If you’ve considered getting serious about your portfolio, you may have heard the term robo-advisor. Many people are under the impression that traditional (human) advisors are opposed to this alternative. This is not necessarily the case; in fact, we at Practical Financial Planning think that robo-advisors can be the right fit for many people whose circumstances may not call for customized investment advice.
What is a Robo-Advisor?
A robo-advisor is an automated investing service. Instead of building and managing an investment portfolio yourself or hiring an advisor, a robo-advisor uses algorithms, model portfolios, and computer software.
Robo-advisors typically include limited interaction with an advisor and can be set up quickly (often in just a couple of minutes).
1. What Are the Advantages of Using a Robo-Advisor?
One of the clearest advantages of using a robo-advisor is low account minimum requirements. Unlike investment managers who may charge a minimum fee or have a minimum level of required Assets Under Management (AUM), most robo-advisors have low or no minimums. This can be an appealing alternative for investors with smaller portfolios.
As with hiring a human advisor, robo-advisors can help reduce the chance of human error or behavioral bias. Using automated algorithms to invest reduces the investor’s chance of making a mistake or falling prey to a gut reaction. It helps reduce emotional but unwise reactions to market changes. While you may be inclined to change your strategy based on what you see on the news (almost always a mistake), a software program won’t do that.
Robo-advisors can be a great way to set-and-forget your investments. They’re typically programmed to automatically rebalance, without a need for you to take any action.
2. What Are the Disadvantages of Using a Robo-Advisor?
Robo-advisors can’t replace the one-on-one, tailored advice and strategies of an investment advisor. They typically only offer limited options for investment portfolios, so if you’re looking to integrate your portfolio into the rest of your financial plan, a robo-advisor won’t be able to tailor your strategy to your needs.
This is especially true for those who have less straightforward financial situations. For example, a robo-advisor would usually be ill-suited to those who have rental real estate, stock options, or who own their own business.
Many robo-advisors advise on an account-by-account basis. Others may look at many accounts, but only those you hold with them. So, if you have outside accounts, such as company 401(k) plans, a robo-advisor may not accommodate these different investment accounts. If you need to integrate these various accounts or have other more complex investment needs, you’ll want to work with an advisor directly. (Be aware that not all investment advisors will look at your entire portfolio, so be sure to ask your advisor if (and how) they will advise you on your 401(k).)
Unlike hiring a holistic financial advisor, robo-advisors only look at your investments, not your whole financial picture. They may provide some tools to help with topics such as retirement planning, but they do not offer much guidance on how to use these tools.
3. Who Primarily Uses Robo-Advisors?
Robo-advisors could be considered a compromise between DIY investing and hiring a professional financial advisor. It can be a time-saving and cost-effective option for those who have a simple investment strategy or are just looking to automate their investments. Robo-advisors are also advantageous for young investors who can’t hire an investment advisor but still would like to get started building a portfolio.
4. What Does a Robo-Advisor Cost?
Robo-advisors vary in cost, but most charge a percentage of the assets under their management. This is typically anywhere between 0.25% and 0.50%, but some providers charge more. Some providers may offer robo-advisor services at a flat fee rather than a percentage of the assets under management. You may have to pay additional fees associated with the investments themselves (such as an expense ratio for a mutual fund).
5. What Services Does a Robo-Advisor Offer?
Robo-advisors are available through several providers, and the services they offer may differ. Common services to look for include:
- Automatic rebalancing of your portfolio (or rebalancing at regular intervals)
- Tools you can use for other financial planning services (such as a retirement calculator)
- Tax-loss harvesting
6. What Are the Alternatives to Using a Robo-Advisor?
If you’re interested in investing but don’t believe a robo-advisor is a good fit for your needs, you can choose between two primary options.
Option 1: Financial Advisors
Working with an investment or financial advisor will help you develop a customized, tailored portfolio. This relationship builds a more personalized strategy, and it makes use of the expertise and guidance of a professional who is focused on your specific needs. Some advisors even incorporate robo-advisor platforms into their offerings, allowing them to work with younger clients (or those who don’t yet meet their asset minimums).
Option 2: DIY Investments
DIY investing requires you to research and select all your investments (stocks, bonds, real estate, etc.) on your own. Some investors choose to work with a financial planner to build a comprehensive financial plan but manage their portfolios independently. We do not recommend this. It deprives the investor of the real, measurable benefit to their rate of return that can be provided by the advisor—not in terms of outperforming investment selection, but in helping the investor to establish the appropriate strategy, to carry it out tax-effectively, and to stick to it in times of market volatility.
Selecting a robo-advisor, especially if you’re investing with a smaller amount to start, can be a suitable way to begin building your portfolio. If you’re unsure whether one is right for you or not, start by comparing the offerings of different robo-advisors. While robo-advisors can be a great place to start your investment journey, after a few years, many people find that their financial situation has changed enough that it is time for the benefits of a fiduciary financial advisor.