One of the biggest threats to the status quo of global financial advisory is the rise of the robo-advisor. Many investors, especially millennials, are flocking to platforms like Wealthfront, Betterment and Acorns rather than the traditional brokerage or financial advisor. So what exactly is a robo-advisor and how do they work?
What is a robo-advisor?
A robo-advisor is an online platform that provides financial advice or portfolio management without the need for human involvement. Robo-advisors, also referred to as automated investing platforms or digital advisors, manage your money based on algorithms that have been built to provide the advantages of a traditional money manager or stock broker, but without the cost or involvement of a person. The benefits include lower fees, less time investment, the insights of big data, tax efficiency benefits, predictive modeling and automatic diversification.
Should you use a robo-advisor?
At a high level, anyone can use a robo-advisor, but it really depends on your personal financial situation. There are a few factors that you should consider when choosing how to invest.
- Time investment – One of the key benefits of a robo-advisor is it takes a lot of the research and management of your money out of your hands. If you have limited time to research and learn the markets, this is a great option for you.
- Comfort level with automation – Are you are someone who prefers to have an advisor that you can call with questions? Do you want to know all of the ins-and-outs of how your money is being invested? Do you prefer the personal service of knowing that you have “a person?” If that’s the case, a robo-advisor may not be right for you.
- Goals – Are you trying to beat the market? Do you want to keep pace with the market? Are you trying to find the single stock gold mines that provide huge returns? Most robo-advisors aim to keep pace with the market or beat it (similar to traditional mutual funds), so if you have the day-trading, penny stock mentality, they may not be right for you.
- Diversification – Do you feel comfortable with a large portion of your money in ETFs or index funds? Do you like the rush of trading individual stocks? Robo-advisors will allocate and diversify most of your money in funds that they have pre-selected, so you may not be “playing the market” the way that you would be if you were trading stocks on your own.
- Comfort level with digital services – The use of a robo-advisor requires a comfort level with online platforms and the associated security. Most robo-advisors have bank level security, so there shouldn’t be concerns here, but some people are still not as trusting of handing over their money and information to purely online platforms.
Benefits of a robo-advisor
- Low cost/fees compared to traditional advisors. With a robo-advisor, you will typically pay between 0.25%-0.5% annually, while traditional brokers charge between 1%-2% per year.
- Accessibility. You can see your account in real-time 24/7 if you have an internet connection
- Ease of use. Without the need for a physical (or digital) interaction to make a trade or adjust your portfolio, the account gets managed with very little time involvement from your side.
- Low or no minimums. Many of the services and tools available through robo-advisors were traditionally only available to high net worth individuals.
Drawbacks of robo-advisors
- Very little human involvement. Sometimes, it is nice to have a live person understanding and responding to your personal financial situation, which robo-advisors cannot offer.
- Lack of sophisticated planning capabilities. For complex retirement planning, estate planning or more robust tax implications, robo-advisors do not have the same abilities as human planners in most cases.
- Lack of customization. The assumption with robo-advisors is that investors understand their financial situation, goals and the implications of their investments. This is not always the case. Robo-advisors do not have the ability to consult and help to figure those things out for you if you don’t already understand them.
- Fees. While the fees are lower than traditional advisors, you are still paying. With a robo-advisor, you will still be paying higher management fees than if you invested directly in a total stock market index fund, or similar option.
- Lack of risk management. When you have a financial advisor and a crisis or unexpected event occurs, you will know that your advisor has a plan. For instance, if the market falls 20% in one day, how do you want to respond? With robo-advisors, they are unable to see these extenuating circumstances, where a human advisor could alert you and put a plan in place.
As the market has evolved for robo-advisors, a number of them have cropped up in recent years. While many are similar, there are some slight nuances that you should research before deciding which platform to go with. Many of the traditional brick and mortar or online brokerages now have automated investing tools available as well.
- Learnvest (acquired by Northwestern Mutual)
- Personal Capital
Robo-advisors won’t be going away any time soon. If anything, you will see more of them coming to market in the near future, including offerings from the large traditional brokerages. They are a great option for those getting started with investing, or anyone who wants to spend less time and money on growing their money. Feel free to comment below with any tips or your experience using a robo-advisor.