Investing can be daunting. If you’re cunning, well-informed, and a little bit lucky, you can make out like a bandit. But it’s just as easy to lose everything you put in. Financial advisors can help, offering their expertise and experience to guide your investment decisions, but their fees are often prohibitively expensive. How can you leave your investing decisions to a reputable third party without all the extra fees? Simple: use a robo-advisor.
What is a robo-advisor?
Robo-advisors are platforms that provide automated investment services. Instead of calling on human experience, robo-advisors use algorithms to curate the best portfolio for your needs.
“If you buy your own mutual funds, it is up to you to pick the funds and manage them,” says Joshua Wilson, CMT®, AIF®, chief investment officer at WorthPointe Wealth Management. “By investing with a robo advisor, you outsource the selection of investments and the management of them.”
They can also help you with rebalancing your portfolio, tax loss harvesting, and more. You’ll typically answer a few questions about your risk tolerance and how long you plan to invest, and the robo-advisor will select a portfolio for you, ranging from conservative to aggressive.
Robo-advisors vs. financial advisors
Let’s break down the three main differences between working with a financial advisor and using a robo-advisor.
A typical robo-advisor management fee ranges from 0.25% to 0.50%. This means that a $50,000 balance would have a yearly fee of $125 to $250.
There are also no commission fees when you buy or sell in your account or rebalance your portfolio. But there are expense ratios associated with each of funds the robo-advisor invests in.
A financial advisor, on the other hand, may charge you 1% to 2% on average, bumping up your annual fee to between $500 and $1,000.
Robo-advisors typically come with only five to 10 portfolio options. In most cases, you don’t even directly choose your portfolio.
“[Robo-advisors] offer very little personalization and, so far, no more sophisticated strategies that can protect investors from certain market outcomes,” says Wilson.
With a financial advisor, you’ll likely get more investment choices. You’ll also have more say on how to invest your money. If you’re a sophisticated investor, you may prefer this option.
Since financial advisors are often paid based on their assets under management, they’re typically not interested in taking on low net worth clients. So if you have $50,000 to invest, you may not find a good advisor who’s willing to take you on.
In contrast, robo-advisors often have very low minimum opening deposit amounts and don’t turn you away based on your income or investable assets.
For the most part, robo-advisor portfolios are made up of low-cost exchange-traded funds (ETFs), which are securities that track an index, a commodity, bonds, or a mix of those. Unlike regular mutual funds, ETFs can be traded on the market.
Because robo-advisors are still relatively new, there’s not a lot of historical data on their performance compared with that of a financial advisor. Robo-advisors like Betterment, however, share performance records as far back as they go.
For example, a Betterment portfolio with 80% stocks and 20% bonds had a cumulative return of 139.8% between January 2004 and May 2017. Average private client investors, on the other hand, saw a cumulative return of 90.1% over that same time.
Of course, past performance doesn’t guarantee future results. It can also be difficult to compare a robo-advisor fund’s performance with that of an actively managed fund, because the underlying securities of the portfolios may differ wildly.
In general, it’s always good to compare different robo-advisors and their performance record before choosing one. But what should you look for in a robo-advisor?
What to look for in a robo-advisor
Each robo-advisor offers different advantages and disadvantages. Some offer access to human advisors to interact with, but charge higher management fees. Others are inexpensive, but use rudimentary algorithms. When researching robo-advisors, keep an eye out for the following traits:
Available account types
There are two different types of investment accounts.
Retirement accounts (e.g. 401(k)s and IRAs) let you deduct your contributions from your taxes, but often have rules about when you can and can’t contribute or withdraw funds.
Nonretirement accounts, or taxable accounts, do not offer the same tax advantages, but sidestep the restrictions of retirement accounts. This is the better option if you desire flexibility and ready access to your earnings.
Before committing to a robo-advisor, make sure it manages the type of account you want to open.
Management fees are deducted annually from your balance, typically as a percentage of your total balance. These fees will reduce your returns (a fee of .3%, for example, reduces an average 7% return to 6.7%) — so you should look for the lowest fees you can find. These fees typically range from .25 to .5% — try to stay on the lower end of that range.
Expense ratios are annual fees paid not to your advisor, but to the investment funds themselves. Mutual funds, index funds, and exchange-traded funds all charge these fees to cover maintenance costs. Expense ratios are unavoidable, but you can seek out an advisor who uses low-cost funds. These fees vary based on the type of investment in question — equity mutual funds charge higher fees than money market funds or equity index funds, for instance. When considering a robo-advisor, examine the funds that they invest in, and ensure that the expense ratios on those funds don’t exceed the market average. If they do, you could be losing a serious chunk of your earnings.
Tax-loss harvesting involves selling losing investments and using that loss to reduce the taxes you’ll owe on your gains. It’s difficult to manage but can save you a lot of money, so if a robo-advisor is able to do it for you, it can be seriously helpful.
However, this is only applicable if you’re looking to open a nonretirement account. Tax harvesting doesn’t apply to IRAs or 401(k)s.
Rebalancing is the process of realigning your portfolio to suit your preferences. Let’s say you wanted an investment ratio of 50% stocks and 50% bonds. If the stock market flourished, your stocks could have grown to comprise 70% of the value of your portfolio. A robo-advisor that offers rebalancing would then sell some stocks and buy bonds to maintain equilibrium.
Seek out a robo-advisor who performs rebalancing to avoid the risk of over-investing in a particular asset class.
Socially responsible investing
If you’re a conscientious consumer, you’ll want your investments to line up with your ethics. After all, if you’re boycotting a company for worker exploitation, you wouldn’t want to find out that you had inadvertently invested in it!
If you want to prioritize socially progressive companies or avoid investing in controversial industries like weapons manufacturing, choose a robo-advisor that advertises socially responsible investing.
Should you use a robo-advisor?
“I think robos in their current state are great for new investors,” Wilson says. “Especially younger investors who have very small sums of money and who do not need to speak with a human for guidance.”
He adds, however, that many people would benefit from paying a financial advisor for good investment advice. Essentially, that includes “anyone who requires personalization, financial planning, estate planning, or more sophisticated investment strategies,” he says. In other words, if you can afford a human financial advisor, they could be worth their wages.
As with any financial decision, it’s important to compare multiple robo-advisors to determine which one you like the best. Each one has a different investment philosophy, and they all offer an assortment of features.
Here’s a quick summary of the top robo-advisors and investment advisors.
As you’re searching for the right one, know what features you want. For example, Betterment is a great overall choice. But Personal Capital may be a better idea if you have a lot of assets to invest and you want more options.
Also, compare the robo-advisors to regular brokerage firms.
As you’re trying to decide the right robo-advisor for you, do your homework on each one and carefully compare the pros and cons. The sooner you pick one, the easier it will be to “set it and forget it.”