What is a Robo-Advisor?
A robo-advisor is an online wealth management service. It's typically software-based so that it can handle more financial transactions more easily than a human advisor. A robo-advisor has software that is able to study your investment goals and risk tolerance and provide advice on how you can reach them.
How do Robo-Advisors Work?
Automated investment services are rapidly gaining popularity. They are called Robo-Advisory, _______, etc programs.
These services take the human element out of investing and let a computer help you make the investment decisions instead. They are often called Robo-Advisors, automated investing, passive investing, robo-portfolio management, etc. Basically, these services do away with the stock broker and advisor.
Instead, you use a special website or app to set up your portfolio. There you can choose from a list of available mutual funds and ETFs. You also select a risk tolerance level, which will determine how aggressive or conservative your investments will be. Then the program will make recommendations on what to buy based on your settings.
By setting up a portfolio of funds, the program calculates how much money you will have for retirement, how much to invest each month, etc.. You don’t have to open up any accounts or have to do any fund trades. All the work is done for you.
The service makes money by charging a percentage of assets under management (sometimes these fees are divided between the manager and the person who recommended the program to you). In exchange for the fee, they take the burden of investing strategy and investment decision-making out of your hands.
After investing with one service, it’s fairly easy to keep using the service over the long term.
Modern Portfolio Theory (MPT).
Warren Buffet is a hero in the investing world for smart investing. He’s dedicated a large part of his life to buying shares of solid companies and sticking with them.
He only devotes a small portion of his portfolio to buy companies he thinks have potential that is out of line with their current stock price. He makes a lot of profit off the 20% of his investment portfolio that he owns in Amazon, for example.
But there’s a lot of people who have followed his lead and made heavy investments in Amazon. Shares are now trading at over 600.
The point? If everyone follows the same idea and everyone owns the same stocks, then there isn’t much opportunity to make a profit. The ideal way to invest is following a rule that helps you make profit while buying and selling companies that relatively few others own.
Modern Portfolio Theory (MPT) is a method of diversifying a stock portfolio. Sounds simple right? But too many people get it wrong, and they end up investing in a bunch of companies they don’t know. What’s the point of diversification if your portfolio only has 5 companies in it?
Technology is helping us work smarter and choose better. That is why we use robo-investing apps.
Exchange Traded Funds (ETFs).
Exchange Traded Funds (ETFs) create passive investors. ETFs are pooled assets and investments (in stocks, commodities, bonds and so on) and are traded on exchanges just like publicly traded companies. Along with their counterparts (Mutual Funds) these are the two most popular instruments for retail investors.
Here I’ll give you a quick explanation of Passive investing. Two or more individuals consider to create a pool of capital and by investing the pooled capital in assets they expect to generate wealth for all the passive investors. These passive investors are unaware of the relationships and agreements between the other investors. Active investors are trying to profit from the investment and management teams. Passive investors are more or less unaware of the underlying operations of the investing capital. The latter depend on the former.
If you are considering investing in ETFs and you are not interested in directly managing your investments, ETFs can be a great alternative. ETFs are similar to mutual funds but with one big difference: ETFs trade like a common stock on an exchange, just like Apple stock. Potential investors should beware that there is a very large market for ETFs, which means that investors can incur large trading costs by buying and selling these instruments. One of the main reasons investors choose ETFs is because they are less likely to sell their shares and incur taxes.
Fully Automated Investing.
Is It Right For You?
Over the past decade, the financial industry has seen a tremendous shift toward automated investing. There are new services popping up on the market every year that want to make investing easier and more efficient than ever before. But is this positive trend going to benefit you? The correct answer depends on several things.
There is good news and bad news when it comes to automated investing. Let’s start with the bad news first. If you’re new to investing, this shift means that you’ll have to spend more time learning how to navigate the new system. Investing fundamentals haven’t changed, but the way in which you can access them certainly has.
In addition, the new automated investing options are designed to provide a quick and easy route to achieving your investment goals. But the trade-off is that they tend to remove all human interaction and emotional involvement. Although some people do prefer to have their investment decisions made for them, many others would not be comfortable making investment decisions without human interaction.
Both of these developments present both challenges and opportunities. On the one hand, you must learn to adapt to the new technology and systems. On the other hand, you’ll have more opportunity to pursue your investment goals than ever before.
What Exactly Does It Mean?
Tax optimization is just that; it’s the process of minimizing your tax liability. Everything you make is taxed, but the tax rate can vary. Depending on how you invest, your profits are taxed at a different rate than ordinary income.
You would think that this sounds like a no-win situation. Who wants to pay their money to the government? But that’s the thing about taxes. The money you give to the IRS is not really gone. It helps pay for roads, police, firemen, and other services that you use. It even helps pay for the health care of people that you don’t know.
Tax optimization is concerned with how to invest your money to minimize your taxes, but you should never invest in a way that compromises your investment objectives. If you’re expecting a 100% return on your investment, the tax optimization almost certainly won’t be 100%.
Tax Loss Harvesting, or TLH.
This is the tool Robo advisors use to keep their client’s gains down and their tax bill as low as possible.
Tax loss harvesting is the name that’s given to this tool by robo advisors. They use tax loss harvesting to keep the gains of their clients down, so that the clients receive a lower tax bill.
With tax loss harvesting, your robo advisor does a tax-based analysis of your portfolio at the end of the year, and if your losses exceed your gains, you receive a tax benefit.
In fact, many robo advisors not only use tax loss harvesting, but also employ a second method called tax-loss selling. To accomplish this, your robo advisor sells your losing investments to generate a loss, which in turn, offsets your gains.
All of this may sound complicated, but it’s really just smart tax management implemented by robo advisors.
Tax loss harvesting and tax-loss selling can help your account balance out and save you a lot of money in taxes. But as we will discuss later in the post, it’s not a perfect system, not by a long shot.
Automation. The promise of a better return. Sounds like robo-advisors are a no-brainer, right?
In the financial services game, robo-advisor is a relatively new term that refers to a new kind of online investment advisor. Robo-advisors, such as Wealthfront and Betterment, manage your portfolio by employing algorithms to periodically invest your money in a variety of low-cost investments.
The main benefit of these robo-advisors is the automated service, which allows you to build a portfolio without having to pay for a personal financial advisor. This allows an enormous reduction in fees, which robo-advisors can then pass on to their clients.
But do robo-investments live up to all this hype? They have limitations and may not be for everyone.
Robo-advisors are a growing sector of the investment industry. As they continue to expand, we’re likely to see more and more of these automated investment advisors on the market. Services will grow and mature, so how will you choose the right robo-advisor for yourself?
The more you understand about the technology, the better.
Robo-investing is a growing industry, and it’s likely that this will be a great way to manage your money. But it may not be the best option for everyone.
An orientation toward new and small investors.
When it comes to investing, there are a number of options available to you, including index funds and cryptocurrencies. You may also have a separate portfolio of stocks you keep in your brokerage account. But what if there was one investment vehicle that could handle it all?
That’s the starting point behind roboadvisory and the growth of the robo-adviser market. They offer you the opportunity to automate your investing, enabling you to lower your expenses and save money in the process. That’s a compelling pitch for a lot of investors.
This type of model can also simplify your investing experience because you’re using software and an online interface to manage most of the work. This is certainly a different investment experience from what you get with your current financial advisor, where you schedule meetings and try to communicate most of your investment ideas by email or over the phone.
But if you’re looking for a clear and easy way to invest your money, do you really need the help of a robo-adviser? Does it really make sense to invest your money in a robo-adviser? Read on for the answer.
The Benefits of Robo-Investing
Investing in the stock market can be a real drag. There are the hours spent tracking your investments and too many choices to make. Day after day, it’s the same tedious process.
Robo-investing apps attempt to simplify the process by taking stock picking cards off of your hands. Instead of having to comb through details of countless stocks, you simply set out parameters for a chosen strategy and let it run. You might be wondering, though, what is the process behind the strategies of these apps? What are their limitations?
It’s great to know that the algorithms that support all robo-investing apps are standardized and readily available. They are based on the work of Nobel Prize-winning economist Harry Markowitz, who developed a theory of efficient portfolios several decades ago. This theory is known as Modern Portfolio Theory (MPT) and it states that the best way to pick stocks is to pick a selection from the entire spectrum of the market including large companies through to small ones, to large-cap stocks, to small-cap stocks and so on.
This theory is the foundation for all robo-investing apps and is particularly relevant if you’re using a robo-investing app to invest in the stock market. There are two main reasons why a robo-investing app that is based on MPT is appropriate.
Professional Portfolio Management.
The Robo Style.
Professional money managers keep an eye on the market trends and buy and sell stocks based on the market conditions. It is an exhausting job as accumulating the required information can be a very tedious process.
To reduce the work load of the professionals, several companies developed financial software that can monitor and interpret data for you. The software generates the necessary trading orders for the investor. However, this service costs quite a few dollars per year.
That is why robo-advisors have emerged lately. Robo-advisors have been set up by firms that offer portfolio management services. If robo-advisors gain more popularity, some financial experts predict that there will be a significant decline in the use of professional portfolio managers.
On the plus side, robo-advisors give you the opportunity to invest, even if you do not have enough money to meet the minimum investments required for a full-fledged portfolio management service. Additionally, it offers you a high degree of flexibility. You can choose the right portfolio for your financial needs, at your own pace.
On the negative side, robo-advisors are not yet able to predict the market and make the best investment decisions. Furthermore, robo-advisory services on the market are still too new and have not yet been tested in tough economic times. This means that collectively, they are not experienced enough to handle the effects of an economic crisis.
Very Low Fee Structure.
Robo-advisors charge annual fees, management fees, or both. Most of them charge 0.25% to 0.50% as an annual fee, or flat fee, for their services. This is lower compared to the average mutual funds.
So all in all, robo-advisors are a very good option for startup investors, as well as those who have very little money to risk, or are unsure if they will be able to handle the stress of investing.
Com: A Breakthrough in Robo-Investing
Wouldn’t it be great to have a financial plan that allows you to make maximum returns on your investment without the hassle of doing it yourself? Well, with “Robo-Investing,” you can do exactly that.
In the last few years, robo-advisors have hit the market hard … and fast. These companies use computer programs that are designed to meet your investment objectives and risk tolerances. Because they are run by computers, they are also able to process each client’s data faster than traditional financial advisers.
The per-client cost of robo-advisory services, which range from 0.15 to 2% of managed investments, is comparable to that of traditional advisory services.
Unlike traditional financial advisory services, the use of robo-advisors doesn’t require a long term relationship or an ongoing financial contract.
Instead, robo-advisors rely on a “set it and forget it” mindset to investing. You set your account parameters, established your risk tolerance, and make your investment decisions. Then from then on, the money will be invested based on those choices.
Robo-investing is perfect for new investors.
Everybody is talking about automation and how we might be heading towards a future where investment services are entirely automated. And while this might be true, for the moment, most of the automated models out there are only suitable for more experienced investors who can easily understand the risks and market variations.
But there’s a problem; the people who need it most – the inexperienced – aren’t aware of this and aren’t taking full advantage of the automation. That’s where robo-advisors come in. Robo-advisors are low or no-fee automated investment service models designed specifically for investors who are just starting out. They take the pressure off investors by ensuring that every purchase or sell order is made at the best time and at the right price without the investor having to worry about picking his own stocks.
There are two types of robos out there; the first is free and automated with the investor’s identity being anonymized. The second is a pay service where the investor has to pay a certain amount every month for access to all the features. However, they do tend to be very affordable at around 0.25% per year.
The Drawbacks of Robo-Investing
Those of us who are still jumping over puddles as they appear in the street may not be the ideal candidates for robo-investing. Robo-advisors do a great job for investors who have the cash to put into stocks and want to invest in a diversified portfolio.
Low-fee investment services are a legitimate alternative to working with a full service broker. But it’s not right for everyone.
Robo-investing services are not appropriate for people who have very little money to invest. These services are also not suitable for people who are afraid they still might need that initial investment in the near future. If you’re just starting to learn about investing and still have some learning to do, you’re probably not ready to go robo.
Another problem with robo-investing is that you surrender control over your investments to an algorithm. You can see it work, but you can’t control it.
Another drawback is that algorithms are programmed to keep your money invested at anytime. This means it won’t sell during a prolonged downturn.
If you’re investing for retirement, that’s fine. But if you’re investing for short-term goals, robo-investing services may not be suitable.
You won’t beat the market.
You won’t even approach it.
Research on the average investment return has shown that, over the long-term, most mutual funds are roughly equivalent to the S&P 500.
In other words, a computer program that simply invests in an S&P 500 index fund will wipe the floor with 95% of actively managed stock funds over time. When you look at individual stocks, the story is even worse. Of the thousands of stocks traded, very few beat the overall market over time.
Of course, this is nothing new. Most of us know about the theory that it takes a lot of skill to beat the stock market. We also know that beating the market isn’t an easy task. That’s why so few try. It’s also why most of us employ index funds and mutual funds that don’t try to beat the market.
But with the rise of Robo-Advisors like Wealthfront and Betterment, there’s a new breed of financial advisors on the block. These start-ups provide automated investment services focused on providing the average investor with superior returns over time. They claim that they can do a better job than you can.
No do-it-yourself investing.
Robo-advisors use smart algorithms to track the markets and to make investment decisions for you. Most give you model portfolios that you can choose from (you can also set up an automatic savings plan if you wish.)
A combination of lower fees, online transaction convenience, and next day delivery make robo-advisors a viable option for many investors. But are they right for you?
If you own a small portfolio and don’t want to worry about market volatility, you should definitely look into robo-advisors. The chances are that they can do a better job for you than you would do yourself.
The way they work is that you fill out a questionnaire about your investing goals and risk tolerance and they provide you with a model portfolio and savings plan based on your answers. You can then choose to accept their recommendation or you can take it under advisement and make your own decision.
Limited customer contact.
Once you’ve selected your investment options, made any necessary adjustments and the investments are set up, your interaction with your online advisor will probably be limited to a few emails or phone calls a year where you’ll update your goals and the advisor will make sure that your investment allocations are still right for your objectives.
Robo-Advisors won’t manage your 401(k).
Robo-advisors are a relatively new investment tool used to help people save for retirement. Robo-advisors provide investment advice and help people invest their money. They do this at a fraction of what an investment advisor of a similar caliber can charge. But think deeply and you’ll realize that these investment tools are designed to work with tax-advantaged retirement plans – like IRAs and 401(k)s. It’s not a standalone product.
As I explained in a previous post, you can put your retirement savings in a traditional or Roth IRA or in a 401(k) plan. The two main differences between the 401(k) and an IRA are that with the 401(k), you get an immediate tax break and you can contribute significantly more money.
These tax advantages were built for the purpose of encouraging people to save for retirement. If you contribute large sums to a 401(k), the tax advantages alone can make the 401(k) an unbeatable option.
A Robo-Advisor or any other robo-investment tool will not be good for your 401(k). Robo-Advisors charge an annual fee that would eat away at your 401(k) savings. And if you’re already maxing out your IRA, passing up a Roth IRA contribution is a major mistake.
Will Robo-Investing Work for You?
As of today, financial advisors are the preferred choice for people who want the convenience of a robo-advisor, but who also want an actual person to talk to. Robo-advisors, automated investment services that offer similar features to investment advisors without the human touch (or the extra fees) offer people a new way to invest.
But will robo-investing work for you? After all, a robo-advisor can’t manage your money the way an investment advisor with a human touch can. Robo-advisors might be able to give you a good start on investing, but they won’t be able to provide the kind of personalized guidance you need to invest your money wisely.
The advantages of robo-investing include:
Simplicity. Creating an investment portfolio with a robo-advisor is easy. You won’t need to spend a lot of time learning about investing or investing terminology. You don’t need to understand stocks, bonds, mutual funds, or bonds. You don’t need to be an expert in world markets or political climate. You can immediately take advantage of the tools that the robo-advisor offers.
List of Popular Robo-Advisors
If you still don’t have a robo-advisor and are thinking of taking the plunge, you should consider whether it’s right for you. It’s important to do your own research and take into account your own financial strategy, needs, and goals.
Here are some of the robo-advisors we recommend.
Waiting until you have the extra cash to invest is one of the biggest mistakes you can make. One of the most common reasons for putting off investing is lack of sufficient cash to invest. This is why many people that are retirement age wish they would have started investing earlier.
Some people don’t have the money to invest in the first place, while others are just waiting for the right moment. Don’t make this mistake. It’s evident that the sooner you start, the more you will get from compound interest.
Care to Compare?
On its surface, robo-investing sounds like a great idea which could both help even the most inexperienced investor and simplify the investing process for everyone. Despite its obvious benefits, regulators have voiced their concern about the increased risks of robo-investing. Concerns include:
- Choice: While robo-investing sounds very similar to investing with a human advisor, the main difference is that the robo-advisor can’t provide subjective investment advice. It provides quantitative analysis, i.e. how the algorithm values the various investment options. But it doesn’t provide the investor with the qualitative insight of what they should invest in.
- Transparency: A risk of robo-investing is that investors may not fully understand how the algorithm behind the robo-investor’s decisions. They may not fully grasp the decision making process about how the investment is split up and may not understand other major factors that affect the robo-investor’s decision.