How Do Robo Advisors Work?
What if I told you that investing could be as simple as picking a number between 1 and 10? After that, a friendly robot would then pick a portfolio of stocks and bonds perfectly suited for risk appetite. All you have to do is sit back and reap the benefits. Crazy stuff. But how do robo advisors work? And where did they come from? And are they right tool for you?
This post will answer all those questions, as well give you a few more ones to think about...
Technology is changing how we invest
New technologies are transforming the world at a rapid pace. Previously, when it came to investments and managing your finances, you really only had a handful of options to choose from…
You could either:
- Go down the DIY path, by opening an investment account and building a portfolio, OR
- Hire a financial investment advisor (FIA), who you would work with to develop a portfolio based on your needs and their recommendations.
Neither of these are bad choices. But what it we could harness the exponential advancements in technology that are increasingly affecting the financial world? As of 2018, bots are executing trades at such a high-frequency that it accounts for as much as 80% of the entire daily volume on the stock market.
It’s not surprising that this incredible environment has given rise to a new option for managing investments; the robo advisor.
So what is a robo advisor?
These finance friendly bots are actually just a collection of computer servers, that auto-magically buy and sell investments. They do this through the use of sophisticated algorithms. The algorithms take into consideration things like a your risk tolerance, age, and what your goals are for the future.
All of this power is then packaged and polished into an easy to use app on your phone. All that's left for you to do is to periodically check in on these magical machines, and see what progress they've made.
How do robo advisors work?
A robo advisor automates the asset allocation process via a computer algorithm. A algorithm is a defined set of rules that a computer can use to solve specific problems, like optimizing a portfolio of investments.
Most folks benefit from the use of algorithms every day when they go ask Google or Siri a question. The main difference is that instead of bringing you the answer you want, it brings you the investments that best reflect the information you’ve provided.
The majority of companies offering robo advisors base their automated guidance on long-standing financial theories. Examples of these include Modern Portfolio Theory (MPT), the Efficient Market Hypothesis (EMH). They also incorporate guided surveys to determine your risk profile when you sign up for their service.
Generally speaking, there are two flavors of robo-advisors:
- Those that are based on a 100% algorithm-driven investment approach
- And those that are paired with human financial advisors, who usually step in for services that require more individual assistance such as taxes or retirement and estate planning
What's the Difference Between Robo Advisors and Traditional Financial Advisors?
Besides the obvious….their differences typically fall into one of three categories;
Due to the higher fees financial advisors tend to charge (1%-2%+ annually), most FIAs prefer to work with higher-net-worth individuals ($500,000+). This means that younger folks or those with a lower net worth may not have the opportunity to take advantage of their services.
On the other hand, robo advisors are for everyone. There are usually low annual fees and low account minimums. This makes them ideal for young people or those who don’t meet the net worth requirements of the larger advisory firms.
Having confidence in your advisor, human or bot, is extremely important. The issue that people can encounter with traditional financial advisors is that some don't recommend products aligned with your best interest. This is not always true, but it only takes one bad apple to ruin the bunch.
One way to make sure your financial advisor is aligned with your interests, is to make sure they are a fiduciary. This means they have a legal obligation to advise with your best interest in mind and not their own.
When they are not a fiduciary, they may recommend products which are less beneficial to you, but produce a higher commission for them. This isn't always true, but happens enough to create distrust in the market.
Robo advisors don’t have the same shortcomings tied to self interest. They utilize specific algorithms to drive their decision making that pulls from the same/similar tools and resources that traditional financial advisors have been relying on for years.
That doesn't mean the firms behind them aren't trying to profit. They absolutely are, but are working to be more transparent with their customers on how that happens.
Everything is not always rosy though when it comes to robo advisors.
Lower cost and higher efficiency usually comes as the sacrifice of options and flexibility. The bots tend to have a less investment choices as compared to traditional financial investment advisors. Often that's limited to a handful of exchange traded funds (ETF's) across a few asset types, sectors, and market mixes.
Additionally, as the field is constantly growing, you might need to spend some time researching companies offering robo advisors in order to make a sound decision.
Who Are Robo Advisors For?
Robo advisors are for people who may not be eligible or in need of the full suite services offered by a FIA. It also helps to be a little technologically savvy, though most of these platforms are super simple to use.
For the most part, any investor can benefit from using them. This is particularly true if:
- You have awhile until retirement e.g. 20+ years
- Don’t have much investment experience
- Or have simple portfolio needs
In these cases, a robo advisor can be a great starting point.
Even if you consider yourself a slightly more experience investor, they can still be beneficial. A bot can help you figure out how good you really are by creating a competing portfolio, and baselining against it. I do this myself, and you’d be surprised how often the little bot kicks my butt . That said, I’m happy either way 🙂
What are the common features?
Features between robo-advisors can vary greatly. A lot of them offer services such as:
- Tax Loss Harvesting
- Fractional Shares Reinvestment
- Portfolio Rebalancing
Some of them are actually not 100% algorithm-driven. In these cases, they are primarily human financial advisors with some tech-assisted interactions. This isn’t a bad thing.
If you’re looking to get advice on long-term life decisions, like retirement or education planning, choosing a company where the human element is not entirely removed may be an attractive choice.
One thing most robo advisors have in common is the relatively low cost. They are designed to offer a cost-efficient solution to traditional financial advisors, and most have enough options to create a reasonable asset allocation.
How do I know if they are right for me?
Personal finance is personal, so only you can really determine if a robo advisor is the right choice. You’ll want to weigh factors such as...
- How much money you’d want to invest
- Overall net-worth
- Complexity of your portfolio and investments
- And whether you feel confident enough to go down the DIY road
In general, robo advisors offer a customized approach that is also affordable and an excellent starting point for people without previous investment experience. Since robo advisors offer a variety of account types (e.g. individual, joint, IRA), it's easy to find one that will work for your needs.
Some even assist you with your 401(k) plan, managing things like asset allocation over time, as this can vary based on your age and the result of their risk assessment.
To make sure you choose the right tool for you, read carefully what each robo advisor firm offers and pay attention to the fine print, particularly those related to fees and deposits. A good starting point would be this guide to the different robo advisor options.
Pay attention to the total cost
Most robo advisors have minimum deposits that are pretty low, but there are some that require a sizable upfront investment. Look closely at the robo advisor fees, as the ones frequently marketed are often only for the services.
Keep in mind, there are fees associated with the Exchange Traded Funds (ETFs) that they purchase on your behalf. Often times these are not obviously stated.
Don’t ignore your gut
If you don’t feel comfortable leaving your finances in the hands of a bot, don’t do it. You can also look for firms that don’t rely on 100% automation and instead offer a human-assisted service
Depending on the amount of time and research you want to invest, you can opt to go for a robo advisor that manages your assets directly, or for a tool that only gives you trading advice.
There are also hybrid options, where robo advisors will only manage a portion of your assets too, leaving the rest to you or a financial advisor.
What to do next
In short, robo advisors are great, cost-efficient option for people who may not have the time and skills needed for the DIY approach or the resources needed to hire a traditional financial advisor.
As with any technology, they don’t come without shortcomings but the bottom line is: they can be a affordable, efficient, and low effort great starting point if you are just starting to get serious about your financial future. As with any investing, I recommend you have a strong financial foundation before you dive into heavy here.
What robo advisors have you tried out? Any pros/cons?
Leave your comments below!