We’ve all seen the movies where robots try to take over the world disguised as humans, or they use humans as living batteries, or smooth-talking red lights try to jettison astronauts into outer space.
And this might lead you to question whether robots have your best interest in mind. Yet, far from the drama of Hollywood, robo-investing—which provides investment advice and management with limited human intervention—can be a useful, low-cost financial tool to help you reach your goals.
What Is a Robo-Advisor?
Traditionally, an investment advisor would work with you to build an investment portfolio, helping you choose an allocation of stocks, bonds and other investments, and periodically rebalancing them as the market and your needs changed. All of this human interaction makes traditional investment advising fairly pricey.
A robo-advisor, on the other hand, uses computer algorithms to build and manage your investment portfolio—often using low cost index and exchange-traded funds—with limited human interaction.
Cut out the human managers and the price for investment services goes down considerably. In part due to their low cost, robo-advisors are becoming increasingly popular. In 2017, robo advisors passed the $200 billion mark in aggregate assets under management, and that number is likely to keep growing.
What’s more, many robo-advisers may offer low or no investment minimums, which means you can start investing any time.
How Much Do Robo-Advisors Cost?
Some robo-advisors charge fees on a per trade basis, while some charge fees based on a percentage of the value of your portfolio. While traditional advisors typically charge a fee of around 1% of assets under management, robo-advisors’ fees range from 0% to 0.89% with fees typically hovering around 0.25% to 0.30%.
The fees charged by robo-advisors are important to pay attention to even if they seem low. Consider that a 0.25% fee reduces an annual return of 7% to 6.75%. This reduction may not seem like much, but over the course of many years, these fees start to add up.
Additionally, the use of low-cost index funds and exchange traded funds tend to drive the cost savings even higher. In 2017, the average expense ratio of a passive investment (such as an exchange traded fund) was .15% compared the the average expense ratio of .72% for actively managed funds.
When you add these two components up the average robo-advisor using passive investments could be 1.32% less per year than the average human advisor using actively managed funds. As balances grow over time this can have a fairly substantial impact.
This is all to say you should carefully weigh fee options against the services different robo-advisors offer to make sure that the fees you are paying are worth it to you. For example, a slightly higher fee might give you access to a human financial advisor who can offer you investment advice. If that kind of service is important to you, it might be worth paying a little bit extra.
Choosing the Right Robo-Advisor
Aside from the fees you’ll pay, there are a number of other factors worth considering when you’re deciding whether a robo-advisor is right for you, including:
Most robo-advisors use a mix of ETFs and low-cost index funds. ETFs hold a basket of stocks or bonds and are built to mirror an index, such as the S&P 500. They are traded throughout the day. Index funds are mutual funds that also hold a mix of investments and track an index.
Mutual funds only trade once per day. Both types of investments are more diversified than an individual stock because of the basket of assets that they hold. When choosing a robo-advisor make sure that they offer the types of investments that you want to include in your portfolio.
You’ll typically be offered two broad types of accounts when you consider a robo-advisor: a retirement account or a regular taxable investment account. A standard investment account has no limits on the amount of money you can invest.
Retirement accounts, such as IRAs and 401(k)s offer specific tax advantages.
Be clear about your goals when you choose your account type. If you’re saving for retirement, the tax advantages of retirement accounts are hard to beat.
But if you’ll need access to the money sooner than that, consider a regular taxable account. You don’t want to be slammed with the early withdrawal penalties that come with dipping into retirement accounts too early.
Robo-advisors usually offer a fixed number of portfolio options designed to cover various levels of risk. The robo-advisor will typically recommend one of these portfolios based on your goals,investment preferences, comfort with risk, and time horizon. Robo-advisors will usually match you with a portfolio by giving you a questionnaire.
This questionnaire doesn’t lock into a portfolio, so you might be able to override the default selection to choose a portfolio of your choice.
Additional Perks of Automated Investing
Once you’ve signed up for an account with a robo-advisor, you will typically be offered a range of automated services.
Based on the process described above, let’s assume you were placed in an allocation that consists of a mix of 60% stocks and 40% bonds. Over time this allocation will likely shift a bit as investments fluctuate based on the movement of the market.
For example, the stock market may grow faster during a particular period of time than the rest of your portfolio. Rebalancing helps you buy and sell assets to realign the investments inside your portfolio to the desired allocation.
Many robo-advisors make it easy to establish sound financial habits such as ongoing saving by establishing recurring contributions. A common example of recurring contributions is in an employer sponsored plan such as a 401k. The value of recurring contributions is that it automates the tough decision of saving for the future. This strategy is not just limited to your 401k, and might help you be more disciplined with your other accounts.
Access to Humans
Some robo-advisors combine the cost-effectiveness of technology with the expertise of humans by offering access to financial professionals. This hybrid approach might enable investors to ask questions, discuss goals, and plan for the future. Robo-advisors might charge for this service, but it tends to be optional if it is offered.
Should You Trust Robo-Advisors?
There are some potential drawbacks to the one-size-fits-all approach of robo-advisors.
Those interested in investing in complicated assets, such as real estate investments, trusts, may want to look to professionals for help doing so.
That said, robo-advisors can be a great financial tool, especially for those who are just starting out investing and who don’t have complicated investment needs.
For example, Millennials who are still accumulating assets may find that robo-advisors are a good fit. The low cost of robo-advising has lowered the barrier to entry for many investors, giving them access to tools once reserved for higher-net-worth individuals.
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