Advisor.)

Robo-advisors will continue to grow more sophisticated as time goes on, but there are some aspects of financial planning that only humans can do. Those who are fairly knowledgeable about investments and know exactly what they need to do can use these automated services with confidence in many cases. But clients who need help determining what their investment objectives should be, or who need more personalized advice for their broader financial plans, may be wise to include a human advisor for now. (For more, see: Robo-Advisors' Next Frontier: 401(k) Plans.)