Robo-advisors are computer algorithms that generate financial advice for individuals. They typically offer lower fees, making financial and retirement planning more affordable for consumers. They also tend to have lower minimum balance requirements. Robo-advisors can steer investors, particularly inexperienced ones, from poor investment decisions. Their services often include rebalancing portfolios, executing trades and tax-loss harvesting.
Such features have attracted individuals who may have been deterred by the higher costs of human financial planners. However, the robo-advisor industry is still new relative to the traditional financial-advice market, and it remains to be seen whether it’ll benefit consumers more in the long run. For instance, individuals with complex investment needs may still find some human advice helpful.
In order to make sure they are choosing the right robo-advisors, consumers can check that they are getting enough diversification for their portfolios. A robo-advisor that still offers human planners who can provide educational opportunities for consumers could also be a good option. Individuals can adjust their preferences for types of investment risk with their robo-advisors if it changes in order to make sure they are not missing out on returns in financial markets.
Such measures can help consumers maximize the benefits of robo-advisors while still enjoying the relatively low costs.
How Does Robo-Advising Work?
Robo-advising uses artificial intelligence to find retirement and financial planning solutions that are tailored to people’s needs. Consumers typically fill out online questionnaires about their financial goals, risk tolerance and investment time frames.
For instance, one person may be saving towards retirement, others towards the purchase of a home. Some individuals may be in their twenties and therefore be willing to invest in more volatile assets such as emerging markets, which could also potentially lead to bigger returns in the future.
Meanwhile, an individual closer to retirement may prefer investments in more stable assets like Treasurys or consumer-staple stocks. Some people may also say that socially responsible investing is a priority for them.
Depending on the consumer’s preferences, robos comes up with the appropriate allocations into different assets and sectors. The robos typically then rebalance portfolios, execute trades and perform tax-loss harvesting.
Factors such as robo-advisor returns, minimum balances, fees, security measures and educational opportunities are among the factors that consumers consider when choosing a robo-advisor. Individuals also tend to see if the robo offers tax-loss harvesting and automatic portfolio rebalancing without fees, as well as whether the opportunity to speak with human advisors is available–or “hybrid robo-advisors.”
Said to have started in 2008, robo-advisors have since grown quickly, estimated to amass $1.4 trillion in assets in 2020. That’s expected to grow to $2.5 trillion by 2023. While these figures are still miniscule compared to the $90 trillion in the asset-management industry as a whole, robo-advisors are seen as potential game-changers that could revolutionize the world of financial advice.
There’s also still a huge untapped market for financial planning and asset management in the U.S., with 75% of Americans managing their own finances without professional or online advice. A separate study found that four in ten workers “guessed” what they would need for their retirement savings.
Traditional asset management often have large minimum balance requirements from clients. At the high end, private wealth managers could require minimums of $5 million. The cost of having a human advisor also drives up fees versus the 0.25% of assets that robo-advisors typically charge.
Because they are direct-to-consumer and digital only, robo-advisors are available around the clock, making them more accessible to individuals. Their online presence has meant that the clientele of robo-advisors has tended to skew younger.
Betterment and Wealthfront were some of the earliest robo-advisor services companies. While robo-advising was initially dominated by startups, they are now part of a suite of services offered by traditional asset managers such as Vanguard, Schwab and Fidelity.
Pros of Robo-Advisors
1. The near rock-bottom fees of robo-advisors tend to make them cheaper than human advisors. Robo advisors typically charge just about 0.25% of assets.
2. In addition to their low fees, robo-advisors can be more accessible to individuals. Research has shown that people who seek investment advice tend to see greater returns on their investments, making professional or online advice an important part of their financial goals. As people’s life expectancy has climbed, more individuals are stressed about outliving their assets, making robo-advisors a good option.
3. Younger users have used robo-advisors because the services are online and since they often have lower minimum balances. Starting to save and making financial plans early is an important step towards investment goals. Users can be as young as college students to start investing.
4. Because they rely on automated asset allocation and trading, robo-advisors can help individuals remove the emotional aspect of their investing practices. This, in theory, could help them not sell their investments after prices drop and are actually near their bottom.
5. Because they lack a human component, robo-advisors may be better equipped to avoid potential conflicts of interest. However, the growth hybrid robo-advisors and the fact that more traditional money managers have entered into the space may make conflicts still possible.
Cons of Robo-Advisors
1. Critics say the algorithms that dominate the robo-advisor industry still lack sophistication, making the financial advice not ideal for individuals with more complex investment needs. Say for instance, a consumer would like exposure to the commodities or derivatives market. This may be trickier to achieve with robo-advising currently.
2. Some individuals still prefer what’s called the “warm body effect”–having a human explain to them what their best options are. Robo-advisors can be like buying a “black box” for some people, with little awareness of the algorithms dictating their investment choices. Having face-to-face meetings may also help some consumers learn more about investing and financial planning in general.
3. Investors may not be getting the right diversification. Because some robo-advisors lack sophistication and many only put investor funds into ETFs, investors may not be getting the right asset allocation. In addition, people’s stomach for risk changes. So while an investor may be feeling risk-averse at one point, he or she may be willing to take on riskier assets later. This could allow them to maximize the potential of their returns.
4. If a robo-advisor shuts down, consumers may be forced to sell or accept a replacement service that’s less suited for their needs. There can also be tax implications that are unexpected.
5. Robo-advisors are a still relatively untested industry. More time may be needed to gauge whether they offer greater benefits to investors versus more traditional financial advisors.
Robo-advisors haven’t been around long enough to really gauge whether they offer better financial outcomes for consumers than human advisors. Research has shown financial advice tends to help inexperienced investors, so using a low-cost robo-advisor may be beneficial to such individuals. Consumers can make sure they’re getting the right diversification and educate themselves on their robo-advisor choices.
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