What is a robo-advisor and how do they compare with hiring a comprehensive financial planner? In this episode of Retire Your Way Radio, I’m going to talk about what a robo-advisor is, how a robo-advisor works, and who may or may not be a good fit for a robo-advisor.
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What is a Robo-advisor?
Perhaps this term “robo-advisor” is new to you. According to Fidelity, “a robo advisor is an affordable digital financial service that uses technology to help automate investing based on information investors provide about themselves and their financial situation.”
According to Wikipedia, a robo-advisor provides “digital financial advice based on mathematical rules or algorithms.” “These algorithms are executed by software and do not require a human advisor to impart financial advice to a client.”
If you want a less technical definition, a robo-advisor is simply a solution that sits in between managing all your own investments and hiring a full-service wealth management firm, such as my firm, Eagle Ridge Wealth Advisors in Morton, IL.
In general, robo-advisors are more affordable than hiring a human financial advisor and more costly than simply doing everything yourself. Like most things in life, you get what you pay for.
None of these options is better than the others. They all fill a need and are right for different people.
How does a Robo-advisor Work?
A robo-advisor’s website will collect some basic information from you such as your financial goals, risk tolerance, and investing timeline. Then it quickly runs your answers through its proprietary algorithm to determine which of their model portfolio investment solutions they recommend for you.
Then the platform will help you get your money transferred over and they will take over the day-to-day investment responsibilities. If you are a new investor, you will be walked through the process of opening a new account and funding it with a 1-time deposit or recurring deposits.
The services provided by a robo-advisor include investment management and periodic portfolio rebalancing. Some also provide access to budgeting and financial tools as well as access to a human for some advice at an additional cost.
Some popular robo-advisors include: Fidelity Go, Schwab’s Intelligent Portfolios, Wealthfront, and Bettermint. There are currently over 100 robo-advisors.
The concept of a robo-advisor has been around since 1928 when the Vanguard Wellington Fund was born, which was considered to be the first balanced mutual fund in the United States, and it still exists today. This fund gave investors instant access to a diversified portfolio made up of stocks and bonds at a low cost and through one solution based on investing rules and a prospectus.
The services of a robo-advisor aren’t all that different from a balanced mutual fund and they are priced similarly. But the robo-advisor landscape does continue to get more and more competitive by adding more services beyond portfolio management.
Are Financial Planners Threatened by Robo-advisors?
I am a financial planner, but I don’t feel threatened by robo-advisors. Each solution has its place.
Pretty much any profession has a low-cost option, but we still have a need for CPAs and lawyers.
You could use LegalZoom to create a legal document from a template or you could have an attorney customize a legal document for your specific situation. Both options have their place and meet the needs of the customers they serve.
The same is true for preparing your taxes using at-home software or having your taxes prepared by a CPA.
Robo-advisors also fill a need.
Who are Robo-advisors a Good Fit For?
If any of these situations describe you, a robo-advisor could be a good fit.
- You are a new investor and you need a low-cost solution without investment minimums to get you started.
- You are in the wealth accumulation stage of life where making money and saving money are most important to you.
- Your financial planning and tax planning needs are simple or non-existent and you just need help with day-to-day investment management.
- You have technical financial planning knowledge and you just want to outsource the investment management part so you don’t fall into any behavioral traps.
Who are Robo-advisors NOT a Good Fit For?
If any of these situations describe you, a robo-advisor might NOT be a good fit.
- You have accumulated 6 or 7 figures and desire a customized portfolio solution that is unique to you and your needs.
- You’re already retired or transitioning into retirement and you are trying to figure out the best way to create an income from your investments and do that tax efficiently.
- Your financial planning needs go beyond investment management, including insurance needs, estate planning needs, Social Security timing, etc.
- You place a lot of value on human professionals who are accessible and available to you as your life evolves and can help keep you accountable to addressing some of the important areas of your financial plan.
The decision to use a robo-advisor vs. doing everything yourself vs. hiring a full-service financial planning firm comes down to your unique needs and also personal preferences. We all value services differently. Some people pay to have their lawns mowed or their homes cleaned, while others would prefer to do those things themselves.
Before making a decision, it’s also a good idea to consider the pros and cons as well as the potential pitfalls of using a robo-advisor.
Pros of Using a Robo-advisor
- Low cost. The average robo-advisor charges about .3% per year or less.
- Behavioral protection. They help protect investors from themselves by providing a layer of protection.
- Modern technology.
- Rules-based investing. This helps to eliminate guesswork with rebalancing based on academic research and historical data.
- Diversification based on risk tolerance.
Cons of Using a Robo-advisor
- Limited customization. You are restricted to the investment options the system makes available to you.
- Little to no human element. These advisors are assigned 1,000 clients or more. This is about 10 times what a single advisor can handle when providing financial planning
- Difficult outbound transfer processes. They make it hard to transfer your money out to another custodian.
- Unknown future. What is their long-term plan? Could they be bought out by a large public firm that is accountable to its shareholders? Betterment is the largest independent robo-advisor with $22 billion. By comparison, Vanguard manages $7 trillion.
- Lack of advanced financial and tax planning.
Pitfalls to Look Out For
They advertise free investing or no fees. In this case, you want to know how they are making their money. There are two main ways they could be making money.
1. They may require you to use their own proprietary investment solutions that often have higher than average expense ratios. Or even if they are average or lower than average, those investment fees are going back into their own pockets because they are their own proprietary funds.
2. They could also require you to hold a large allocation to cash as part of your investment portfolio. A large cash allocation creates a drag on your portfolio returns, especially in a low-interest environment like we are in today. If they have a large cash requirement, they are lending out your cash and making money by doing that.
These aren’t necessarily bad, but it is good to know what you are getting for no transparent fees and a high cash allocation requirement.
They focus on tax-loss harvesting. This strategy is far from being appropriate for everybody. Academic research is mixed on the value of tax-loss harvesting because you are just pushing your growing tax liability out into the future. It just saves you from a tax bill temporarily, but there are costs and risks associated with tax-loss harvesting.
If you determine a robo-advisor will meet your needs, I hope you have found this information helpful when considering robo-advisors. If you determine you would prefer to hire a full-service wealth management firm, there are great ones all over the country, including my firm in Morton, Illinois.