Automated portfolios have become a common option offered by financial companies, providing many people with a cost-efficient way to invest for retirement and other goals — while helping to manage certain market and behavioral risks via automated features.
Because robo-advisors typically rely on sophisticated computer algorithms to help investors set up and manage a diversified portfolio, some have questioned whether technology alone can address the range of needs that investors may have — beyond basic portfolio management.
Others note that the lower fees and lower minimum balance requirements typical of most robo-advisors, in addition to certain automated features, may provide a much-needed option for new investors.
Is a Robo-Advisor Right for You?
Robo-advisors typically use artificial intelligence to generate retirement and financial planning solutions that are tailored to people’s individual needs. Here are some questions to ask yourself, when deciding whether a robo-advisor is right for you.
How Does a Robo-Advisor Pick Investments?
While the term robo-advisor can mean different things depending on the company that offers the service, investors usually fill out an online questionnaire about their financial goals, risk tolerance, and investment time frames. On the back end, a computer algorithm then suggests a portfolio of different securities based on those parameters.
For example one person may be investing for retirement, another saving for the purchase of a home. Depending on each person’s preferences, the robo-advisor generates an asset allocation that aligns with the person’s goals in the form of a pre-set portfolio.
A portfolio for someone nearing retirement age would typically have a different allocation versus a portfolio for someone in their 20s, for example. Depending on these details, the service might automatically rebalance the portfolio over time, execute trades, and may even conduct tax-loss harvesting.
Can I Choose My Own Investments?
A robo advisor typically has a range of investments they offer investors. Usually these are low-cost index exchange-traded funds (ETFs), but the offerings can vary from company to company. In most cases, though, your investment options are confined to those available through the robo-advisor, and typically you’re offered a selection of pre-set portfolios with limited or no ability to change the securities in that portfolio.
As the industry grows and becomes increasingly sophisticated, more companies are finding ways to offer investors new options like themed ETFs, stocks from different market sectors, socially responsible or ESG investing options, and more.
Who Manages the Portfolio?
Part of the appeal for some investors is that these portfolios are automated and thus require less hands-on involvement. This may be useful for people who are new to the process of setting up and managing a diversified portfolio, or who don’t feel comfortable doing so on their own.
In some cases, a robo-advisor service may also offer a consultation with a live human advisor. But again, in most cases the investor has limited control over the automated portfolio.
Are There Risks Involved in Using a Robo-Advisor?
Investment always involves some exposure to market risks. But robo-advisors may help manage behavioral risk. Many studies have shown that investors can be impulsive or emotional when making investment choices — often with less than optimal results.
By reducing the potential for human error through the use of automation, a robo-advisor may help limit potential losses.
What Do Robo-Advisors Cost?
While there are some robo-advisor services that have higher minimum balance requirements or investment fees, the majority of these services are cost efficient.
In some cases there are very low or no minimums required to set up a portfolio. And the management fees are typically lower than what you’d pay for a human advisor (although there are typically brokerage fees and expense ratios associated with the investments in the portfolio).
Pros and Cons of Robo Advisors
Hopefully, the questions above have clarified the way a robo-advisor works and shed some light on whether a robo service would be right for you. In addition, there are some pros and cons to keep in mind.
Pros of Robo Advisors
Saving for Retirement
It’s true that you can use a robo-advisor for almost any short- or long-term goal — you could use a robo advisor to save for an emergency or another savings goal, for example. But in many ways these services are well-suited to a long-term goal like retirement. Indeed, most robo services offer traditional retirement accounts like regular IRAs, Roth IRAs, SEP IRAs.
The reason a robo-advisor service can be useful for retirement is that the costs might be lower than some other investment options, which can help you keep more of your returns over time. And the automated features, like portfolio rebalancing and tax optimization (if available), can offer additional benefits over the years.
Typically, many robo portfolios require you to set up automated deposits. This can also help your portfolio grow over time — and the effect of dollar-cost averaging may offer long-term benefits as well.
Achieving a well-diversified portfolio can be challenging for some people, research has shown, particularly those who are new to investing. Robo-advisors take the mystery and hassle out of the picture because the algorithm is designed to create a diversified portfolio of assets from the outset; you don’t have to do anything.
In addition, the automatic rebalancing feature helps to maintain that diversification over time — which can be an important tool to help minimize risks. (That said, diversification itself is no guarantee that you can avoid potential risks completely.)
Similarly, many investors (even those who are experienced) may find the task of rebalancing their portfolio somewhat challenging — or tedious. The automatic rebalancing feature of most robo-advisors takes that chore off your plate as well, so that your portfolio adheres to your desired allocation until you choose to change it.
Some robo-advisors offer tax-loss harvesting, where investment losses are applied to gains in order to minimize taxes. This is another investment task that can be difficult for even experienced investors, so having it taken care of automatically can be highly useful — especially when considering the potential cost of taxes over time.
That said, automatic tax-loss harvesting has its pros and cons as well, and it’s unclear whether the long-term benefits help make a portfolio more tax efficient.
Cons of Robo-Advisors
Limited Investment Options
Most automated portfolios are similar to a prix fixe menu at a restaurant: With option A, you can get X, Y, Z investment choices. With option B, you can get a different selection, and so on. Typically, the securities available are low-cost index ETFs. It’s difficult to customize a robo account; even when there are other investments available through the financial company that offers the robo service, you wouldn’t have access to those.
In some cases, investors with higher balances may have access to a greater range of securities and are able to make their portfolios more personalized.
Little or No Personal Advice
The term “robo-advisor” can be misleading, as many have noted: These services don’t involve advice-giving robots. And while some services may allow you to speak to a live professional, they aren’t there to help you make a detailed financial plan, or to answer complex personal questions or dilemmas.
Again, for investors with higher balances, more options may be available. But for the most part robo-advisors only cover the basics of portfolio management. It’s up to each individual to monitor their personal situation and make financial decisions accordingly.
Robo-advisors have become commonplace, and they are considered reliable methods of investing, but that doesn’t mean they guarantee higher returns — or any returns. We discuss robo advisor performance in the section below.
Robo-advisors have grown quickly since the first companies launched in 2008-09, during and after the financial crisis. Prior to that, financial advisors and investment firms made use of similar technology to generate investment options for private clients, but independent robo advisor platforms made these automated portfolios widely available to retail investors.
The idea was to democratize the wealth-management industry by creating a cost-efficient investing alternative to the accounts and products offered by traditional firms.
Assets under management in the U.S. robo-advisor market are projected to reach about $2.76 trillion in 2023, according to Statista (estimates vary). There are dozens of robo-advisors available — from independent companies like SoFi Invest®, Betterment, and Ally, as well as established brokerages like Charles Schwab, Vanguard, T. Rowe Price, and more.
While this market is small compared to the $100 trillion in the global asset-management industry, robo-advisors are seen as potential game-changers that could revolutionize the world of financial advice.
Because they are direct-to-consumer and digital only, robo-advisors are available around the clock, making them more accessible. Their online presence has meant that the clientele of robo-advisors has tended to skew younger.
Also, traditional asset management firms often have large minimum balance requirements. At the high end, private wealth managers could require minimums of $5 million or more.
The cost of having a human financial advisor can also drive up fees north of 1% annually, versus the 0.25% of assets that robo-advisors typically charge (depending on assets on deposit). Note that this 0.25% is an annual management fee, and does not include the expense ratios of the underlying securities, which can add on another 5 or even 50 basis points, depending on the company and the portfolio.
How Have Robo-Advisors Performed in the Past?
Like any other type of investment — whether a mutual fund, ETF, stock, or bond — the performance of robo-advisors varies over time, and past performance is no guarantee of future returns.
Research from BackEnd Benchmarking, which publishes the Robo Report, a quarterly report on the robo-advisor industry, analyzed the performance of 30 U.S.-based robo-advisors. As of Dec. 31, 2022, the 5-year total portfolio returns, annualized and based on a 60-40 allocation, ranged from 2.84% to 5.12%. (Data not available for all 30 firms.)
Despite being relative newcomers in finance, robo-advisors have become an established part of the asset management industry. These automated investment portfolios offer a reliable, cost-efficient investment option for investors who may not have access to accounts with traditional firms. They offer automated features that newer or less experienced investors may not have the skills to address.
Robo advisors don’t take the place of human financial advisors, but they can automate certain tasks that are challenging for ordinary or newbie investors: selecting a diversified group of investments that align with an individual’s goals; automatically rebalancing the portfolio over time; using tax-optimization strategies that may help reduce portfolio costs.
Please understand that this information provided is general in nature and shouldn’t be construed as a recommendation or solicitation of any products offered by SoFi’s affiliates and subsidiaries. In addition, this information is by no means meant to provide investment or financial advice, nor is it intended to serve as the basis for any investment decision or recommendation to buy or sell any asset. Keep in mind that investing involves risk, and past performance of an asset never guarantees future results or returns. It’s important for investors to consider their specific financial needs, goals, and risk profile before making an investment decision.
The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. These links are provided for informational purposes and should not be viewed as an endorsement. No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this content.
Communication of SoFi Wealth LLC an SEC Registered Investment Advisor
SoFi isn’t recommending and is not affiliated with the brands or companies displayed. Brands displayed neither endorse or sponsor this article. Third party trademarks and service marks referenced are property of their respective owners.
Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at www.adviserinfo.sec.gov. Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at www.sofi.com/legal/adv.
Don’t think you’re ready to invest? This expert says think again
Featured Image Credit: Elena Katkova/istockphoto.