Learn more about how robo-advisors work, identify some of the pros and cons of using robo-advisors for your investments, discuss fees and functionality of robo-advisors.
From drones to self-driving cars, machines that perform functions previously done by humans are moving away from science fiction and into reality. So if they can make a self-driving car, what about a self-driving investment program?
That idea has been a reality for a few years now. Automated wealth managers, more popularly known as “robo-advisors,” are here, and they’re growing fast, stepping into roles traditionally filled by financial planners and investment advisors.
Is a robo-advisor right for you?
This guide provides information on how robo-advisors work, identifies some of the pros and cons of using robo-advisors for your investments, discusses robo-advisor fees and features, and offers 10 things to look for when choosing a robo-advisor.
How robo-advisors work
Robo-advisors use algorithms to translate your investment tolerance into a diversified investment portfolio. This includes both determining asset allocations and selecting individual investment funds to populate those allocations.
If you set a retirement income goal and a retirement date, the program can tell you how much you need to contribute to your IRA or 401(k) each year to meet that goal.
As you may have noticed, asset allocation, security selection and retirement planning are all functions performed by human financial experts. Can robo-advisors do it better?
Advantages and disadvantages of robo-advisers
Robo-advisers solve two problems that have traditionally plagued the financial sector: cost and human error. Here we assess the risks and benefits:
Since some investors perform above average and some perform below average, overall, fees play a big role in how well individuals track the market and make progress toward their goals.
As for human error, apart from the fact that some investors are more competent than others, it is a fact that both professional and amateur investors have been caught out time and again by the emotions associated with the ups and downs of the market. They become more aggressive during bull markets and more cautious during bear markets. A robo advisor can smooth out these extremes and keep your portfolio on an even keel.
Limited by past data
The other side of the coin is that a robo-advisor can’t see into the future any better than a human investment expert.
Market models may not be accurate
The formulas that robo-advisors use to make decisions are based on the historical behaviour of different stocks. The problem is that history doesn’t always predictably repeat itself. Especially when bond yields are exceptionally low and equity valuations are exceptionally high, the historical risk/return characteristics of these asset classes may not be very relevant. This would make the type of models used by robo-advocates less effective.
How to choose a robo-adviser
If you decide to use a robo-advisor, what is the best company to use? It largely depends on your needs. If you look through this shopping list of ten things to look for when choosing a robo-advisor, you should have a better idea of which company is best suited to your needs.
Robo-advisors typically charge a fee based on a percentage of the assets they manage. A base fee of 0.25% seems to be common among industry leaders. As robo-advisors are expected to reduce investment costs through automation, it is a good idea to start by checking the base fee. Note that in addition to this fee, you will also have to pay the expense ratios of the funds used to construct the portfolio.
Is there a charge for each trade made under the programme? This can quickly become quite costly, so look for robo-advisors that do not charge such fees. Also, if you plan to do some self-directed trades through the same firm, check that their commissions are competitive compared to leading discount brokers.
Reducing fees for larger balances
In theory, administration should become more cost-effective the larger the account size. Typical robo-advisor accounts are less than $100,000; however, if you have more to invest, you should see if you can reduce fees.
Proprietary vs. external products
Some robo-advisors are affiliated with fund families and use proprietary products to build investment portfolios. A robo-adviser using independent investment products has a wider range of options.
Also, check to see if the robo-advisor’s asset allocation model can take into account assets you have outside of their account, such as your employer’s 401(k) retirement plan.
If you plan to place a taxable portfolio under the management of a robo-advisor, understand what tax-efficient strategies they use and whether you can use methods such as tax loss harvesting, if applicable.
Minimum account size
Make sure you have enough assets to qualify for the firm’s services and that you are not so close to the minimum limit that you could fall below it after a market crash or payout.
Play around with the user interface. It should be easy to use and work efficiently on the device you choose.
Socially responsible investment options
If your investment guidelines include disallowing certain types of investments for ethical reasons, or certain sectors you want to focus on positively, make sure the robo-advisor system can take these priorities into account.
Setting retirement goals
In addition to managing your money, some robo-advisors offer tools to help you see which savings are needed to achieve your retirement goals. By integrating these goals into your investment program, you can ensure that your retirement savings are properly aligned with your retirement investments.
Automated investment allocations should be periodically reset to ensure they remain in balance. Examine each robo-advisor’s rebalancing method. Rebalancing too frequently can be ineffective, while rebalancing too infrequently can result in a portfolio that is no longer in line as asset values change at different rates.
Choosing the best robo-advisor is only the first step. Once your program is in place, make sure that fees remain competitive and that the robo-advisor delivers the expected results.