Robo-advisors use algorithm-generated investment advice to help individuals manage their money. Consumers have gravitated toward the lower fees and convenience that are the hallmarks of robo-advisors.
Here’s how robo-advisors work. Individuals fill out questionnaires online about their financial plans or investment goals. They select preferences on how much risk they want in their portfolios and over what time period they’d like to be invested.
The robo-advisor then makes asset allocations based on the individual’s selections. Following the initial investment, the robo-advisors also can then rebalance the portfolios, make trades and conduct tax-loss harvesting. This is in contrast to active investing, when consumers take on a more hands-on approach with their investment selections.
How to Evaluate Robo-Advisors
Robo-advisors are cheaper because they don’t require the cost of hiring human financial advisors who require salaries. Robo-advisors also tend to put customer money into low-cost exchange-traded funds or ETFs–investment vehicles that trade like a single stock but allow investors to wager on a basket of public companies or assets.
One important attribute of robo-advisors that consumers can consider are their performances, or returns on their investment. Returns by robo-advisors can reveal the sophistication of the computer algorithm that generates the portfolio allocations. Such proprietary algorithms can be based on investment theories that have been developed by Nobel-Prize winning economists.
However, because it is such a nascent industry, robo-advisors don’t necessarily have the long track record of returns that consumers can use to reliably judge their merit. Plus, past performance is not necessarily indicative of future returns.
Like with many investments, it can also be helpful to compare results against performance by a benchmark. For instance, a consumer can look at the returns by their robo-advisors versus returns by the S&P 500, the benchmark stock index.
But judging a robo-advisor goes beyond performance. Consumers can look at a variety of factors when picking a robo-advisor, including fees and the minimum balances required. Other important features can be security measures that the robo-advisor takes to protect their consumers’ data, as well as potential educational opportunities that teach individuals more about investing and financial planning.
The options to speak with a human advisor and socially responsible investing may be available. The platform’s ease of use can also be an important factor when consumers are choosing a robo-advisor.
Below are the average returns of some robo-advisors compiled by Backend Benchmarking, a Martinsville, New Jersey-based firm that follows the industry. The data in Backend Benchmarking’s Robo Report has been cited by several business publications. The returns shown in the table are after fees and are as of Sept. 30, 2020. All returns for periods longer than one year are annualized.
|Robo-Advisor||Third-Quarter 2020||YTD (through 9/30/20)||2-Year|
Source: Backend Benchmarking
Evaluating Recent Robo-Advisor Returns
The S&P 500 has climbed about 12% in 2020 through the end of November. But the figure alone doesn’t capture the stock volatility that rocked markets and investors in 2020 amid worries about the economic impact of the Covid-19 virus.
After tumbling 20% in the first quarter and entering a bear market, the S&P 500 rebounded rapidly in the second quarter, surging 20%, the best performance since 1998 and in general, one of their strongest quarters on record. Optimism that corporations and the economy will be able to weather the challenges wrought by the global pandemic helped share prices recover. The benchmark gauge continued to strengthen into the third quarter, climbing another 8.5%.
Robo-advisors posted mixed returns in the beginning of the year amid all the volatility but rebounded as the year progressed. The average robo-advisor portfolio returned 7.58% on its equity holdings in the third quarter and 1.02% on its fixed-income holdings, according to Backend Benchmarking data. The average total return for robo-advisor portfolios was 1.88% for the year through the end of September. That compares with the S&P 500’s roughly 4% gain over the same period.
A few trends in equity markets drove which robo-advisors did better than others, according to the Robo Report. Investors have favored companies with larger market-capitalizations over mid-cap or small-cap stocks. Another notable trend has been the dominance of growth stocks, like those in the technology sector, over value investing. Investors have also preferred shares of U.S. companies as opposed to those based overseas, like in emerging markets.
Consequently, robo-advisors that tilted their allocations more to large-cap, growth and the U.S. outperformed their peers, according to Backend Benchmarking.
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Can Consumers Lose Money With Robo-Advisors?
Yes, consumers can lose their money with robo-advisors. As with all investments, there’s a risk of investors suffering losses. The performance table above with data from Backend Benchmarking shows that some robo-advisors were down in 2020 through the end of September.
There are some precautions that investors can consider when weighing different robo-advisors. The industry is still growing and the computer-generated financial advice may not meet all their needs. In addition, face-to-face meetings can help consumers better understand their financial profile and investment risks.
In addition, if a robo-advisor shuts down, consumers may be forced to sell or accept a possibly unrelated replacement service. Unexpected tax implications could also crop up.
Why Younger People Use Robo-Advisors More
The digital and mobile platforms offered by many robo-advisors have made them more appealing to younger users. Lower fees and minimum balances have also been draws for consumers in the millennial generation.
An October survey found that millennials are twice as likely as some older investors to consider using a robo-advisor. The recession caused by the Covid-19 pandemic has led to more interest among younger people in getting financial advice, the survey also found.
The economic downturn has hit younger workers harder. According to an analysis, unemployment among 16- to 24-year-olds jumped to more than 24% in the spring of 2020. That’s up from 8.4% in the same period in 2019.
But interestingly, some younger investors also want a human advisor coupled with a robo one to help them with their financial-planning decisions. It’s important that younger investors don’t just treat robo-advisors as a black box that handles their investments. Learning about investing and retirement planning early can help millennial investors avoid mistakes and make their money work for them.
Robo-advisors don’t yet have enough of a track record for consumers to measure whether they’re delivering superior financial solutions than traditional human advisors in the long run.
However, robo-advisors have expanded the customer base for financial planning services with their lower fees and minimum balances. This has motivated younger individuals like millennials to get financial advice as well. Research has shown that professional or digital advice tends to boost returns for inexperienced investors, making robo-advisors an increasingly important part of the financial-advice industry.
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