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Bloomberg had an article yesterday that was one of the first of it’s kind – and I was glad to see it.

It addresses the universe of robo-advisers, which has grown to $50 billion in assets according to the Aite Group LLC.  Specifically, it addresses risk management in this space, or lack thereof.

Robo’s don’t need a lecture on the benefits of keeping costs low, proper allocation, and modern portfolio theory.   They are staffed with brilliant minds that understand the academic world of modern portfolio theory.   The problem is – the academic world is a much different place than the real world.  Investor behavior is a problem, especially during volatile markets. The Robo firms have no clue how people will react when money is lost.

The Robo space is growing, and overall, that’s a good thing for the industry as a whole.  But, it’s also important to recognize their growth has been buoyed by stocks not going down.  Who knows what’s in store for the market, I sure don’t, but I do know that stocks will behave like stocks – and sometimes prices go down.  I also know that people will behave like people.  Believe it or not, people don’t make rational decisions during times of increased stress, especially when it comes to money.  Irrational decisions are real…no amount of communication can avoid that, and robo’s offer no hand to hold.  What happens to the Robo industry during a prolonged market downturn?

I know, I know…the robo guys are properly diversified and that will protect account values!  I hope that’s not the plan,  Robo’s are full of holdings with relatively high correlations.  A prolonged downturn increases that correlation, reducing the benefit of diversification.   US Stocks, Real Estate, International Stocks, Emerging Market Stocks, etc all get their face ripped off in a nasty market environment.  More than just diversification is needed, and Robo’s don’t have it.

I know, I know…robo investors are typically younger and will be more patient during a market pull back!  Not True.  Humans are humans, nobody likes loosing money.  There is a threshold when all investors will have the urge to “Do Something”.  That’s an urge that should be avoided.  Robo’s have no mechanism to do so.

This isn’t a knock on the Robo industry…it’s the opposite.  I think the Robo trend is only beginning, I just think the current model is flawed.  Falling prices will determine just how flawed it is.

Here is the article if you are interested, it’s worth the read: FOR ROBO ADVISERS, THE NEXT BEAR MARKET IS A MAKE OR BREAK