August 7, 2013

The Advisor of the Future: Neither Human Nor Robot, but Cyborg

As the world moves increasingly into the digital age, technology-driven solutions continue to threaten the traditional way things are done, and the world of investment management is no exception, as numerous "robo-advisors" have cropped up in recent years with an aim to threaten and disrupt financial advisors. Yet the reality, at least so far, is that virtually all of the offerings are narrowly constrained to just portfolio solutions—where the world of mathematics and algorithms work well—with little capability of addressing the rest of an individual's financial picture.

But perhaps the biggest caveat of robo-advisor-driven solutions is that for many consumers, the real issue is not a cost-efficient portfolio solution, but managing the self-inflicted "behavior gap" where many investors, as a result of their own greed and fear, achieve inferior results. It's not clear that robo-advisors will have any solution to these behaviorally driven problems; just as a website that says "eat less and exercise more" doesn't solve the country's obesity problem (because it's a behavioral problem, not an information problem), it's not clear that robo-advisors and their portfolio construction recommendations will fare much better by providing information solutions for what are ultimately investors' behavioral challenges. Furthermore, at this point it's only the human advisors that address the entire set of comprehensive financial planning goals for clients.

Nonetheless, the reality is that a purely human solution isn't always better, either; many of the things advisors do can in fact be implemented far more efficiently with technology, and overall it's important to acknowledge that there are some things that humans do better but some things that really are done better by computers. Which means in the end, the real winner may not be the robo-advisors, nor the human advisors, but the technology-augmented humans—the cyborg advisors—who blend human and technology together into an optimal financial advice solution for consumers.

The Rise of the Robo-Advisor

One major theme of recent years has been the rise of the so-called "robo-advisor," which can be defined as online computer platforms that provide financial advice directly to consumers, mathematically analyzing the client situation to come up with portfolio recommendations. These companies, like Betterment and Wealthfront, claim the promise of less expensive and more accessible financial advice for the mass of consumers by cutting out the cost of the advisor.

Using the tools of modern portfolio theory, the robo-advisors have built algorithms to construct optimized efficient-frontier portfolios for their investors (assuming, of course, that you still trust purely quant-algorithm-based portfolio construction in the aftermath of the financial crisis!). Added on top of this portfolio construction advice are some additional value-adds that are conducive to technology scaling (and algorithmic analysis), such as effective asset location (at least if you have multiple types of accounts with the platform), automated rebalancing and ongoing tax loss harvesting. Each of these features has been shown in separate industry research to potentially bring significant value to the table (although in many client situations, blindly implementing tax loss harvesting without an awareness of client circumstances can actually result in wealth destruction, not wealth enhancement).

On the other hand, while they do leverage technology for some significant value-adds, at this point the algorithm-driven platforms are generally constrained to only analyzing investment portfolios. To date, no robo-advisors have implemented any algorithms to analyze a client's estate plan and help them understand how to best protect, manage and distribute money to their heirs. Nor do any robo-advisors evaluate a tax return, or show clients what risks they are exposed to that need to be insured (and how much to insure them for), or coordinate retirement withdrawals with prudent tax planning and when to begin Social Security benefits, etc.

In other words, robo-advisors at this point are little more than robo-investment-advisors; they do not compete with comprehensive financial planning, which remains a significant differentiator from commoditized passive strategic portfolio management.

Human Advisors Serving Human Clients

Notwithstanding the lack of comprehensive financial advice, the most significant fundamental problem with a robo-advisor-driven solution is that it assumes our problems are problems of information; if only we had more knowledge, and better tools, we could all achieve financial success. Therefore, as the business pitch goes, the robo-advisors will use technology to scale the solutions for this information problem, bringing quality portfolio solutions to the middle class.

The caveat, though, is that most of our problems are not really problems of information. Having a website that constructs for all Americans a well-balanced portfolio and tells them to save more and spend less won't solve our country's financial woes, any more than having a website that constructs for them a well-balanced diet and tells them to eat less and exercise more would solve our country's obesity crisis.

The problem is not one of information, knowledge and technology-scaled execution. The problem is behavioral.

In the second part of this blog series, I’ll discuss specifically what this cyborg will look like.

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