Robo-advisers are growing in popularity. According to one estimate, assets under management for robo-advisers has grown more than ten-fold in three years, from less than $10 billion in 2013 to almost $100 billion in 2016. At the same time, there’s been a lively debate around the future of robo-advice across the financial services industry. One of the chief questions is will robo-advisors replace face-to-face financial advisors?
Financial advisors’ strengths may be in the details
While robo-advisers are expected to continue to have a strong presence in the financial ecosystem, there are three behavioral factors that could mean that the battle of robo-advisers vs. financial advisers may not be a fight to the death after all.
Here’s a look at the three behavioral factors to consider in the robo-adviser vs. financial adviser debate:
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Algorithm aversion: An active area of behavioral research is around “algorithm aversion”—when people prefer advice from humans over advice generated from algorithms even though they’re aware that algorithmic-driven recommendations outperform humans, on average. These findings are actively being debated in the literature and raise an interesting possibility: Even if robo-advisers were more accurate, investors might still prefer to talk to a financial advisor.
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Unrealistic expectations: No predictions are free of errors. However, algorithm aversion is heightened when people see algorithms make errors. In other words, people are generally less forgiving of algorithms making any errors than humans, and thus may unrealistically expect algorithms to be 100% accurate—something that’s essentially impossible to achieve.
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Context specific: A 2017 study by Jenn Logg, a postdoctoral fellow at Harvard University, finds that when it comes to subjective choices, such as which movie to watch, people prefer advice from humans. But when it comes to objective choices, such as forecasting future events, people relied more on algorithms.
What are the implication of these findings when it comes to investing?
It’s not robo-advisers vs. financial advisers – but a hybrid model
These three behavioral factors support a hybrid model of financial advice. When it comes to seeking financial advice, people prefer working with financial advisers to sort out subjective aspects of investing, such as identifying investment goals that are important to them or having someone to personally contact during market volatility. At the same time, they feel confident that they can reach those goals by objective means, such as with algorithms constructing a well-diversified portfolio, auto-rebalancing, tax-loss harvesting. In this hybrid model, financial advisors serve as a behavioral coach, helping investors avoid and overcome behavioral biases—a value that robo-advisors are currently unable to completely replace.
Investor views of robo-advisers may change rapidly in a down market
Much of the growth of robo-advisers occurred in the past nine years where it was a bull market, which may give the impression that investing with robo-advisors may outperform financial advisors. However, investors’ unrealistic expectation that algorithms should be completely error-free may induce some investors, especially those who invest with robo-advisors exclusively, to panic sell and exit the market completely during the next market correction.
Robo-advisors vs. financial advisors: Complementary, not mutual exclusivity
Robo-advisors and financial advisors tend to be portrayed as mutually exclusive. But instead of pitting financial advisors against robo-advisers, it appears that they may be complementary.
Generally, robo-advisors are more efficient in computational-intensive tasks such as dynamic portfolio allocation, auto-rebalancing, and tax-loss harvesting. For financial advisors, incorporating robo-advisers into their practice can free up time to pursue tasks that contribute value to their clients, such as playing the role of behavioral coaches.
So perhaps the growth of robo-advisers may actually be beneficial to financial advisers because it highlights one of the most valuable contributions that an advisor can bring to their clients: helping them overcome their behavioral biases.
This post by Ray Sin was first published on Morningstar Blog.
