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Pros & Cons of Robo-Advisors



Once upon a time, only the rich could hire an investment advisor. Fortunately for the rest of us, times have changed. Over the last two decades, robo-advisors have risen to disrupt the financial industry and offer affordable, accessible investment management for anyone with $20 in their pocket. While that sounds great, there are pros and cons of robo-advisors that you should consider before diving in.

Each robo-advisor comes with advantages and disadvantages and isn’t a perfect fit for everyone. But you no longer have to choose between learning to invest and hiring a professional advisor.

What Are Robo-Advisors?

When you have money to invest, someone has to decide where to invest it. That someone could be you or an investment advisor — or it could be a sophisticated algorithm, better known as a robo-advisor.

These algorithms operate on a few basic principles. The first and most crucial is diversification: They want your nest eggs spread across many different baskets so your portfolio doesn’t shatter when the next Enron comes along.

Robo-investors also employ a passive investing strategy, which dovetails perfectly with diversification. They don’t pick stocks or try to time the market. They buy passive index funds — funds that merely reflect broader stock indexes with no human interference.

Of course, there’s no one-size-fits-all approach to investing. Everyone has different financial needs and goals. But most people’s needs fit into neat categories, which is why robo-investing works well for them.

When you create an account with a robo-investing brokerage company, you complete a basic questionnaire. They primarily focus on your age, risk tolerance, investing goals, and your income and wealth.

Based on your profile, they recommend an investment plan. You don’t have to accept it and can choose other options as you prefer.

Robo-advisor plans operate as part of an investment brokerage service. Like any brokerage, you can open different types of accounts, from a regular brokerage account (taxed normally) to tax-advantaged accounts, like an individual retirement account (IRA), Roth IRA, or simplified employee pension IRA. The only difference is that they choose and manage your investments for you.

Pro Tip: Have you considered hiring a financial advisor but don’t want to pay the high fees? Enter Vanguard Personal Advisor Services. When you sign up you’ll work closely with an advisor to create a custom investment plan that can help you meet your financial goals.


Pros of Robo-Advisors

Like most tasks, humans do some things better, and machines do others better. Consider these advantages of robo-advisors before you hire a financial planner.

1. Low Fees

Why does anyone ever turn to automation rather than paying a human to do it? Simple: It costs less.

Human investment advisors typically charge 1 to 2% of your portfolio’s value every single year. For a $250,000 portfolio, that could mean $5,000 annually.

Robo-advisors charge a fraction of that, often 0.25% to 0.5% of your portfolio value. The fees for that $250,000 portfolio suddenly drop to $625 to $1,250 — potentially an eighth of the cost of a human advisor.

Further, robo-advisors don’t generally charge commissions to buy or sell assets within your account or to rebalance your portfolio. Human advisors sometimes do.

2. Automated Rebalancing

Most robo-advisors automatically rebalance your portfolio so it doesn’t drift outside your target asset allocation. If that was all Greek to you, it means they keep your portfolio looking the way it should look for someone with your needs and goals.

For example, imagine your target asset allocation is 90% stocks and 10% bonds. Stocks have a bad year, and by the end of the year, your portfolio has drifted to 85% stocks and 15% bonds. That triggers your robo-advisor to correct your portfolio, selling some bonds to buy more stocks.

Robo-advisors can also adjust your target asset allocation over time based on your age and other factors. As you get older and near retirement, your portfolio should become more defensive and income-oriented rather than aggressive and growth-oriented. You can worry about this yourself, or you can just let your robo-advisor gradually shift your asset allocation as appropriate for your profile.

3. Diversification

Since one of the fundamental principles robo-advisors operate on is diversification, they don’t bet the farm on one stock. Instead, they reduce risk by spreading your investments across many industries, market capitalizations, regions, and asset types.

They do that by investing in exchange-traded funds (ETFs) that in turn own hundreds or even thousands of stocks. In most cases, these ETFs are simply index funds that mirror a major stock market index like the S&P 500, NASDAQ, or Russell 2000.

It’s safer, and it works. Over time, broad market exposure gives you the benefit of high growth without high risk.

4. Accessibility

Human investment advisors only accept clients with a higher net worth. That net worth varies, but it’s never low since these advisors earn their money based on the size of your portfolio. Typically, these minimum portfolio requirements start at $50,000, and many advisors require much higher minimums in the six or seven digits.

That puts human advisors out of reach for most Americans, considering that nearly half of Americans don’t own any stocks at all, per a 2017 Gallup poll.

While some robo-advisors do require a minimum investment, many don’t and allow anyone with a few extra bucks to start investing them. It democratizes investing so anyone can do it with no specialized knowledge or preexisting wealth.

5. No Emotional Investment Decisions

One reason the average person’s investments underperform the market is emotional investing. They react to what the market has done recently rather than taking the long view.

After the market has risen for a while, they warm up to the idea of investing because it looks “safe.” Often, that’s the moment when it’s the least safe: when it’s overinflated and ready for a market correction.

Likewise, when stocks fall, investors panic and sell. That creates a vicious cycle of buying high and selling low, leaving inexperienced investors losing money on stocks rather than earning it.

Robots don’t do that. They invest based on sound, long-term investing principles rather than fear, greed, or hunches.


Cons of Robo-Advisors

For all those advantages, robo-advisors aren’t perfect. They can fall short for some investors, and there are some things you should know even if you do decide to invest with them.

1. Limited Flexibility & Personalization

Robo-advisors are designed for the masses. They base their decisions on investing profiles for people like you — not you personally.

Often, that means robo-advisors offer you a handful of investing plans to choose among, such as “aggressive growth” or “income-oriented.” They recommend a plan based on your profile, which you can accept, or you can pick a different plan. But in many cases, you can’t customize the plan.

Think of it like buying a suit or a dress. It’s much cheaper to buy a suit or dress off the rack than it is to have one custom-made for you. The same goes for managing your investments.

2. There’s No One to Manage Your Emotions

Robo-advisors don’t have feelings, which makes them better investors in most cases. But you’re human, and you have emotions, which sometimes need managing.

When the market drops by 8% in a week, some investors panic. Just because your robo-advisor won’t start panic-selling, what’s to stop you from pulling the plug on your account?

With a human advisor, you call them up in a panic and they reassure you. They talk you off the ledge. It’s part of their job, in fact.

But your robo-advisor is just a website with algorithms. You can log in, sell everything, and close your account. There’s no human intervention to slap some sense into you.

The harsh truth is that most of us are bad at investing. Algorithms are actually pretty good at it. But an algorithm can’t speak to you in the emotional terms you sometimes need to avoid bad investing decisions.

3. Limited Human Interaction

An emotional crisis isn’t the only reason you could need to talk to a human being. But humans are often in short supply in the virtual world of robo-advisors.

They all offer varying degrees of customer service, but speaking with a low-paid customer service rep over live chat is not the same as speaking with a financial planner with decades of experience. And sometimes, we need that reassurance of speaking with someone who truly knows what they’re talking about.

Granted, some robo-advisors offer hybrid human-robo-advising. The algorithm does the heavy lifting until you need to speak with a human advisor or customize your investments, at which time you can do so.

And, of course, those human-hybrid advisors charge accordingly.


Who Are Robo-Advisors Best For?

Robo-advisors are a reliable option for many investors, but not everyone. The types of investors who can benefit from a robo-advisor are:

  • Novice Investors. Robo-advisors are ideal for inexperienced investors who don’t know a price-to-earnings ratio from a pencil sharpener. Not everyone has the time or interest to learn about the differences between a mutual fund and an ETF, picking stocks, or analyzing dividend yields. And there’s nothing wrong with that — as long as you outsource the work to someone — or in this case something — that does know what they’re doing.
  • Lower-Net-Worth Investors. Likewise, robo-advisors allow less wealthy investors to gain access to the kind of expertise that simply wasn’t available to them a few decades ago. Many robo-advisors don’t impose any minimum portfolio requirement at all, so anyone can start building their portfolio with confidence in their investments.
  • Investors Comfortable With Technology. Let’s be honest. Your uncle who distrusts all things electronic is probably not the best fit for putting his life savings in the hands of an algorithm. If you couldn’t sleep at night knowing that artificial intelligence is managing your money, then don’t do it.
  • Investors Who Want to Set It and Forget It. Robo-advisors offer the ultimate passive form of investing. You don’t even have to transfer the money into the brokerage account every few weeks — they can automatically transfer savings for you, then invest it per your parameters. No stress, no headaches, no work. You just build wealth in the background on autopilot.

What to Look for in a Robo-Advisor

Not all robo-advisors are created equal. As you start searching for the perfect robo-advisor for you, there are a few points to keep in mind.

Flexibility

Some robo-advisors allow far more flexibility than others. If you want to keep more control over your investments or put together a more personalized investing strategy, pay close attention to the flexibility.

Look into what kind of plan options are available. Start by asking how many there are to choose among because some robo-advisors offer as few as five.

Also, check to see if the advisor offers a human hybrid option. A human advisor can help you tailor your investments more personally than the typical group plan.

Costs

Different robo-advisors charge different fees. While most fully automated advisors charge between 0.25% and 0.5% annually, some charge more, especially if they offer a human hybrid advising option.

Some robo-advisors also offer a free introductory period, such as zero management fees for the rest of the year. Sure, it’s a marketing gimmick, but that doesn’t mean it can’t be persuasive.

Beyond the annual management fee, look at the specific funds currently chosen by the robo-advisor. Fund managers, not the robo-advisor, charge an ongoing percentage fee called an expense ratio. These are listed as an annual percentage of the fund shares you own. But expense ratios vary dramatically, even among passively managed funds. Look for funds with low expense ratios to minimize losses due to fees.

Minimum Portfolio

Most robo-advisors require a minimum amount invested, even if it’s only $100. If a robo-advisor requires a $50,000 minimum investment, and you have $25,000, you can’t invest in it.

It sounds basic, and it is, but it’s still something to check before choosing a robo-advisor.

Access to a Human Advisor

Some robo-advisors now employ a hybrid approach to investment management. They allow you to speak with a human advisor as needed and add more customization to your portfolio.

While that’s not important to everyone, for some, it makes all the difference in the world. Just be prepared to pay more for services that include human advisory.

Available Account Types

Most robo-advisors let you open IRA accounts in addition to regular brokerage accounts. But some go further to allow other types of accounts too, such as trusts and 529 plans.

Some can even review your 401(k) investments even though they don’t manage your 401(k) account. They then make recommendations to help you choose better investments in your 401(k) to better align with your age and investing targets.

It’s a nice feature for investors with an employer-sponsored 401(k).

Tax-Loss Harvesting

Some of the more advanced robo-advisors offer a particularly intelligent service. They can automatically harvest losses toward the end of the tax year to offset your gains.

Tax-loss harvesting works like this: You bought a fund at a high price, it fell in value, and now, it doesn’t look like it’s going anywhere good in the foreseeable future. You could wait it out — or you could cut your losses, sell, and reinvest the money in a more promising investment.

It makes particular sense to take those losses in a year when you’ve made more money on other investments and Uncle Sam will tax you at a higher level.

The tax-loss harvesting feature is purely optional, and you may not want it. But it can help save you money come tax time and improve your returns in the long term.

Socially Responsible Investing Options

Some investors prefer to put their money where their mouths are and invest in funds that reflect their values. That’s easy if you’re picking stocks or funds yourself, but what happens when an algorithm chooses them for you?

A handful of robo-advisors now offer investing options catering to these investors. When you invest with them, you can opt for socially responsible investments if you prefer.


Choosing the Best Robo-Advisor for Your Needs

As you research the best robo-advisors on the market, bear in mind that there’s no single best service. Each serves a different set of needs.

I use Charles Schwab’s robo-advisor service, called Schwab Intelligent Portfolios. I like it because it’s 100% free for investors with over $5,000 invested, they don’t charge commissions, and their index fund ETFs mirror their respective indexes with extremely low expense ratios. They offer the more standard robo-advisor features such as automated contributions and automated rebalancing, and they even offer tax-loss harvesting for accounts with more than $50,000. They also offer a unique flat-fee premium service with human financial advisors.

Many female investors like Ellevest, with its woman-centric approach to investing tools and education. Investors with very little money to start with like SoFi Invest, which is entirely free and requires a minimum investment of $1. Wealthier investors gravitate toward Personal Capital, which charges more but offers all the flexibility and human service features wealthy investors want.

Choose based on your own unique financial needs rather than trying to find one universally perfect robo-advisor.


Final Word

With robo-advisors, investors don’t need to be rich to benefit from investment management. They’ve truly democratized investing, with completely free options available with no or low minimum investments.

The wealthiest investors may still prefer having a human advisor at their beck and call, but today’s hybrid investors offer that service as well.

Even if you enjoy occasionally investing with a little “play money” in individual stocks, robo-advisors can automate the bulk of your investing and keep it aligned with your long-term goals. With automated contributions, investments, and rebalancing, robo-advisors put your wealth-building on auto-pilot.

That leaves you free to focus on your career and your personal life and not spend your nights and weekends trying to learn the nuances of investing.

Are you open to trying a robo-advisor? Why or why not?

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.
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