In recent years, we’ve seen a lot about robo-advisors. It seems like the hot new way to invest.
But what is a robo-advisor?
A robo-advisor is a computer algorithm or program that manages your portfolio rather than a person. The term robo-advisor is a misnomer because this type of program is limited to investment management, whereas a financial advisor looks at retirement planning, estate planning, insurance needs, taxation needs and other topics that are not part of the investment portfolio.
How do robo-advisors work?
You typically sign up online with a robo-advisory firm. Some of these are the same firms that might provide traditional advice – brokerages, banks, and fund companies. You fill out a questionnaire assessing your risk profile, return needs, and investment knowledge. The program chooses a portfolio based on your answers. Once the portfolio is chosen, the program automatically invests money you provide, and also reinvests income earned in the portfolio.
Most robo-advisors operate using principles of asset allocation according to modern portfolio theory. Using algorithms based on your answers, your portfolio will be adjusted over time.
What about the fees?
Robo-advisors typically charge an amount based on how much you invest with the company. The percentage tends to be lower than a traditional mutual fund and is comparable to buying exchange traded funds (ETFs). Another way of charging fees is to charge a fixed dollar amount each month. Payments are automated and linked with your back account. ETFs are often the cheapest way to gain access to various markets, and most robo-advisors use these products to keep costs down and liquidity high since most clients of robo-advisors are smaller investors.
What are the limitations of robo-advising?
In order to keep things simple and costs low, robo-advisors offer a limited number of portfolios. These are typically a low-risk, medium-risk, and high-risk portfolios.
Low-risk portfolios feature higher allocations to cash and bonds, while high-risk portfolios are composed of 90% to 100% equities. A medium-risk portfolio is similar to a balanced fund with 50% equities and 50% fixed-income as a general simplification (the numbers might balance out differently).
If you want to choose individual stocks, derivative products, specialized funds or other securities, you likely will not be able to do this with a robo-advisor. If you believe in a fund manager picking securities for you (also called active management), a robo-advisor platform won’t meet your needs. If you want customized planning or advice, a robo-advisor might not work well for you. You also need to map out the purpose of your investment portfolio in the context of your personal situation before starting. If you want help with integrated long-term financial planning, you need to look for a person, not a robo-advisor.
Who is the ideal client for a robo-advisor?
Robo-advisors are best for people with smaller amounts of money, and who do not want to manage their own portfolios. If you want to automate the dividend reinvestments in your portfolio, or all of your investments in one account, a robo-advisor allows you to outsource the management of individual accounts and save time monitoring your investments. If you are building up the assets in your accounts, a robo-advisor is a good way to maintain exposures without having to trade yourself each month or quarter. Robo-advisors are suitable for you if you are looking to buy ETFs and obtain the average rates of return in a given market for the lowest cost.
How do I choose a robo-advisor?
The products offered by robo-advisors are very standardized in terms of portfolios and costs. Comparison shop the various providers and choose a company that offers the best value for your money. The reputations of most firms are generally very solid, and the execution of the trading is consistent across companies. The level of service provided may be a consideration, but it is not likely you will deal with a person unless there are problems or you have inquiries that do not have standardized responses. There are many companies launching new platforms, so it would make sense to revisit what is available in the marketplace.