• Go mobile
NOTIFICATIONS
Close
Chat 1701
+
4 months ago
Source

Robo-Advisors: All You Need to Know

PLUG

If you don’t have a background in finance, or if numbers just aren’t your thing, here’s some good news. There’s never been an easier time to pass on the task of managing your money to someone (or something?) else.

Thirty years ago, you would have paid a king’s ransom for others to manage your money. Knowledge about stocks and investments was sparse and hard to track down. But with the advent of the internet, those walls around financial knowledge have come tumbling down. Today, you have access to a plethora of investing services, and it’s never been easier to open an account with low management fees (we’ll get to why those low fees are so important below).

That’s a bad thing for professional money managers who were relying on your ignorance. It’s a great thing for everyone else.

Illustration of a robot trying to solve problems by consulting virtual apps.

Image source: Getty Images.

But even today, financial literacy doesn’t get the attention it deserves in America, and people get nervous making their own decisions about investments. It seems too risky. They want someone else to do it for them but don’t want to pay huge fees for that service. Enter robo-advisors — one of the strongest trends the financial services industry has ever seen.

What is a robo-advisor?

A robo-advisor is a website or app set up by a company to help manage your money. The robo-advisor invests your money according to an algorithm that is designed around maximizing your earnings with minimal human intervention. This ease of execution often allows for no account minimums and fees as low as 0.25% of your portfolio per year — that’s almost 90% cheaper than human-driven financial services!

The setup is simple. The algorithm can be tailored to your own life circumstances, taking several factors into consideration:

  • Your age and desired date of retirement
  • Your income level
  • The number of people in your household
  • Financial goals for your money
  • Your tolerance for risk

After getting your answers to questions like these, the robo-advisor is ready to start strategically investing your funds. That’s it — you’re free! Behind the scenes, a robo-advisor will take care of your diversification, asset allocation, and portfolio rebalancing. If you’re not sure what all that means, read on to learn more about how a robo-advisor can help you — and what risks it might entail.

This type of service is booming in popularity. According to Statista, the number of robo-advisor users has tripled since 2017 to almost 46 million people worldwide. That number is expected to continue its torrid growth rate: By 2023, 147 million people are expected to be using a robo-advisor to manage their money.

The history of robo-advisors

As alluded to in the beginning of this article, the cost of investing used to be large. There were onerous costs to place a stock trade and management fees if you wanted someone else to handle your money for you. Let’s tackle both in order.

Trade fees: In the 1970s, there was only one way for a do-it-yourself investor to place a trade: via a stock broker. The one-time costs to buy a single company’s shares could run to $45 (and often were much higher). And to place the trade, you usually had to have enough money to buy one “block” of 100 shares. This alone kept many nonwealthy individuals out of the stock market.

Let’s put this into perspective with a real-life example. In January 2017, I had $2,000 to invest in my family’s portfolio. We paid a $6 commission and bought 50 shares of Shopify. Today, those shares are worth $15,000. That’s a meaningful gain for my family.

But back in 1970 (though Shopify itself wasn’t a company at the time), it would’ve been very different. I would have been forced to wait until I could buy 100 shares of the company at once — and set aside an extra $50 just to place the trade. Because the price of the stock just kept climbing, I’m not certain I would ever have been able to purchase shares.

This problem was largely solved with the advent of discount brokerages in the 1990s. In fact, today, many investors are finding ways to trade without paying commissions at all!

Management fees: It is common for a financial planner to charge as much as 2% annually to manage your money. If you start with $100,000, that equates to $2,000 per year! Not only would you lose that money forever, but you also miss out on all future growth that could have been built with that “lost” money.

If you’re thinking “2%? That’s not so bad!” you’re not alone. To most of us, 2% seems quite small. But consider this: Knowing that the average annual return of the stock market is almost 10%, that 2% fee suddenly becomes a significant loss. That 2% of your total portfolio is the same as 20% of your total annual gain! And that’s a best-case scenario: Most financial advisors don’t beat the market, and don’t forget that a human advisor will still be taking his or her 2% cut even in a year of losses. That’s why, compounded over time, such fees were often the single largest line-item expense for a middle- to upper-class household.

This is truly where robo-advisors solve a critical problem. The ease of execution and low fees have attracted many users to invest funds with robo-advisors. As of 2019, the three largest pure-play robo-advisors — Wealthfront, Personal Capital, and Betterment — combine to manage more than $35 billion in wealth. But there’s still lots of room to grow. Robo-advisors have only been on the scene for a decade, and Statista estimates that robo-advisors have captured less than 1% of the entire asset management field they could one day garner.

What is the most important advantage of using a robo-advisor?

There are lots of technical advantages to using a robo-advisor, but a much more important benefit needs attention first: the emotional factor.

Believe it or not, we are all still wired to act and behave as hunter-gatherers, meaning our natural focus is almost always on the short term. It is unnatural for us to favor the long term at the expense of the short term, yet when it comes to trading and investing our money in the stock market, nothing leads to disaster more quickly than making decisions based on short-term emotions.

Setting up an account with a robo-advisor — especially if it receives automatic deposits every month from your paycheck — takes your emotions out of the equation and allows the cold, hard, calculating algorithms to do all the work.

At this point, it might seem like robo-advisors are the best thing since sliced bread. But keep in mind that there’s a flip side to this unemotional approach to investing: Robo-advisors don’t involve a lot of human contact. Although handing over the stress of decision making to a robo-advisor helps you sleep well most nights, there’s no one to hold your hand if/when the market is crashing.

What are the other benefits of using a robo-advisor?

Of course, you could always eliminate your emotions from the equation by turning over your cash to a human advisor (though they’re susceptible to the influence of emotions, too). But the benefits of robo-advisors continue.

For starters, there’s the benefit of reduced fees. Many robo-advisors can manage your money for as little as 0.25% of your portfolio per year. You’ll never get a deal like that with an actual human managing your money.

Robo-advisors can also do some of the heavy lifting of investing automatically:

  • Tax-loss harvesting: A robo-advisor’s algorithms can help lower your tax bill by buying and selling certain investments at certain times.
  • Automatic rebalancing: Every year, the robo-advisor algorithm looks at where your portfolio stands and decides if it needs to be rebalanced. If you aim for a 60/40 mix between stocks and bonds, for instance, but the stock market had a great year, you might be at 70/30. The robo-advisor will automatically rebalance the portfolio by selling some stocks and buying some bonds.
  • Changes as you age: Some robo-advisors utilize “goals-based investing” that focuses on different investment time horizons. For instance, let’s say you have an account to save for Junior’s college education. As high school graduation nears, the robo-advisor will shift toward more conservative investments to preserve capital that will soon be withdrawn.

These steps can be difficult and time-consuming for an individual investor to tackle, and a paid professional could do it — but at a much higher cost. That’s what makes using these efficient, cheaper algorithms so appealing.

But every form of investing has a potential downside we must take into consideration.

What are the risks of using a robo-advisor?

Although robo-advisors are quickly rising in popularity among investment solutions, they aren’t without their own unique risks.

For someone like me, who enjoys managing his own investments and doing research on them, I solidly believe that I can get better results than the algorithms.

Some robo-advisors — Wealthfront PassivePlus, for instance — will buy up to a thousand different stocks in your portfolio. By diversifying so broadly, this method starts to approach becoming an index fund. Index funds, much like robo-advisors that invest broadly across the market, greatly reduce the risk that you’ll suffer a cataclysmic decline from a single company declaring bankruptcy, but they also mute your returns.

In reality, only a small number of stocks drive huge investment returns over the long run. If you own 1,000 different stocks, there’s a high likelihood that you’ll own those stocks — which is a good thing. The problem is that each of these stocks will only account for 1/1,000th of your portfolio. Ultimately, this means that your portfolio will become tied very closely to the market overall. When your money is passively invested across hundreds or thousands of stocks, it will largely mimic the stock market.

There’s nothing inherently wrong with that. But if you believe “lower risk” and “no risk” are the same thing, you could be in for a world of hurt. The stock market in general can — and likely will again — fall more than 40% in a short time frame. Investing via robo-advisors doesn’t offer foolproof protection from such dives.

Plus, rather than tracking the market, wouldn’t you rather beat the market and rake in substantially greater returns? If you could devise a way to pick those big winners, then your investments could considerably outpace the wider market.

Because robo-advisors are relatively new, there hasn’t been enough time to develop deep research on the performance of these accounts. One such study, for example, shows slight market-beating returns for the top robo-advisors — but the time frame is just one year ending in December 2018. Investing is a decades-long process, so we should all keep our eyes peeled for more evidence as time goes on and data is collected.

Should I use a robo-advisor?

When it comes to investing your money, everything gets boiled down to four simple options: invest on your own, hire a professional to invest it, use a robo-advisor, or don’t invest at all.

Your answer to a few simple questions will tell you whether a robo-advisor is right for you.

  1. Do you like spending time researching investments? There’s nothing wrong with answering “no.” It’s far more important to be honest with yourself. If you don’t find this type of stuff particularly interesting, robo-advisors are worth checking out.
  2. Do you have clearly defined financial goals? If not, talking to a human is paramount. Some robo-advisors offer a human element, while others don’t. Either way, if you don’t have a clear vision for what you’d like to happen with your investments, robo-advisors can’t solve that problem for you.
  3. Have you covered your basic financial needs? Before investing any money, you need to have paid off your high-interest debt, saved up for an emergency fund, and made sure that you won’t be needing this money for the next three years. Such are the guidelines for any type of investment — robo-advisor or not.

For many Americans, robo-advisors may be a great option. Robo-advisors have a solid track record with low costs, tax advantages, and sensible risk-management strategies. But there might be better options to gain better market-beating returns if you are willing to put in the effort.

What are the important variables to consider?

If you’re interested in using a robo-advisor, there are five key variables to consider before making a choice.

  • Ease of use: Don’t waste your time on a website that is confusing or difficult to navigate. There are many options out there, so pick an interface that’s intuitive for you. Your attention should be focused on relaying your goals and life circumstances — not on how to navigate a site.
  • Customer service: At one point or another, you’re bound to run into problems. When it comes to troubleshooting, read up on which robo-advisor offers the best customer service. This can include everything from a call center to a chatbot that provides helpful tips.
  • Fees: A management fee of 0.25% is the gold standard. But check and make sure you’re getting the whole picture. Sometimes the items in which your money is invested — like an ETF — have additional fees. Other times, it may cost extra for a service like tax-loss harvesting. Do some digging and add them all together before making a decision.
  • Taxes: Not every robo-advisor will offer tax-efficient portfolio construction. Then again, that may not be of the utmost importance to you. Make sure you understand how your tax liability will be affected by using a robo-advisor.
  • Account minimums: Sadly, some of the robo-advisors with a more human touch have higher account minimums. Personal Capital, for instance, requires that you have at least $100,000 to invest.

Which is the best robo-advisor?

There are more than 30 robo-advisors to choose from. A simple Google search will yield a wealth of knowledge. Even then, some traditional brokerages and investment firms, such as Vanguard and Charles Schwab, are also included in that group because they have robo-advisor-focused offerings in addition to their traditional services.

Let’s focus on the top three pure robo-advisors — Wealthfront, Betterment, and Personal Capital — and see how they compare.

Wealthfront Betterment Personal Capital
Best for… Those just getting started on saving for retirement Households with modest nest eggs and specific goals High-net-worth households with complicated finances
Account min. $500 $0 $100,000
Fees 0.25% 0.25% to 0.40% 0.49% to 0.89%
Human advisors? No Yes Yes
Key feature No-frills option Goals-based investing Access to RIAs

Wealthfront

Wealthfront is probably the best bet if you’re looking for the cheapest possible robo-advisor and you don’t have a ton of money to start with. Although the robo-advisor does require an account minimum of $500, that’s a relatively low bar to clear for those that have their finances in order (read: have paid off all high-interest debt and have an emergency fund built up).

The fees for using Wealthfront are probably the lowest in the industry: 0.25% for all money the company manages. In other words, you’ll pay $250 per year — or about $21 per month — if you have $100,000 invested with the company. For your fee, you’ll get access to low-cost funds, automatic rebalancing, and tax-loss harvesting.

One way Wealthfront keeps the costs down is by skipping the bells and whistles that other companies provide. For instance, there are no human advisors for you to communicate with at a moment’s notice.

Betterment

The next step up in terms of service is Betterment. On the surface, you might think this is the cheaper option for newbies like recent college grads. Case in point: The company has no account minimum — meaning that even if you only sock away $10 per month, you could still open an account.

Dig under the hood a little and you’ll see that costs, however, are higher. Your account can be charged anywhere between 0.25% and 0.40% per year, depending on the plan you choose. Over the decades-long time frame, those costs end up being far more than the advantage of a no-minimum-balance starting point.

That’s not to say that Betterment’s extra fees aren’t worth it. For one, the company has human advisors with whom you can discuss the best plan for your own circumstances. It also practices a slightly more sophisticated form of tax-loss harvesting that is carried out on a daily basis.

Critically, the company also offers what it calls “goals-based investment advice.” This allows you to consider certain landmarks — like saving for retirement or a major purchase like your child’s college education — when determining your investment style. If you’re looking for that level of personalization and are willing to pay slightly higher fees, it’s worth looking into Betterment.

Personal Capital

Finally, and while this list isn’t exhaustive, we have Personal Capital. Of the three options covered here, it is definitely the Cadillac of plans. You need at least $100,000 to start investing with the company, and fees can range from 0.49% to 0.89% depending on your plan.

Of course, you’re actually getting something very tangible for your money. Clients talk with real, human Registered Investment Advisors (RIAs) prior to investing their money. The access to these RIAs — for fees that are smaller than would generally be found on the open market — are the key feature for many users. They can help navigate more complicated finance issues that come with having money tied up in different investments beyond simply stocks and bonds.

The fees paid don’t start going down until your account reaches a minimum of $1 million — giving you an idea of the net worth you’ll need before deciding to kick the tires on Personal Capital.

A final word on robo-advisors

The availability of robo-advisors as a modern investment option is an enormously positive development for most people. What was once the luxury of the uber-wealthy is now a convenient service within reach of the masses.

But you need to put in a little work at the start. Make sure you have a firm grasp on what your goals are, how your selected robo-advisor will help you achieve those goals, what fees you’ll be paying, and what you expect to get in return. Do your homework, and robo-advisors could provide valuable leverage in turning your modest retirement account into a robust provider of income in your golden years.

10 stocks we like better than Walmart
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, the Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of June 1, 2019
The author(s) may have a position in any stocks mentioned.

Brian Stoffel owns shares of Shopify. The Motley Fool owns shares of and recommends Shopify. The Motley Fool has a disclosure policy.

 

5 months ago
267 Views
Comments

Your email address will not be published. Required fields are marked *