Caution: Robo-Advisor Ahead

Technology is a wonderful thing. It has shortened distances. It has made more information available to more people. It has increased our life spans, and simply made our lives easier and better. However, sometimes new technology should be approached with caution – most especially as the kinks are worked out. (Anyone who has ever upgraded to a new operating systems on an electronic device can appreciate this.)

This caution about newer technologies can be readily applied to a slew of web-based, automated investment management services. Said another way, know the risks of choosing any unproven investment portfolio allocation tool:

• Tax-Loss Harvesting Fallacy: Automated investing services take great pride in their ability to generate – or “harvest” – tax losses. The value of this strategy, however, is in debate.

While realizing a capital loss (for tax purposes) seems like a good idea in theory, crunching the numbers shows a different result: the tax-loss harvesting strategy can push clients into higher tax brackets later in life. The result increases the amount of money a client ultimately pays in taxes over their entire lifetime.  One financial planning thought leader – Michael Kitces – writes about this technique, saying that it can:

. . . actually drive up future tax rates and leave the investor worse off than having done nothing at all.

For most people (those with relatively smaller investment portfolios), the above will be a non-issue. Account holders with modest assets will face relatively smaller taxable gains and losses. However, for those with greater investable assets, the consequences of this strategy should be carefully scrutinized. (Curiously, sometimes these “tax-loss harvesting” features of the automated investment platforms are only available to those clients with larger asset bases.)

• Investment Selection: While diversification is great – which many web-based investment services provide – not all asset classes are worth investing in.

Said another way, some things you should simply never put your money into. Those things are investments that are too risky – and are unproven. Investments can be “unproven” given inferior risk-adjusted returns. In plain English, considering how much risk (a lot) is required for a given return (a little), there may be better investment opportunities available. This is especially important for clients in retirement – where risk management is paramount to investment return.

• Over-arching Tax Considerations: Automated investment managers do not take into account the specific tax needs of clients.

One example where you’ll get a one-size-fits-all approach: municipal bonds will be included in your portfolio – whether or not you are a high income earner. (Municipal bonds can offer tax-free interest payments. This can be beneficial for clients in a high marginal tax bracket.) For those investors not making $400K+/year, the inclusion of municipal bonds within a portfolio will generate a lower after-tax return than can be had if the investor had held taxable bonds. Simply, the investor earning modest income would be best served by holding different fixed-income products – those that are taxable.

Also, automated investment management services do not offer the option to delay or accelerate the realization of capital gains. Accelerating or delaying the realization of capital gains can be very useful for those clients whose income tends to fluctuate from year to year – i.e. small business owners. As with tax-loss harvesting, this issue is more significant for those clients with greater investable assets. For those with more modest accounts, the benefits of timing the realization of capital gains is less important.

∙ ∙ ∙

If you’re unsure if an automated investment management service is right for you, work with a fee-only financial planner to help you evaluate the pros and cons of web-based portfolio allocation tools. A fee-only financial planner can examine your unique financial circumstance, determining if a robo-advisor will work for your particular financial situation.

References

Kitces, M. (2014, February 5th). Wealthfront Tax Loss Harvesting White Paper – How NOT To Calculate Tax Alpha | Kitces.com. Retrieved from Nerd’s Eye View: http://www.kitces.com/blog/wealthfront-tax-loss-harvesting-white-paper-how-not-to-calculate-tax-alpha/