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.
Diversification
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.)
Automatic Rebalancing
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.
Tax Optimization
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.
Performance
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-Advisor Industry
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.)
The Takeaway
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.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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Don’t think you’re ready to invest? This expert says think again
Do you suffer from investing inertia? Even though you know that investing in the markets may help achieve your financial goals and ultimately help you be more financially secure, you may have trouble figuring out just how and when to start.
That’s not unusual. For many people the thought of investing, especially during uncertain times and volatile markets, can put a dead stop to even the best intentions.
Manisha Thakor, Certified Financial Planner, Chartered Financial Analyst, Harvard MBA, and founder of the financial wellness consultancy MoneyZen, knows how this can happen.
Thakor has spent the past 25 years in a range of financial roles, all with an eye toward improving financial literacy and advocating for investors, particularly women. She is the author of two personal finance books and sits on the board of the National Endowment of Financial Education.
Here, she answers some of the most important questions regarding investing inertia. She shares her thoughts on why you should invest, and importantly, when you know you’re ready both financially and emotionally.
Related: What is a dividend?
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A: The art of investing is the ability to make decisions in the face of imperfect information. There are aspects about the overall markets that no one can know in advance. For example, what will happen to interest rates or when will the next market dip occur? This is also true for individual stocks and bonds. In fact, if someone did have perfect information about an individual security in advance, well, that could also be called insider trading!
Here’s the rub. It is precisely because we don’t have perfect information, because we are exposing our money to a degree of risk — well that’s what gives you the opportunity (but not the guarantee!) that your investments will grow faster than inflation. No risk, no return.
For many people, it’s extremely difficult to make a decision based on something they don’t know a lot about. They mistakenly think they “need to know it all” in terms of understanding the subtle nuances of investing before taking a step, thus keeping them paralyzed from making any decision at all.
Ironically, not making a decision actually is a decision when it comes to investing. Keeping your money in cash practically guarantees that your money will not keep up with inflation. Or said differently, doing nothing also exposes you to risk – the risk that your purchasing power will decline over time.
Interestingly, I’ve observed qualitatively that men seem to have an advantage when it comes to making decisions without full knowledge. Note, I want to be extremely clear that this does not mean the decisions are always good ones. In fact, a range of studies indicate that when women do invest, their investment returns tend to be slightly better than men’s.
What I’m talking about here is simply the propensity to “take the leap” into the market. A high comfort level with not “knowing it all” before making a move forward can also inform investment decisions. This is why we often see women, even those with plenty of savings, being more reluctant to invest than men.
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A: It’s usually a life event. Sometimes that life event can be as simple as having more money to invest. Perhaps you just got a new job with a higher salary, a different compensation structure, or maybe you received an inheritance. In my experience, men are particularly motivated by simply having the money to invest.
By contrast I’ve observed women with large savings still hold back. My unscientific hunch is that men are socialized to start talking about money and investing with each other earlier on in their lives, and that perceived financial fluency inspires them to take investment action.
When women are on the diving board, it’s often something bigger than themselves that helps them jump in. Getting married, getting divorced, having a child, caring for an elderly parent or the death of a loved one are all examples of something so important to women’s lives, they force themselves to take the investing leap despite imperfect information.
Of course, everything is a little different now because of the pandemic. Many people have seen their savings decimated from unemployment and health care costs related to Covid-19. On the other hand, other people who weren’t directly affected by Covid may have been able to save more during this period because their discretionary spending on things like travel and entertainment stopped.
That said, they may still feel plenty of anxiety about finances and the markets. That means, for now at least, the pandemic may be a life event that is holding investors back.
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A: You’re ready to invest once you have three core personal finance building blocks in place.
The first block? A solid emergency savings fund. It’s easy to think that if you just made more money, then you would be able to do this. Yet shockingly, the research shows that there are people making over $100,000 a year who still have trouble coming up with $500 in cash for an emergency — simply because they didn’t make this core building block a priority.
I think it’s vitally important to build up an emergency fund of three to six months of living expenses. That sounds simple but it can take up to five years for some people, especially if you’re also contributing to a 401(k) or other retirement savings plan. (Which you absolutely should be doing.)
The second building block: You’ve paid off all of your high-interest debt. What constitutes “high interest?” Here’s how I think about it. Over the very long run, stocks historically have generated a 7% return after inflation (using a 3% historical inflation rate – the future could be higher or lower.) So, if you have debt that has an interest rate of 7% or above, in most cases, it’s a better return to get rid of that debt before you start investing outside of a retirement account. Why? Because you’ve just guaranteed yourself a “return” of whatever that interest rate is — as you no longer have to shell out that money!
The third building block? Having money that you don’t expect to spend in the next five to ten years. That gives you a long runway to hold steady while the market inevitably goes up and down. One of the single biggest investment mistakes is selling when the market is down — either out of fear or worse, because you put money into the market that you knew you were going to be spending.
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A: This is a gigantic question that should be asked more often. If more people were aware of the two basic flavors of investing, my hunch is that people would be much less fearful of putting their money in the market.
I like to think of it like this. Some people like to drive in the left lane, weaving in and out to pass cars, speeding up to make it through the traffic light. Some people like to drive in the right lane, keeping to the speed limit and a straight line to their destination. Both drivers tend to end up at the red traffic light, albeit using different speeds! And of course, there’s always that one driver that zooms through right at the last minute of the yellow light.
The same goes for investing. Driving in the right lane is akin to investing in index funds and ETFs that mirror the markets. Driving in the left lane is akin to investors choosing actively managed mutual funds and ETFs or individual stocks and bonds.
In the right lane you are guaranteed to get whatever return that index generates (minus fees). In simple terms, you’ll earn the market return. In the left lane you have the possibility — but not the guarantee — to be that one car that makes it through before the light turns red. Because of the power of compounding, the incremental results of being that “one car” that generates much better returns than the overall market can have a gigantic impact. That’s the thrill of left lane investing.
I find that when potential investors understand that just like your driving style, you can find an investing style that matches your personality, they feel more comfortable investing. And of course, it doesn’t have to be all one or the other — many people choose a mix of the two. If I know a particular road well, I may drive faster and get to where I’m going faster. But if I’m unfamiliar, I may slow down and become less aggressive. The same thinking can be applied to your selection of an investment strategy.
Over the years I’ve noticed a tendency for many women to like the idea of right lane investing. While some may think we’re being “too conservative” — academic research shows that just like the car trying to weave in and out of the traffic, nine times out of ten you end up at the same place over the long run driving in the right lane, but with a lot less stress!
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A: When first-time investors are bombarded with information overload about investing in hot new trends like crypto and NFTs, it can make you even more reluctant to invest. When it comes to these hot trends, I actually think that’s a healthy gut reaction. To me, investing in these areas is like wanting to take a commercial rocket ride into space. Risky and not well-tested yet.
However, I fully realize that there is so much hoopla around these shiny new objects — headlines, broadcast reports, and social media posts — you can feel like you should be doing it too. My advice for first-time investors: Stay clear of these and focus on driving in that right or left lane. But if you absolutely can’t stop yourself from joining that loud, wild party, only invest money you can totally afford to lose.
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A: If you are a first-time investor, the power move is to focus on getting your three building blocks in order. Simply doing that will put you miles ahead of the average person when it comes to the health of your finances. Having these building blocks in place will go a long way towards increasing your comfort with starting to invest for the long run.
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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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