How Robo-Advisors Can Protect Your Assets During A Stock Market Drop

by: Barbara Friedberg
Summary

The stock market will fall.

Individual investors might prosper from diverting a portion of their funds to a digital investment manager.

Investing with a robo-advisor might protect you from excessive losses in the next market downturn.

Any investor who’s aware of stock market history or invested for more than ten years knows that markets go up and down. Even newbies, who lived through the 2018 market volatility saw the S&P 500 lose 4.23% last year.

Despite a ten-year bull market, there’s ample evidence that a correction will occur. Just as the business cycle waxes and wanes, the stock market also rises and falls.

Even the smartest investors might behave irrationally when their investment values decline. Research shows that while the stock market returned roughly 9% annually 1928 through 2018, investors typically realized lower returns.

Even smart investors make dumb mistakes.

Had you invested in SPDR S&P 500 ETF (SPY), ten years ago and kept your money invested your annual return would have been 15.83%, despite a 2018 4.45% drop. Staying the course is smart investment practice, yet difficult to implement.

Behavioral finance research shows that many investors panic when markets decline and ultimately under-perform unmanaged index funds.

How Robo-Advisors Can Save You From Yourself

Robo-advisors, barely ten years old, are low-fee computerized managers who oversee your investments in accord with your risk tolerance levels. Betterment and Personal Capital were among the earliest robos launching in 2008. Since then, scores of digital investment managers launched.

Where robo-advisors shine is in their non-biased portfolio management.

Typically, you input your age and goals. Next, take a short risk tolerance quiz and the digital investment manager creates an index ETF portfolio in the allocation that fits with your responses. If you don’t like the asset allocation, you’re able to adjust it to fit your preferences.

Some robo-advisors offer financial advisor access, like Betterment and Personal Capital. Most provide rebalancing, tax-loss harvesting, socially responsible investing and tools to help with portfolio analysis.

Even if you’re a DIY investor, allocating a portion of your assets to a robo-advisor can simplify life and guard you from making rash investment decisions.

Investors panic. It’s common for investors to bail when the markets drop. Adding insult to injury, those same investors then let their fear keep them from buying ‘on sale’ assets at the market bottom and only buy back in after a significant rebound. That behavior can be summed up as selling low and buying high – the opposite of the best investing practices, buying low and selling high.

This maladaptive investor behavior is common, even among seasoned investors.

Robo-Advisor Strategy to Cushion Stock Market Losses

Here’s an investment approach to save you from inadvertently damaging your investment returns.

  • Choose a low fee, customizable robo-advisor like Schwab, Betterment or Wealthfront.
  • Invest 25 percent, or a reasonable portion of your assets in either a taxable brokerage or IRA account.
  • Choose an asset allocation that is more conservative and tilts towards bond investments.
  • Commit to leaving the money invested.

Placing a layer between you and the buy or sell button on your brokerage account dashboard makes it difficult to trade.

By nature, humans are lazy. Should you panic if markets drop, you’re less likely to go into the robo-advisor platform and liquidate your holdings or adjust your asset allocation. This keeps you from acting irrationally.

In choosing a more conservative allocation for your robo-advisor invested assets, this portion of your investment portfolio will be less volatile. So, even if an equity-heavy brokerage account tanks, the robo-advisor's returns remain more stable.

Another benefit, no need to rebalance or oversee the robo-advisor account because it’s being managed for you.

Should I go With the Best Performing Robo-Advisor?

It’s tempting to seek out the best performing robo-advisor and invest with that firm. Please don’t use that approach. The purpose of this strategy is to protect you from yourself and to offer stable returns. You’re not looking to beat the market with the robo-advisor account.

Your goals for robo-investing are:

  • To provide a layer of protection between you and your investments.
  • To invest conservatively and reduce portfolio volatility.

With this strategy, your robo-advisor account is one component of your investment strategy.

As with mutual funds, chasing performance is rarely successful. As Mark Hulbert found, after years of tracking the performance of individual investment newsletters, rarely does an outperformer repeat. The same reversion-to-the-mean phenomenon applies to mutual funds. Last year’s top performer is infrequently at the top of the pack the following year.

Whether you invest on your own or with a financial advisor, it's beneficial to divert a portion of your investments to a robo-advisor. Financial markets are volatile. While a robo-advisor won’t eliminate investment volatility, having an account more conservatively allocated, with a layer of oversight, might keep you from acting impulsively. After all, investing isn’t only about getting the highest returns, but also about preserving capital.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have an account with Betterment and Wealthfront and use the investment dashboard at Personal Capital.