What Is a Robo-Advisor?
Robo-advisors, automated investing services or online advisors create investment strategies and manage your investment through computer algorithms. Meanwhile the general process of a robo-advisor remains similar to the one financial advisors e.g. at banks use, the whole process takes place online without human intervention but based on algorithms. This has the advantage that wealth planning also becomes accessible for small investment amounts. Robo-advisors usually use ETFs to invest, some might also use equity portfolios directly.
Most robo-advisors are limited to portfolio management, this means robo-advisors only consider asset classes without taking into consideration real estate or retirement planning. A financial advisor instead sees a more holistic picture of the clients and provides overall advice. Robo-advisors usually offer:
- Asset allocation of your investment based on your preferences and risk affinity
- Rebalancing of your portfolio, automatically within limits or at regular intervals, e.g. every quarter.
- Tax optimization strategies, e.g. tax-loss harvesting for taxable accounts
Why Should I Use a Robo-Advisor?
As mentioned in our Academy financial advisors either earn their salary through commissions or through direct fixed payment from the customer. If they earn it through commissions, they are likely to suggest products with higher commissions.
Usually, the better companies for the client offer less commissions as they want to keep the money to invest in order to receive higher returns. If you pay a financial advisor directly, he will only be interested if there is a minimum revenue that he can generate. This would be around $5,000 annually, either to be paid as a direct fee or as a percentage of the overall value of the portfolio (usually around 1%).
Others might charge by the hour which pushes the time pressure and decreases the quality of the suggestions.
How Much Does a Robo-Advisor Charge?
Robo-advisors charge less than 1% of the money under management annually. E.g. Betterment charges 0.15 to 0.35% of the money under management annually, Wealthfront is free for the first $10,000 and takes 0.25% percent annually for more than $10,000 under management.
As seen in the example, costs of robo-advisors vary from service provider to service provider. Costs can be differentiated into:
- Management fees are usually 0.25% to 0.5% of the invested capital annually.
- Funds’ expense ratios are fees from the funds the robo-advisor invests in. Usually, this fee is around 0.05% to 0.65%.
- Incidental fees: Usually there are not many incidental fees, however service providers might charges fees to set-up an account or for special services.
However, you are free to manage your account, it does not cost anything to buy and sell, move money out of your account or change your allocation if your risk tolerance changes.
How Do Robo-Advisors Work?
Robo-advisors ask for your preferences and give you a suggestion concerning the asset allocation and the respective instruments to invest in. On an ongoing basis, the robo-advisor adjusts your investments automatically to keep your identified target asset allocation.
Robo-advisors mostly invest in ETFs and manage your ETF portfolio, therefor your choice concerning the investment is limited. This makes sense for smaller portfolios, bigger portfolios can be managed more actively and other factors like taxes have to be taken into consideration more thoroughly.
Who Should Use Robo-Advisors and What Are the Limitations of a Robo-Advisor?
Robo-advisors are a convenient solution for beginners with small amounts of less than 25.000$ to invest. However, robo-advisors only cover a certain area of possible investment products, e.g. company benefit programs and tax-favored solutions like the 401(k) in the USA are not regarded.
Here, a professional advisor might have some specific advice or you might want to dig deeper by yourself. Therefore, keep into consideration:
- Robo-advisors are a low-cost solution for beginning investors.
- Robo-advisors provide services at low-cost but they do not provide integral financial planning, which is much more complex.
- Robo-advisors do not necessarily protect from mistakes like buying low, selling low or making irrational decisions. Also they do not protect from market fluctuations as they invest mostly into ETFs. You still need to stay cool at a market low.
How Do I Find a Robo-Advisor That Suits Me?
To find the right robo-advisor for you, you should take into consideration different criteria:
- Investment Fees: Management fees are a general amount charged for managing your money from the robo-advisor company and Funds’ expense ratios go directly to the ETFs that you invested in and are basically the management fee of the ETF.
- Minimum Investments and Promo Offers: Some robo-advisors have a minimum investment that they require, others are free up to a certain amount. Others may have promo offers that are interesting for you.
- Advice and other services: Some robo-advisors offer regular stock trading at the same time, advice on estate planning, insurance, mortgage and taxes. Some offer financial advice, however, this will cost extra but offer you a one-stop solution.
- Ethical Investing: Some robo-advisors offer investments in social and environmental-friendly portfolios.
- Apps: Some robo-advisors are more focused on their App than others. Make your mind up how important this is for you.
There are several different robo-advisors available and they mostly operate only in specific markets globally.
Summary
Robo-advisors provide services, not financial planning. Therefore, robo-advisors provide a low-cost solution to investors who are just getting started and lack experience and an initial investment amount to invest so that a financial advisor is too expensive.
Robo-advisors should be used as any other implementation tool with caution as you are still free to take your money out of the market. A robo-advisor does not necessarily protect against forgetting to continuously invest, sell low or buy high or any other irrational decisions.
