A robo advisor is an online software that manages customer portfolios using algorithms. Though robo advisors work using computer-driven systems, some come with licensed financial advisors to offer guidance to customers. Robo advisors have existed have yet to experience their first financial downturn.
How do they work?
Investors start by filling in a questionnaire with details such as age, investment goals, income and risk tolerance. The robo advisor will then use this data to suggest investment strategies that may suit the customer. It is up to the investor to decide whether or not to use the recommended strategies. If the investor’s situation changes later, they can always update the questionnaire to adjust the investment strategy.
Using the Modern Portfolio Theory, robo advisors diversify your portfolio by investing in a wide range of assets. Having a diversified portfolio lowers the chances of getting wiped out by one investment. Robo advisors mainly use exchange traded funds (EFTs) to create the diversified portfolio. Since it is a collection of bonds and stocks, an EFT is less risky compared to single stocks. In addition, trading with EFTs is less costly, thus making the portfolio cheaper to maintain.
Who robo advisors are suited for
Robo advisor is right for the following kinds of investors:
- Account consolidators – People who already have several portfolios and want to consolidate them into one investment strategy.
- Sophisticated investors – These are investors that have a good grasp of how investments and accounts work and believe in a passive approach to investing.
- Cost-cutters – Investors that want to save money by avoiding traditional investment management fees.
- Tech-savvy investors – People that have a good understanding of technology and are able to utilize it to manage their finances.
- Smaller investors – People that don’t have much money to invest.
However, robo advisors may not be a good fit for these investors:
- The uber-wealthy – Families and individuals that are very wealthy usually depend on complex estate and tax-planning strategies that robo advisors do not offer.
- Experienced investors – People that are very familiar with the markets and want to choose their own ETFs or stocks.
- Non-tech savvy – Anyone that is not comfortable using technology should consider avoiding robo advisors.
Pros of robo advisors
Here are the advantages of using robo advisors for investing:
- Low fees – Most robo advisors charge less than 1% of your portfolio as management fees, while traditional advisors charge 1% to 2%.
- Less paperwork – Creating an account with a robo advisor can be easier and quicker than setting up one with a human financial advisor.
- Objective decision-making – When humans are involved, decision-making is usually subjective and prone to errors. Using robo advisors removes the emotional element from investing.
- Low minimum investment – The minimum investment required by robo advisors is much lower compared to that demanded by traditional financial advisors.
- 24-7 access – Robo advisors are convenient since investors can access them at any time of the day or night.
Cons of robo advisors
Some of the downsides of using robo advisors include:
- A lack of personalized guidance – When an investor relies solely on robo advisors, they lack the personalized guidance that an experienced investment professional would offer. Although some robo advisors give you access to a financial advisor, you may need to have a large amount of funds in your account.
- No review of the system – Robo advisors use investing systems that are proprietary. As a result, investors don’t get a chance to test the system beforehand to discover how it works or uncover its weak points.
Robo advisors can be very cost-effective and powerful tools for managing a portfolio. If you believe a robo advisor is a good option, there are numerous options out there. Look out for robo advisors that offer a wide variety of services, low or no minimum investments and competitive fees. Financial advisor may be a better solution for people that are not tech savvy or have a complicated situation that needs specialized attention.