WTF Is a Robo-Adviser?
Yeah, you guessed it right. It’s a robot that advises. But this robot has a very specific task: to help humans manage their investments. Robo-advisers — or robos, for short — are computer programs that do the heavy lifting for investors.
Robo-advisers also go well with investors who feel more comfortable working with a computer than with a human being (that is, a financial adviser). Cost is a big factor, too. Robots charge a lot less to handle your money than humans. For these reasons, they’ve been attracting many millennial and do-it-yourself investors who want easy and speedy online transactions. Who wants to deal with some old guy in a suit in a stuffy office?
How Robo-Advisers Work
Using sophisticated algorithms, robos can automatically select investments to build a diversified pool, or portfolio, for anyone who has some money to invest. They can buy stocks, bonds, commodities, mutual funds, and exchange-traded funds (ETFs) for the portfolio, although most robo-managed portfolios just purchase inexpensive and easy-to-use ETFs. The robo can tailor a portfolio to fit your needs, fears, and dreams. What are your goals? A new house? College? Financial security?
Further Reading: “Setting Financial Goals That Work”
Over time, the robo-adviser will automatically buy or sell investments to match the investor’s level of risk tolerance (how much are you willing to lose?) and investment-allocation plan. During good times, most investments increase in value. It’s best to sell your winnings while looking for bargains. This is called rebalancing, and it is one of the standout features that robos offer.
Another thing that earns praise? They can automatically sell losing, hopeless investments to reduce your taxes, a process called tax-loss harvesting. Think of the robo-adviser as the ever-vigilant watchdog and fixer that ensures you don’t miss out on tax-saving opportunities while keeping you true to your investment personality, which likely falls into three categories: conservative, moderate, and aggressive. Tell the robo by way of a questionnaire whether you’re a risk-taker or a worrywart and how many years you plan to invest, and voilà, it will create a specialized plan for you — and make you stick to it.
What Is a Financial Adviser?
Before I move on, I need to mention the robo-advisers’ human counterparts, who as a professional class have been around much longer than computers. To be fair, not all financial advisers are old guys in suits. A lot of them are young, in their 20s and 30s, and committed to helping their generation.
Further Reading: “Partner With the Right Financial Adviser”
Robots can manage your portfolio without any real drama. If there’s a conflict, you can override the computer. But robo-advisers can’t match the human-to-human connection when you’re investing, and over time, money needs grow more complicated.
Financial advisers come in all sorts of names and descriptions: brokers, financial planners, insurance agents, and registered investment advisers. Robots can’t pick up on the subtle nuances of body language that humans can. When you are building wealth, a family, or a business, you’ll need more than a computer program for assistance. Only a human being can properly craft a retirement strategy or an estate plan for that time when you need to hand off your wealth to you kids.
Computers are good at managing money, but not our lives. That’s why financial advisers offer tremendous value that may be worth the added cost. Someday, when you’re older and have more complex finances and goals, you’ll probably need to hire a real-life financial adviser.
Is a Robo-Adviser Right for You?
Robos can be ideal for young investors who have simple goals and no investment experience. And you don’t need that much money to open an account. (For example, Stash Invest requires only $5 as an initial deposit.) This is hardly the case with financial advisers, who typically demand thousands of dollars in account minimums before they’ll give you the time of day. Some robos don’t initially require money at all to open an account.
Further Reading: “Struggling to Invest? Here’s One Way to Start Small”
Automated online guidance and decision-making works well for those who lack the confidence or know-how to do it themselves and those who know a little about investing but can’t be bothered with complex and time-consuming chores like making trades, filling out paperwork, reading and analyzing reports, and so on.
But what really makes robos a perfect choice for young investors is cost and performance.
Robots are cheap compared with humans. On average, traditional financial adviser typically charges an advisory fee of one to two percent to manage an investment portfolio. Meanwhile, robos charge 0.40 percent, on average, on an investor’s account value. That’s a $40 annual fee on $10,000 invested.
Most robo-advisers passively invest in ETFs that track indexes, namely the Standard & Poor’s 500. They never try to beat the market, but simply match it. Financial advisers tend to “actively” manage their clients by attempting to beat the market, which over the long run is costly and rarely outmatches returns for the passive approach.
There are other notable benefits, as well. Robos will give their customers access to living, breathing financial advisers online or over the telephone. And robos are legally classified and regulated under federal law as registered investment advisers, commonly called RIAs, which means that they’re lawfully required to act and advise in the best interest of a client (that’s you).
Further Reading: “You Should Fire Your Financial Adviser If They Are Not a Fiduciary”
The Case Against Hiring a Robo-Adviser
Again, it’s about human interaction. Some of us don’t mind dealing with an online computer when playing the markets. Others need constant hand-holding that only a human adviser can provide.
Here’s something to keep in mind: The robo-adviser industry emerged a decade ago, just as the markets started rebounding from a steep decline during the Financial Crisis of 2008 to 2009. Since then, most investors have grown accustomed to relatively steady gains. Investors also are smitten with the passive-investing approach — just put your investments on autopilot and watch your money grow without having to lift a finger or worry about risk.
The robo approach to investing could make you complacent. But what happens in a time of crisis, when the markets tank and trillions of dollars vanish overnight?
How do robos stack up against humans? At such times, the biggest threats facing investors are their fear and capacity to make irrational decisions. Just one bad decision can wipe out years’ worth of investment gains. Do you think a computer program can use reason and logic or emotional intelligence to prevent you from selling at a huge loss in a panic? Humans can.
Further Reading: “WTF Is Market Volatility?”
What to Look for When Choosing a Robo-Adviser
The robo-adviser industry has taken off in recent years. There are more than 200 robos in the United States, managing about $200 billion in assets for their clients. Some are independent start-ups, while others are the big wealthy money managers that run Wall Street. Some offer hybrid plans — robo combined with a human financial adviser.
Given the stiff competition, robos are all forced to keep their expenses and fees low as they compete for clients. Cost is paramount. Most robos will charge an advisory fee ranging from 0.15 percent to 0.89 percent. Some don’t even levy advisory fees, but make up the revenue through other fees and services.
That brings me to another point: When choosing a robo, keep an eye out for other fees that are charged in addition to the advisory fee. Each time your portfolio makes a trade, you pay for it. Costs range from $7.95 to $49.95 per trade. Another fee is an expense ratio, which you must pay if you own mutual funds or ETFs, the mainstay of most robo portfolios. Other factors you should pay attention to are minimum deposits to open an account, the selection of investments and products offered, and the robo’s assistance-and-support infrastructure.
Further Reading: “The 4 Best Investing Apps to Make Investing Easy”
The concept of automated portfolio management isn’t new. For years, financial advisers have employed software to create investment portfolios for their clients. Robo-advisers simply got rid of the human element and made the software affordable, as well as consumer- and retail-friendly.
I’ve considered going robo, but have never pulled the trigger. There was one robo that caught my eye: Vanguard Personal Advisor Services. It’s a hybrid, charges a 0.30 percent advisory fee, gives you access to wide selection of low-cost ETFs, and has billions in assets. The only drawback is that you need to have $50,000 to open an account. I eventually decided I’d rather manage my own investments.
But robos and young investors may be the perfect match. I suggest Betterment, which launched the industry in 2008, as a good one to start with. I like its low advisory fee and the fact that it has no minimum balance to open an account. That said, shop around. Not every robo is the same. But there are a lot to choose from, so finding the one that best matches your needs and goals should be easy.
Further Reading: “WTF Is Artificial Intelligence?”