Financial literacy is probably the single biggest obstacle to investors successfully adopting a fully DIY approach to their finances.

All of the hype around fintech, and Robo-advisors in particular, is exciting peoples imagination because in theory it brings previously “exclusive” services to the masses.

But for individuals to successfully make appropriate use of robotic advice tools they will still need to be equipped with enough knowledge to (at the bare minimum) determine which robo-advisor to use.

Make no mistake robo-advice platforms can, and will, still incorporate inferior products, with high management costs while marketing themselves as a low or no-fee advice services.

Additionally, going the DIY route and buying robo-advice is actually only truly helpful if you understand what you have bought and why.

Individuals will still need to understand their strategies and the assumptions* that have been used in getting to their portfolio recommendation so that they are equipped to update the strategy as their life circumstances change.

Understanding their strategy and its assumptions will also hopefully help individuals to manage their expectations and to understand how their portfolios are likely to react during periods of heightened market volatility – Another key element to long-term success.

A robotic advisor will not question your inputs or help you put them into perspective. The advice and portfolio you receive will be based purely on the inputs you make into a robotic advisor’s Q&A.

If your goals, priorities or combination of goals are not perfectly clear to you, then you may inadvertently run the risk of providing inappropriate inputs to your robo-advisor which of course in turn will inevitably provide you with inappropriate outputs.

Another area of potential concern is that automated response algorithm investing without some human influence (be it your own educated self or a human advisor) can be hazardous to your long term financial well-being.

A good example of this is the so-called life-stage modelling which reduces “risk in portfolios” as people approach their retirement. The “glide-path” is automated, so for example, when you reach five years before retirement, your portfolio automatically reduces your equity exposure by 15% in favour of cash and fixed income. Then with 4 years to go a further automatic reduction takes place and so on. Unless you understand the implications of this you are opening yourself up to all sorts of potential risks – What happens if 5 years prior to your retirement, equity markets are at a bear market trough? Will your automated algorithm model still sell down to supposedly “de-risk” your portfolio right at the bottom of the market?

You will probably find that Robo-advisors are pretty good at individual goals but not as well equipped at prioritising or combining objectives. Helping you to understand your overall situation and the challenges you have ahead of you, prioritising multiple goals, and matching those up to risk appropriate investment solutions (find out more)* may require additional research or input outside of the scope of a robo-advisor.

Robotic advisers are more like sophisticated calculators that will use algorithms to provide you with a ‘model portfolio’ based on your answers to some pre-defined questions.

They do not possess artificial intelligence or technology that can benefit your financial success outside of what a good human advisor would.

They will not dynamically adjust your portfolio or strategy unless you change your own inputs.

They don’t have any superior ability to predict market returns or produce better performance.

You will still be assigned to the same funds you would have had access to outside of the robo-advice environment.

Your human advisor and your robo-advisor are probably both using financial models, largely based on the same investment or portfolio theory.

Both are likely to use some form of portfolio optimisation model which incorporates past performance and risk measures to determine an efficient portfolio allocation given your risk and return requirements.

While these tools do provide some useful insights they speak nothing of current valuations across the asset classes – The price at which you buy an asset is directly linked to the long-term returns you can expect to derive from that asset.

For example if you are considering a new lump-sum investment and you answer all the robo-advisor questions in a manner which confirms you are happy with ”high risk”, you will land up with a portfolio predominantly holding equities and listed property. This relatively arbitrary rule of thumb process does not take into account current market valuations. This is problematic because the risk and expected future returns of buying into an equity market which is trading at a Price-to-Earnings multiple (PE ratio) of 24x, is completely different to one which is trading at a PE of 12x. Evidence in research conducted in US equity markets, illustrates that periods of historically elevated PE ratios is associated with low investment returns in subsequent years – this makes intuitive sense but is not captured in a mechanical process.

In addition to these risk and return assumptions, models will use assumptions on inflation to determine future required contributions* which in turn will influence your specific strategy. Understanding what assumptions*are being used and how well they match up to reality in your robo-advisor strategy is therefore crucial to meeting your goals successfully.

Robo-advisors should by definition significantly reduce or eliminate your advice costs. But you should be aware that advice is just one element of what the cost of investing involves. (Find out more about fees here*)

An ill-informed individual could still be at risk of buying robo-advice services (at low or even no advice fee) which incorporate funds with high fund management fees and high platform fees, which in turn could potentially nullify the benefit of a reduction in advice fees altogether. This will still ultimately lead to a poor financial outcome.

By the way, the best way to eliminate advice fees is the same today as in pre-robo-advisor days. Improve your own personal finance and investment knowledge – Unfortunately that takes some time and effort on an ongoing basis and does not suit everyone.

Now in theory making your investment strategy as mechanical as possible would actually benefit most people because it would eliminate emotions from the decision making process.

If you have any experience managing your own finances then you will be aware that investing and emotional decision making are not good bed fellows.

But since individuals are emotional beings and prone to making emotional decisions, and since they will maintain the ability to override the robotic advisor, they remain exposed to falling into the same trap that most DIY investors and professionals alike tend to make, namely, selling out of market at the trough of the cycle and failing to get back in so missing out on the upside.

The risk is that people using Robo-advisors will struggle not to intervene with their strategy when markets go into free-fall. Note we said when and not if – that’s the cycle and that’s how markets generally work.

Perhaps even more importantly, behavioural traits and habits, which don’t even fall into the robo-advisor realm of competence, may scupper* many inidviduals hopes before they even get to accumulate any savings with which to approach a robo-advisor.

People frequently fail in their financial goals, and in turn therefore many of their life goals, because they fail to understand and control even the most basic fundamental personal finance decisions.*

A robo-advisor cannot help manage these behavioural aspects of your financial planning journey and so once again you need to understand what you are going to experience as a long-term investor and how to deal with it. This usually involves gaining experience and knowledge.

A platform that offers a robo-advisor service will utilise their own funds or a chosen suite of product provider funds to make portfolio recommendations based on your objective and risk profiling inputs.

You will not be told if there are better or more suitable options out there for your investment goals. No matter what you input into the system regarding your objectives or risk profile, you can be guaranteed that a robo-advisor will have a portfolio for you.

So in essence you will potentially get the portfolio that ‘most fits’ your inputs rather than a solution that ‘best fits’ your situation.

So a robo-advisor platform is essentially a different distribution channel for product providers to sell their own product or affiliated product.

An independent human advisor should NOT be focused on selling product. They sell a service and then theoretically use the best products and platforms to deliver on that.

Risk profiling is the process whereby you answer 20 questions which aim to determine your appetite for risk and perception of risk. Based on your answers you will be “profiled” into a pre-determined category, commonly something like: Aggressive; Moderate Aggressive; Cautious; Conservative; Low risk; medium risk or high risk.

These profiles are then linked to a model portfolio, which will typically have more equity and property in them the higher up the risk spectrum your answers take you, and more cash and fixed income the lower down the risk spectrum you fall.

While this process is required (not least of which by regulations) it is in my opinion of limited real value on its own.

In practice most people want equity like returns while taking cash like risk, which is clearly unrealistic. So risk is determined more by the objective, the time horizon and the contributions one can afford to make, rather than by the risk individuals would like to take.

Another point is that in the real world peoples risk profile changes. It changes when life circumstances change (we get older, we get wiser, we have kids, we get retrenched, we win the lottery). Our risk profile frequently changes when knowledge or financial literacy improves – understanding that cash is a risky investment if your objective is long-term wealth creation can be something of a conundrum to the novice investor.

Individuals using robotic advice services will need to understand the link between their risk profile, the model portfolio they are allocated into and the probability of then achieving their goals.*