What is a Robo-Advisor?
As part of the continuing series, “Why Robots Will Soon Rule the Earth”, I bring you robo-advisors. A robo-advisor is an investment advisor in the form of a computer algorithm. A robo-advisor will, based on information that you provide, select a portfolio of stocks and bonds that are consistent with your preferences in terms of how much risk you want to take with your investment portfolio. There was a lot in that last sentence, so let’s unpack it bit by bit.
Robo-advising is a service offered by an investment management firm. Some investment management firms only provide their investment advice through robo-advising; others may offer clients a choice of using a human investment advisor or a robo-advisor (or a bit of both). And to be clear, the advice from a robo-advisor is strictly about the composition of your investment portfolio; a robo-advisor should not be confused with a financial advisor who may offer more far-reaching financial advice.
When you use a robo-advisor, the experience generally goes something like this:
- You will start by answering a series of questions about your investment risk preferences. Your investment decision must balance two factors: Understanding objectively what your capacity is to take on risk, based on your time horizon, and more subjectively, understanding what kind of an investor you are and how you are likely to react in both good times and bad. (You can read more about risk capacity versus risk tolerance here.)
- Next, the computer algorithm will devise a portfolio that represents a mix of stocks and bonds. More specifically, you will typically be presented with a collection of index exchange-traded funds (ETFs). Just like an index mutual fund, an index ETF is a diversified pool of assets, usually stocks or bonds. It is designed to mirror the performance of a market index, for example the S&P 500. This portfolio represents an asset allocation that is consistent with your risk preferences, as you expressed in the initial questionnaire. As asset prices change with market conditions, the robo-advisor continually adjusts, rebalancing your portfolio to maintain your desired asset allocation.
- Depending on the company, a robo-advisor may offer the ability to open a traditional or Roth IRA account in addition to taxable (i.e. non-retirement) accounts.
There are several rather attractive benefits to using a robo-advisor:
- They are lower in cost than a traditional investment advisor. When you buy an ETF or mutual fund, there are two kinds of fees that you will pay. The first is the fee for the operation of the fund itself (called the expense ratio). Index ETF expense ratios are typically lower than even index mutual funds, and certainly lower than a managed mutual fund that you may be offered by a traditional advisor.
- The second type of fee is for the cost of the advisor herself. What can I say? Robots work for cheap compared to humans. A usual advisory fee for a robo-advisor is about 0.25% (as a percentage of the assets in your account) and often much less, perhaps even zero in some cases. (It varies with the balance and the robo-advisor company.)
- Only a low (or possibly no) minimum investment is generally required to get started with a robo-advisor account.
- Many robo-advisors have convenient mobile apps, allowing you to manage your account easily from your phone.
So is a robo-advisor right for you? One important consideration is whether or not you value the human touch, the ability to have a back-and-forth conversation with a knowledgeable person about not just what to invest in, but why. The investment decision takes place within the context of your larger financial life: How much of your income should go towards long term investment? Retirement account or taxable account? Should you be a long term investor at all at this particular moment, given other priorities? These are all excellent questions that, alas, even the savviest robot cannot answer.
To learn more about robo-advisors, check out this excellent and comprehensive resource from the Securities and Exchange Commission (SEC). And of course, feel free to keep this conversation going with the experts at Your Money Line!