What Is A Robo-Advisor?
A robo-advisor is an automated, online platform that creates investment portfolios and financial plans for individuals. Roboadvisors compete with traditional human financial advisors but provide their services at a far lower cost with much lower minimum investment requirements and greater convenience.
Robo-advisors have been around since 2008, but they have attracted a growing number of clients and share of assets under management. Indeed, several large traditional financial advisory firms, including Morgan Stanley, Charles Schwab, and Merrill Lynch Bank of America, have launched or are in the process of rolling out their own robo-advisory services for customers who prefer this type of service in order to stay competitive.
How Does A Robo-Advisor Work?
Customers of robo-advisory firms generally begin by completing an online survey that helps their computers design a financial plan and portfolio. This information usually includes the person's age, how much money they have to invest, their risk tolerance, their investment time horizon (i.e., how close they are to retirement and when they plan to retire), their long- and short-term financial goals, and the like. Of course, new clients of traditional advisory firms also complete similar surveys so the advisor knows what to do.
Using this information, the robo-advisor creates a diversified portfolio of investments, which generally consists of exchange-traded funds (ETFs) and mutual funds, that seeks to meet the client's financial goals. The computer also periodically—usually once per quarter or so—rebalances the client's portfolio automatically to ensure that their asset allocation remains consistent and the plan stays on target. For example, if the client's plan calls for a 60-40 allocation of stocks to bonds, but a runup in stock prices has moved their portfolio to a 70-30 mix, the "robot" will automatically sell stocks and buy bonds to put it back into a 60-40 mix.
Robo-advisors can also help clients avoid or reduce taxes through automatic tax-loss harvesting. This involves selling assets at a loss in order to offset a capital gains tax liability in a similar security in the portfolio.
Advantages Of Robo-Advisors
Robo-advisors have become very popular very quickly for several reasons, but cost is the major appeal.
Online advisors generally charge about 0.25% or 0.5% of assets annually, compared to 1% or more that traditional advisory firms charge. On a $100,000 portfolio, that would mean paying US$250 to US$500 per year compared to the US$1,000 that a human advisor would charge. Some automated advisors charge a monthly, quarterly or annual fee for their services rather than one based on a percentage of assets; likewise, some traditional human advisors charge by the hour.
Robo-advisors also have much lower minimum asset requirements than traditional advisors, many of which require clients to have at least US$500,000 to invest. Many robo-advisors, by contrast, require only about US$5,000 to start, and some have no minimums at all. As a result they've been able to attract a greater share of younger investors.
Robo-advisors are also available online 24 hours a day, seven days a week at the customer's convenience. Customers can check and make changes to their accounts anytime they want, for example, or add funds to their account electronically. Human advisors are generally only available during traditional business hours.
Robo-advisors by definition also take the "human element" out of investing. This can prevent clients from making knee-jerk or panic decisions in a crisis, which can have long-term negative effects on their financial plan.
Disadvantages Of Robo-Advisors
Since they are generally automated services, robo-advisors by definition lack the "human touch" that traditional advisors have and many customers want. However, clients of digital services generally don't care or actually prefer an impersonal online experience. Some robo-advisory firms have a hybrid model in which customers can choose to have a human advisor as backup in situations where they would prefer to interact with a live person. This hybrid service often comes at a greater fee.
Robo-advisors also generally don't offer a full gamut of investment choices that traditional firms offer or that investors can buy on their own. For example, most robo-advisors invest their clients' money only in a mix of ETFs and mutual funds, avoiding individual stocks and bonds and other assets. They also don't offer alternative investment options that traditional advisors often do. Plus, clients don't have the option of selecting their own investments, although most customers choose robo-advisors because they don't feel competent or confident in choosing the right investments.
Robo-advisors generally can't provide the same level of customized financial plans and asset allocations that traditional advisors do. People with complicated financial lives, such as professionals who own their own businesses, may find that a human advisor is a better choice and that the extra money spent is well worth it for the personalized service.
However, the algorithms that robo-advisors use to fashion financial plans and investment choices for their customers have gotten more sophisticated as technology improves. Indeed, traditional human advisors use the same basic technology to create financial plans and portfolios for their customers.
Traditional advisors may also be better suited to handling financial emergencies, such as the death of a family's main provider.
As their popularity has grown, so has the number of robo-advisory firms. Here are some of the most popular robo-advisors on the market today:
- Schwab Intelligent Portfolios
- Personal Capital
- SoFi Wealth
Robo-advisors provide automated financial plans and investment services for individual investors at a small fraction of the cost that traditional human advisors do, usually 0.25% to 0.5% of assets versus 1% or more that traditional advisors charge.
After the customer completes an online survey, the robo-advisor creates an investment portfolio of mutual funds and exchange-traded funds that seeks to meet the client's financial goals, then rebalances the portfolio automatically periodically. Robo-advisors have grown in popularity since they were introduced in 2008, to the point where traditional advisors have begun offering their own online-only automated services.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…