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For robo-advisers, the next bear market is make or break

The challenge facing robo-advisers is they haven't encountered a large economic downturn before.

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Robo-advisers might have more reasons to be worried about the next bear market than investors do.

Low fees and an investing-on-autopilot approach have attracted about $50-billion (U.S.) in assets to the broad universe of robo-advisers, according to researcher Aite Group LLC. The rise of these robots and their automated investment strategies has largely coincided with a multiyear bull run in stocks, which means the nascent industry could face a big test if markets were to turn.

A bear market would represent a challenge that the ranks of robo-advisers haven't encountered yet, and it would be the ultimate test of just how crucial, or irrelevant, working with actual humans is to good, long-term investing.

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"The biggest issue right now is that we haven't seen what a big downturn looks like [for the robos]," said Nick Colas, chief market strategist at Convergex. "Younger investors could be more patient, but the bottom line is to what degree does human intervention play a role. This is what financial advisers get paid for."

To try to live up to client expectations, robos are analyzing data on client reactions to recent bouts of volatility.

In theory, using algorithms to analyze client behaviour and manage portfolios should be a robo's big edge. For example, robos can see what size stock-market drop gets a client logging in more often or causes someone to sell stock. They can then send a pro-active message about how volatility is normal, reminding the client of market rebounds he or she missed by selling into previous down markets and parking money in cash.

"A human adviser knows which client gets skittish, and we can know the same thing through technology," said Tobin McDaniel, president of Schwab Wealth Investment Advisory, which oversees the company's robo-adviser.

Betterment LLC and Wealthfront Inc., two of the largest independent robos (with $4-billion and $3-billion in assets under management, respectively), both saw big jumps in account logins after last year's Aug. 24 market turmoil, when the Dow Jones industrial average dropped roughly 1,100 points in the first five minutes of trading.

That didn't necessarily lead to much action – Wealthfront chief executive Adam Nash said that less than 1 per cent of clients opted to lower their so-called risk scores, which govern how conservative or aggressive their portfolio mix is, as a result of that volatility.

The robos say they are better equipped to help clients deal with future volatility after the market's recent drops. "We've used each of these downturns to learn what works," said Dan Egan, director of behavioural finance and investments at Betterment. "We tested pro-actively reaching out to customers and that didn't work." Monitoring client logins – and having popups or personal messages appear when someone logs in, for instance – has been the better option instead of Betterment being quick to reach out, he added.

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Reading too much into the frequency of logins can be tricky though, Wealthfront's Mr. Nash said. "Some people, when markets are choppy, actually check their account less often, not more. It's the ostrich syndrome."

Calming clients in a downdraft is especially crucial for robos because many of their clients are younger and have high allocations to the stock market.

Meb Faber, co-founder and chief investment officer of Cambria Investment Management, points out that while stocks typically outperform bonds over the long term, they are more volatile and likely to have bigger corrections. Those market swings might not bother younger investors as much as their parents, in part because they aren't watching markets as closely as past generations did.

That's good, Mr. Nash said, because paying close attention to market news leads to worse trading decisions. "The benefit of an automated service is that we have an increasing number of young people who have decided not to focus their time on their portfolio, but are focusing on friends, their career, their social life. Fewer young people believe their path to fortune is buying or selling a stock today."

Robo-advisers have weathered the recent market storms pretty well. Betterment and Wealthfront have seen continued growth in customer accounts and net deposits, even after the volatility in August and the first few weeks of 2016. January and March of this year were Betterment's best for customer growth and net deposits, CEO Jon Stein said.

Wealthfront's Mr. Nash said the firm added three times as many clients in January, year over year, and saw fewer changes in risk scores as well, meaning that clients aren't choosing to make their portfolios more conservative as a result of recent market volatility.

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In the end, perhaps there really is only so much that a traditional adviser – or even a robo-adviser – can do to stop investors from doing the wrong things.

"Human behaviour is going to be human behaviour," said Josh Brown, CEO of Ritholtz Wealth Management.

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