Robots are slowly invading society, but at least so far, the relationship isn’t adversarial like you see in the movies. You can command Alexa, clean with a Roomba and even invest your money through a bot.
In this article, I’ll explain the types of investors for whom using a robo-advisor makes the most sense. I hope the information and analysis here will help you decide whether a robo-advisor could be a good tool to help you reach your personal investment goals.
Table of Contents
- What Is a Robo-Advisor?
- Who Should Use a Robo-Advisor?
- Advantages of Robo-Advisors
- Disadvantages of Robo-Advisors
- Understanding Robo-Advisor Fees vs. Other Options
- Analyzing the Results: Robo-Advisors vs. Other Options
- Analyzing the Results: Robo-Advisors vs. Full-Service Advisors
- Differences Between ETFs, Mutal Funds and Index Funds
What Is a Robo-Advisor?
A robo-advisor is a passive investment management company that often costs a fraction of a full-service financial advisor.
You fill out a questionnaire about your age, income and financial goals. The robo-advisor then recommends a pre-built portfolio that matches your risk tolerance. Since that process is automated and usually happens through a mobile app, robo-advisor companies enjoy relatively low overhead, which they pass to you as a consumer in the form of low annual management fees.
The idea is that you’ll continue contributing money to the robo-advisor, but for a small fee, you’ll never have to buy or sell a single stock. Robo-advisors usually invest your funds in a variety of low-cost mutual funds, exchange traded funds (ETFs) and bonds.
The portfolios are well-diversified and often lean on Modern Portfolio Theory. They usually aren’t built to beat “the stock market” (often represented by the S&P 500). However, based on their allocations, robo-advisor portfolios should remain relatively stable even when the U.S. stock market isn’t performing well.
Who Should Use a Robo-Advisor?
“There are many people who don’t need comprehensive financial planning, who just need simple guidance on building and managing a portfolio,” money expert Clark Howard says. “Robo-investing gets people the right investment mix at a very low cost.”
There are plenty of reasons to use a robo-advisor to handle your investments. Start by asking yourself if you belong to any of the following groups.
- New investors who want a low-cost solution. Maybe you’re willing to manage your own investments. But you’re new to the game, and you recognize you’ve got a lot to learn. You could pay a professional financial advisor to give you holistic, personalized attention. Or you could pay a fraction of that to get similar investment guidance from a robo-advisor, saving yourself significant fees while you learn.
- Investors with little capital. The less money you have in your portfolio, the fewer options you have to diversify. The strategies that robo-advisors tend to use will give you broad exposure to numerous asset classes, even if you don’t have a lot of capital to invest.
- People who lack the time to manage their own investments. Perhaps you know what you’re doing as an investor. But if you’re forced to manage your own portfolio, and you’re busy, you may end up neglecting it. A robo-advisor can help you avoid having to rebalance your own portfolio or spend time maximizing your tax strategy.
- Those who aren’t interested in learning how to invest. The term “YOLO” (You Only Live Once) comes to mind here. Maybe you find investing to be boring. Maybe you’d rather spend your time planning your next beach vacation or playing with your kids. If this is you, perhaps you want to use a robo-advisor to invest.
Advantages of Robo-Advisors
Let’s review some of the advantages of using a robo-advisor.
- Take away stress. Once you’ve set up your robo-advisor, you’ll never have to make a decision about which stock to buy or what percentage of your portfolio to put into bonds.
- Offer professional management at a bargain. Your robo-advisor isn’t going to reassure you on the phone, help you prepare your taxes or adjust your finances on the fly when an unexpected life event happens. But if all you want is professional investment advice, you may be better served if you pay a little money to a robo-advisor rather than a lot of money to a human professional advisor.
- Allow for automated investing. This is great from a behavioral standpoint. Automation ensures you’ll continue to invest new money.
- Offer stability during market downturns. The United States stock market became volatile during the first half of 2020 as COVID-19 hit. Robo-advisors, which tend to be diversified, still did well during that period.
- Handle tax-loss harvesting and automatic rebalancing. If one asset class in your portfolio performs well, it may start to represent an outsized percentage. Good robo-advisors rebalance those percentages for you. Many robo-advisors also offer some sort of tax-loss harvesting. This reduces your tax burden by selling off assets that have lost value (often replacing them by purchasing similar assets).
- Make it fast and simple to get started. Much like some of the best stock trading apps in 2021, you can open and fund a robo-advisor account with very little time and effort.
- Get you into the market for cheap. You probably won’t need a large sum of money to get started with a robo-advisor, and with some, you don’t need a cent to open an account.
Disadvantages of Robo-Advisors
Let’s consider some of the negatives to using a robo-advisor.
Robo-advisors aren’t perfect because:
- It’s relatively easy to avoid fees by following the same strategy on your own. It may seem intimidating, but it doesn’t take much internet research to figure out how to follow the same low-cost, diversified, long-term investment strategies that robo-advisors use.
- They provide little to no help with financial planning. Some robo-advisors have decent tools for tracking your goals, but you’ll find more sophisticated advice and planning elsewhere.
- If you do get any human help, it’s usually similar to a call center. By nature, robots don’t carry conversations with humans (not yet, anyway!). If a robo-advisor does offer the option of talking to a human, they’re likely working off a script at a call center. It’s extremely rare to get free advice from a Certified Financial Planner through your robo-advisor.
- They aren’t designed to beat the market. Your ROI (return on investment) probably will lag behind market indexes like the S&P 500 during bull markets.
- You won’t be able to pick individual stocks or securities. That isn’t necessarily bad. Most people overestimate their ability to pick individual stocks. But if you like to parlay your knowledge and reading into an occasional investment in a company you think will perform well, you can’t use a robo-advisor to make that buy.
- They aren’t a silver bullet to eliminate human error. You can still forget to contribute (if you don’t set up automated transfers), sell at a market low point in a panic and/or fail to increase your contributions over time.
Understanding Robo-Advisor Fees vs. Other Options
If you’ve read anyone’s advice regarding your investment options, you understand the general idea that you want to avoid fees. But it can be difficult to understand reality vs. theory when considering specific choices.
Among the companies that made our list of the eight best robo-advisors, it’s reasonable to expect a 0.25% annual fee and a 0.1% expense ratio. That’s an all-in cost of 0.35% per year.
“What separates robo-advisors is the cost of advice combined with the cost of the funds and investments,” Clark says. “Many high-cost outfits now tout robo-advisory and end up harming your financial future instead of helping it. Over time, low cost is everything in building financial security or wealth.”
You can replicate the strategy of most robo-advisors on your own by buying index funds, target date funds and ETFs, which are all passively-managed, low cost and well-diversified. You have to pay for the expense ratios whether you’re investing on your own or through a robo-advisor, but the DIY approach will save you the annual fees.
In the chart below, we compare the costs of robo-advisors to the alternatives.
We based our index fund on Vanguard’s Total Stock Market (VTSAX), which includes a 0.04% expense ratio.
We based our target date fund on Vanguard’s Target Retirement 2050 (VFIFX), which carries a 0.15% expense ratio. Vanguard has waved its commissions, so you can buy into those funds with $0 trades.
For the calculation of working with a full-service financial advisor, we assumed we’d pay 1.25% in annual fees and expense ratios. (The price range for full-service advisors varies more than the self-directed and robo-advisor investment categories, but 1.25% is a reasonable number.)
Our hypothetical investment in each case is $10,000 upfront and an additional $10,000 per year for 5, 10, 20 and 30 years with a 6% annual return.
|Years||Index Fund||Target Date Fund||Robo-Advisor||Financial Advisor|
Analyzing the Results: Robo-Advisors vs. Index, Target Date Funds
Of course, fees aren’t the only factor in real-life totals. Performance, almost guaranteed to vary, also matters. But in our hypothetical, all performances are equal.
The table shows that, after five years, the differences in net earnings between an index fund, target date fund and robo-advisor are less than $1,000. However, after calculating the fees after 30 years, the gap between the super low-cost index fund and the robo-advisor grows to more than $50,000.
In a fee-only vacuum, it’s clear you’ll make the most money over 30 years with the index fund. But there are other reasons to consider using a robo-advisor: convenience, automated rebalancing, tax-loss harvesting and diversification into assets beyond U.S. stocks.
Robo-advisors haven’t been around that long, so we don’t know how they’ll perform over three decades. But in the decade they’ve existed, they’ve slightly underperformed the typical total stock market index fund. The “why” is pretty easy: Robo-advisors usually include bonds in their portfolios, so the return is a bit lower. That said, the inclusion of bonds leads to more portfolio stability.
Analyzing the Results: Robo-Advisors vs. Full-Service Advisors
You can see the numbers yourself in our table. If you’re just considering fees, your returns with a full-service advisor are really going to suffer.
But good financial advisors offer benefits that may be just as important to you as market return. Sure, they’ll make sure you have the right allocation for your investments and will offer counsel if you need to adapt to a financial curveball. But most of them offer a comprehensive roster of services including financial planning, tax strategy and estate planning. You won’t get those perks if you’re investing on your own or through a robo-advisor.
Differences Between ETFs, Mutual Funds and Index Funds
Whether you’re thinking about investing on your own or you want to compare robo-advisor options, you’ll want to understand the differences between an ETF, a mutual fund and an index fund. Let’s start with the definition of each term.
Mutual Fund: Mutual funds are professionally managed collections of securities like stocks, but you can buy them only after the trading day is over. One advantage of a mutual fund is that you can make automated contributions.
Exchange Traded Fund (ETF): Similar to mutual funds, ETFs are a professionally managed collection of securities such as stocks that often track indexes. ETF shares trade when the stock market is open just as ordinary stocks do. ETFs tend to have lower minimum investment requirements than mutual funds. From a tax perspective, ETFs usually are more efficient at avoiding capital gains than mutual funds.
Index Fund: Index funds are so-named because they track popular market indexes like the Dow Jones Industrial Average and Nasdaq Composite. The SPDR S&P 500 ETF (SPY), which tracks the S&P 500, is a good example of an index fund. Most ETFs and some mutual funds are index funds.
Morningstar’s most recent study showed that in 2019, the average expense ratio for mutual funds and ETFs was 0.45% and was likely to continue its two-decade downward trend. The study cited Vanguard’s 0.09% asset-weighted average expense ratio as the lowest that year.
The expense ratio of a fund largely depends on whether it’s actively or passively managed. Actively-managed funds require humans to make constant trades, buying and selling positions in an attempt to beat the market. All that activity makes for higher costs. Passively-managed funds such as index funds need occasional rebalancing, but since they track an index, there aren’t any decisions about which equities to include.
If you’re an investor who doesn’t want to pay a full-service advisor, you have a major decision to make. Do you want to pay a significant amount of money to a company that will handle your portfolio for you? Or do you want to save that money and instead spend the time and effort to handle it on your own?
Remember, choosing which way you’re going to invest is just one part of your overall financial strategy. When you dig into this subject, it’s easy to feel like making the wrong choice will ruin your life.
But if you’ve made it this far into this article, you’re probably pretty serious about making the most out of your investments. That puts you ahead of the game, so don’t get paralyzed by what can often be relatively small differences between your options.