Updated on Friday, July 17, 2020
A robo-advisor is a digital investment advisor that creates a portfolio on your behalf, usually with the help of algorithms. Many robo-advisors have basic guidelines and use the principles of Modern Portfolio Theory (MPT), which asserts that asset allocation matters more than the individual investments in a portfolio when deciding how to assemble your account.
If youâ€™re looking for help choosing the investments to build your portfolio, a robo-advisor can be a great option. Weâ€™ll take a look at robo-investing so you can decide if itâ€™s right for you.
When signing up with a robo-advisor, you typically respond to a questionnaire thatâ€™s used to establish a general idea of your risk tolerance, investing time frame and financial goals. Once youâ€™ve completed the questionnaire, a portfolio is constructed for you, usually from a selection of exchange-traded funds (ETFs) and similar investments. The idea is to create an asset allocation that matches the general principles of investing for those who have similar characteristics to you.
While some robo-advisors might offer some financial planning help and a small degree of customization, you probably wonâ€™t get fully tailored investment solutions. Instead, many investors are drawn to robo-advisors for their ease of use, low cost and low barrier to entry.
Many robo-advisors follow similar rules to other investment advisory firms and are registered with the U.S. Securities and Exchange Commission (SEC). They also carry SIPC insurance, protecting investors against failure by the firm.
While not every robo-advisor offers the exact same features, hereâ€™s a sampling of what you might find.
Depending on the robo-advisor, you might pay an annual fee based on your account balance, or you might pay a flat monthly fee. For example, the average fee charged by robo-advisors, based on an account balance of $50,000, was 0.36% per year, or about $180. If you sign up for some robo-advisors, though, you might just pay a flat fee of $1 per month. Depending on your account size, that might be a better deal.
Itâ€™s important to note, however, that these management fees charged by robo financial advisors donâ€™t always include the expense ratios from the ETFs they use. So that could add another layer of cost. However, ETFs, in general, have low expense ratios.
In general, one of the reasons that people consider a robo investment advisor has to do with the relatively low cost. With automated investing, there isnâ€™t as much required of humans to manage your portfolio, so the idea is that costs are lower. On top of that, with robo investing, many of the portfolios are constructed using ETFs, which generally have low expense ratios. This also contributes to the relatively low cost.
On the other hand, a human investment advisor might charge more for their services. Many charge a percentage of your assets under management. According to a study by RIA in a Box, the total average fee for a traditional advisor is 1.17% of assets under management. This is over three times the cost of a robo-advisor.
You might be tempted to just manage your own investments to save money on management fees altogether. Some brokers have gotten rid of transaction fees for stocks and ETFs, making it possible for you to trade without paying these fees. However, you still have to pay expense ratios and other possible costs. Additionally, you might have to pay a transaction fee (in addition to fund fees) to trade mutual funds with some brokers. Most robo-advisors donâ€™t charge transaction fees, as those are baked into the annual management fee.
When trying to decide if robo-advisors are worth it, you should compare the pros and cons. Hereâ€™s what you need to know.
When choosing a robo-advisor, itâ€™s important to consider your needs and financial goals Here are a few things to keep in mind.
In general, robo-advisor fees are based on your account size and charged as a percentage of your assets under management. There are some robo-advisors, however, that charge a flat monthly fee. If there are other services, like financial planning, you might pay an additional one-time fee for the session.
While there are some free robo-advisors, the average fee for a balance of $50,000 is 0.36%. This is much lower than the average fee of 1.17% seen with human investment advisors. Still, youâ€™ll want to compare costs between robo-advisors to make sure youâ€™re selecting the best option for your financial situation.
Many robo-advisors donâ€™t require a minimum investment. Often, you can open an account with $0 and then invest when itâ€™s convenient. There are some robo-advisors that do have minimum balance requirements of $5,000 or more though, so itâ€™s a good idea to check. Look for a robo-advisor whose minimum you can meet.
Also, be aware that some robo-advisors allow you to â€śunlockâ€ť certain premium services once your account balance reaches a certain amount. For example, with Betterment, once you have $100,000 in your account, you get access to a financial planner (although the management fee is higher). If youâ€™re hoping to get more advanced and personalized help later, check to see if a growing balance allows you to gain access to these additional services.
Depending on your situation, you might want different types of accounts. While most managed investment accounts offer individual and joint taxable accounts, you might also be looking for other types of accounts, like trusts. Alternatively, you might also want a robo-advisor Roth IRA or a SEP IRA. Some robo-advisors offer help with college savings and allow you to set up custodial accounts for your kids, too.
However, not all robo-advisors offer all possible account options. Before opening an account, review the types of accounts to make sure youâ€™re getting what you want.
Many robo-advisors use their own investment algorithm based on the principles of MPT, which favors asset allocation over individual stock picks and holds that risk and reward are correlated. Additionally, many use different ETFs to construct portfolios. A robo ETF selection usually includes stocks, bonds and real estate investments.
Check the robo-advisor returns to see how different model portfolios perform. You can also get an idea of robo-advisor performance by looking at a prospectus from the different funds used. This will give you an idea of what to expect, even though past robo investing returns canâ€™t predict future results.
An index fund allows you to own a small piece of each investment in the fund. To buy an index fund, you normally need to go through a brokerage. Depending on the brokerage, there might be a selection of index funds that donâ€™t come with transaction fees. If you want to build your own portfolio, this can be one way to go about it. However, you still have to be aware of potential transaction fees and expense ratios.
With a robo-advisor, your portfolio is constructed for you, from a selection of ETFs the advisor favors. Itâ€™s important to note that, with ETFs, you donâ€™t own the underlying assets. If you donâ€™t mind a hands-off approach and donâ€™t care if you pick your own funds, this can be a good choice.
When choosing your own index funds and managing your own investment account, youâ€™re responsible for rebalancing and managing any tax strategy. With a robo-advisor, depending on the offered features, that can all be taken care of on your behalf.
With a robo-advisor, you can choose the general direction of your portfolio, in that itâ€™s possible for you to adjust your asset allocation. However, you wonâ€™t be able to do a lot of serious customization, and you might not get personal attention. Portfolio decisions are largely handled by algorithms, whether it has to do with tax minimization or portfolio rebalancing.
On the other hand, a financial advisor can provide you with more tailored advice. They can look at your situation and provide guidance based on your unique circumstances. Plus, depending on the services they provide, you might get access to a wider variety of asset classes and investment choices. If you want more involvement from a financial advisor, going this route â€” instead of choosing a robo-advisor â€” may make more sense.
In the end, a robo-advisor can be a smart choice, especially for beginning investors. It can provide you with a low-cost way to start investing without the need for a lot of specialized knowledge. If you decide later that you need more help with financial planning, or if you learn enough to branch out into managing your own portfolio, you can always move your money and invest in a way that makes more sense to your changing situation.