By T.J. Porter, WCI Contributor
Investing is one of the most effective ways to build wealth, but figuring out how to invest and actually build and maintain a portfolio can take time. Robo advisors are a relatively new way to invest that uses algorithms instead of humans that can put much of your investing plan on auto-pilot.
Robo advisors, for a fee, can handle the entire investing process for you, designing a portfolio and maintaining it based on your contributions and withdrawals. We’ll break down the pros and cons of robo advisors and how to decide if they’re right for you.
What Is a Robo Advisor?
Many brokerage companies, including Vanguard and Fidelity, now offer robo advisory services. A robo advisor is a program that handles the day-to-day investing tasks on your behalf. Typically, when you sign up for a robo advisor, you’ll need to answer some questions about your investing goals and risk tolerance. Based on your answers, the robo advisor will design a portfolio for you.
When you deposit funds into your account, the robot advisor automatically invests them. As different securities gain or lose value, the robo advisor will also rebalance your portfolio to maintain the target asset allocation. When you make withdrawals, the robot advisor handles selling securities and sending the money to you.
Robo advisors can also handle other investing tasks—such as tax-loss harvesting—which many robo advisory companies claim can improve your after-tax returns. Whether it improves them enough to justify the fees is a different question.
Because robo advisors are programs and not people, they tend to charge much less than human investment advisors, and they claim that they can offer better returns due to their impartial analysis of investments.
Benefits of Robo Advisors
There are many advantages to consider when you’re thinking about investing through a robo advisor.
- Low fees: Most robo advisors charge less than traditional investment or financial advisors. Typical fee structures are a percentage of your invested assets. Most companies will charge between 0.25%-0.75% of your invested assets per year. Compare that to the 1% Assets Under Management (AUM) fee that many financial advisors charge their clients. Most of the time, it's going to be less expensive to use a robo advisor.
- Cutting-edge technology and strategies: Since all the investing is automated, robo advisory services can use cutting-edge technology and new strategies to try to generate the highest possible returns while minimizing risk. Many base their investment strategy on modern portfolio theories that aim to increase overall earnings.
- Tax-loss harvesting: Most robo advisors offer tax-loss harvesting. This strategy involves selling underperforming investments for a loss and then buying a similar investment without impacting overall portfolio returns, allowing you to deduct those losses on your income taxes (a maximum of $3,000 per year).
- Low minimum investments: Most robo advisors are very accessible, letting investors get started with as little as $1,000 or less. But some may have much higher minimums or they might lock certain features, such as tax-loss harvesting, behind higher minimum balances.
- Combine human and software assistance: Because the software handles the day-to-day investment management, robo advisory companies can give their human staff more time to speak with their clients to learn about their goals and needs and to address things like tax planning or other financial concerns.
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Drawbacks of Robo Advisors
Robo advisors can be great for some people but have some noteworthy drawbacks that you must consider.
- Lack of flexibility: Most robo advisory services are inflexible. They construct portfolios from a set list of securities (usually Exchange Traded Funds) and can’t deviate from those securities. That can mean they ignore some useful, but more complex, strategies—like options or other asset classes.
- Limited personalization: Robo advisors ask for information about your risk tolerance and goals, and they will personalize your portfolio based on those factors. However, most can’t personalize your portfolio further. If you want to leave out certain types of stocks, such as vice stocks, that wouldn't work with a robo advisor.
- May require you to use them as an all-in-one solution: Robo advisors work best when they know all of your investments. That lets the program construct the ideal portfolio for you based on your goals and risk tolerance. If you have investments outside the robo advisor’s portfolio, such as through a company 401(k) retirement plan, it may not account for those investments when designing your portfolio.
- Can't be used with your 401(k): They generally only manage IRAs and taxable accounts. If you'll need to do your 401(k) or 403(b) on your own (or pay an advisor to do so), what's the point of the robo advisor? If you know enough to do the 401(k), you know enough to do the IRA. If you need an advisor for your 401(k), then they should be doing the IRA too. Thus robo advisors are only good for those without a workplace retirement plan, which is a pretty limited set of people at any point in life and almost no investor for their entire life.
- No financial planning: Robo advisors are generally just asset managers. Most people seeking out a financial advisor don't realize that most of the value they're getting is in financial planning, not in investment management.
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Is a Robo Advisor Right for You?
Robo advisors are designed to handle every step of the investing process for you. That means designing your portfolio, managing your investments as you add or subtract funds, and making adjustments based on your portfolio’s performance.
If you like the idea of a 100% hands-off investing experience and all your money is an IRA and/or a taxable account, a robo advisory might be a great choice for you. That’s especially true if you don’t mind the fact that you won’t be working directly with a human advisor.
If you have a 401(k) or another employer-provided retirement plan, you’re a more hands-on investor, or you want to implement complex strategies that rely on anything besides ETFs, a robo advisor probably isn’t the right choice. A robo advisor also isn’t suitable for investors who want a human that they can talk to and rely on for investing help.
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Where to Find Robo Advisory Services
Robo advisory services have grown far more popular in recent years, expanding from specialized companies that were the first ones to offer it to now where many major brokers have added it. Some of the best robo advisors include:
- Betterment: Betterment was one of the first robo advisory services. It charges a low fee of 0.25% of your invested assets and invests your money in low-cost Vanguard mutual funds. It also offers other services, like automatic crypto investing and cash accounts.
- Vanguard: The Vanguard robo advisor, called Digital Advisor, lets you get started with just $3,000 in your brokerage account. Like most Vanguard products, it is inexpensive at 0.20% of your invested assets or less.
- Wealthfront: Wealthfront gives investors the flexibility to design their portfolios from a selection of hundreds of funds and cryptocurrencies and then automates the investing process. Like Betterment, it charges 0.25% of your invested assets each year and offers cash accounts.
- Schwab: Schwab Intelligent Portfolios is unique in that it has no advisory fees or commissions. You can get robo advisory service for free if you have at least $5,000 to invest in your Schwab account. However, it may offer slightly more limited portfolio options and states that it keeps a portion of your investment in cash, which could impact returns.
Robo advisory services are cheap and easy to use, but they're not a great option for most people until they figure out how to handle employer-provided investing accounts. Plus, if you’re a more hands-on investor or want human assistance with your portfolio, you may want to look elsewhere for investing services.
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