How Do Robo Advisors Work? How Tech Impacts Investing

Should I use a robo advisor? The answer to that question depends on your approach to investing.

So before you try to decide which is the best robo advisor to select your investments, we should probably take a closer look at how robo advisors work. That way, you can decide whether or not you’d rather use technology to guide your investments or work with a human being to develop your investment philosophy.

The appeal of a robo-advisor

What if I told you that investing could be as simple as picking a number between 1 and 10?  Or 1 and 100? And answer a few questions that don’t seem to have much to do with picking stocks.

After that, a friendly robot would then pick a portfolio of stocks and bonds perfectly suited for your risk appetite.  All you have to do is sit back and reap the benefits without having to pick your own investments. Crazy stuff.  

That’s what the news channels would have you believe. But the truth is far more complicated. Let’s start with some basic questions.

For example, you know how robo advisors work? With a little more understanding of how robo advisors work, you can decide for yourself whether you want to use one.

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:

  • Leverage technology to help implement the investment strategy you created together.

Neither of these are bad choices. While some people will always prefer the personal touch that a human financial advisor provides, others will yearn for the low fees that go with robo advisor investment accounts.

So what is a robo advisor?

A robo advisor can be described as a self-guided online investment management platform that employs portfolio management algorithms to deliver low-cost, automated investment advice with low account minimums.

The first robo advisors were launched in 2008 during the financial crisis. Betterment, arguably the first robo-advisor to gain widespread appeal, was created in 2010. Their intention was to provide new investors, especially younger investors, with the ability to create a properly diversified portfolio for their specific situation without having to pay a management fee or meet account minimums.

How do robo advisors work?

A robo advisor creates an investment strategy, assigns an asset allocation model, and automates the investment selection process via computer algorithm. On top of this, these algorithms optimize portfolio management with additional functions that are hard to replicate by hand. These functions include:

  • Automatic rebalancing: When investment prices fluctuate, sometimes the investment mix between asset classes becomes unbalanced. Rebalancing is simply the process of selling securities that are overrepresented in the portfolio, while buying securities that are underrepresented.
  • Tax-loss harvesting: When done as part of rebalancing, tax-loss harvesting can focus on generating lower capital gains and creating the most tax efficiency in the portfolio.

However, the algorithms do not work without human input. Each investor has financial needs, investment goals, and risk tolerance preferences that are unique to their financial situation. The robo-advisor platform is responsible for acquiring this information from each investor. This is usually done by survey or questionnaire when the client first opens the robo-advisor account.

This isn’t much different from the everyday use of computer algorithms when people ask Google or Siri a question. The main difference is that instead of bringing you the answer you want, the robo-advisor platform incorporates your input into wealth management services that automate your investment decisions.

How do robo advisors work?

The majority of companies offering robo advisor services base their automated investment guidance on long-standing financial theories, like Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMH). 

These theories help provide the framework for the algorithms that automate the investment selection process. By replacing the human component of investment selection, robo-advisors are also able to drive down costs.

You can see this in the trend towards lower investment fees and lower account minimums that have prevailed over the past 10-15 years.

What’s the difference between a robo advisor and a traditional financial advisor?

When robo-advisors first came on the scene, there seemed to be an ‘either-or’ type scenario. When Betterment and Wealthfront, another pioneer robo provider, first rolled out services, they appealed to investors who:

  • Did not want to pick individual stocks
  • Could not meet the account minimum in a typical brokerage account
  • Did not care for the financial advice that a traditional advisor would provide

But a lot has changed over the past decade or so. Many traditional brokerages have since started implementing technology to automate their investment management services for customers. You can see robo offerings from:

  • Vanguard: Vanguard offers two options:
    • Vanguard Personal Advisor Services, which matches a human advisor to the client
    • Vanguard Digital Advisor, for those retail investors who prefer a robo-advisor approach
  • Fidelity Go
  • Charles Schwab Intelligent Portfolios

It used to be the case that robo-advisor fees were lower than what financial planners would charge. And when it comes to pure investment management, that largely holds true.

However, the above-mentioned platforms are quite competitive with the best robo-advisor offerings. Additionally, these custodians offer the flexibility to provide customer service and human interaction when the client decides they need financial advice.

With that said, it’s worth looking at fees.

How much are the fees?

Many traditional financial advisors charge around 1% of assets under management (also known as AUM) as an investment management fee. Compared to this, Betterment charges .25% for a ‘do-it-yourself’ model. This pricing difference used to be the premium spread between the traditional advisor offering and a robo-offering.

No more. There are a couple of trends at play here:

The distance is closing between service offerings.

Interestingly, Betterment also offers a ‘Premium’ model. This allows an investor to have ‘unlimited calls and emails with our team of CFP professionals.’ This model is available for .40% to investors who have a minimum investment balance of $100,000.

In comparison, Vanguard’s Personal Advisor Services, with customer support, is available to investors with $50,000 in assets, for .30%. So no longer is the robo-advisor the lowest fee model available. But there are changes within how fees are calculated to begin with.

Trend towards fixed fee pricing

There is another trend in financial planning pricing. Many advisors are gravitating towards a fixed, flat-fee model, also known as a retainer.

Having a flat fee enables advisors to:

  • Be more transparent about what they’re charging. With a flat fee, clients know exactly what they are paying, and they can stop when they no longer see the value.
  • Protect their business from stock market downturns. The AUM model allows advisors to benefit when their client portfolios go up. However, it means that their business also suffers when the stock market goes down. Providing fixed fees allows the financial planner to protect their business. Because most advisors really earn their money when the market declines.
  • Serve clients that don’t have tons of investment assets. This isn’t just people who don’t have money. This could be:
    • Business owners who need advice before selling their business
    • Highly compensated executives who have significant amounts of net worth tied up in company stock
    • High earners who are looking to make up for lost time in their retirement accounts.

But more than fees, there is the issue of trust. Most people hire the financial advisor because they trust the advisor. Whether it’s a person or algorithm, do you trust the company behind the investment management?

Do you trust the company?

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. There are still commission-based salesmen who peddle overpriced financial products to unsuspecting clients.

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.  

Most robo advisors are able to invest in low cost index funds, which reduce your fees.

When an advisor is not a fiduciary, they may an investment or insurance product that produces a higher commission. In today’s market, there are plenty of low-cost index funds available so clients can keep fees down.

That doesn’t mean the firms behind robo advisors aren’t trying to profit. However, by automating a lot of investment services, like rebalancing and tax-loss harvesting, robo advisors can keep costs low. This allows them to turn a profit while providing value to the investor.

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 traditional investment advisory firm. Robos also appear more attractive to people who are technologically savvy, or who can envision how technology helps enable better investment management.

Even if you consider yourself a slightly more experienced investor, robo advisors can still be beneficial.  For example, a person who understands investments, but doesn’t have time to manage rebalancing can benefit a lot. You still maintain control of the overall investment objective, but the day-to-day transaction management is automated.

Now that I know how robo advisors work, should I use one?

Personal finance is personal, so only you can really determine if a robo advisor is the right choice.

Here are some of the factors that might inform your decision:

  • How much money you’d want to invest
  • Overall net-worth
  • The complexity of your portfolio and investments
  • And whether you feel confident enough to go down the DIY road

In general, robo investing does offer an affordable, customized approachand 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.

Manage your investments from your mobile phone.

Some robos can 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 pretty low minimum deposits. However, there are some that require a sizable upfront investment.  Look closely at the robo advisor fees, as the ones frequently marketed are for mimimum services. There are a lot of ways for companies to incorporate an ‘up-charge’ for premium services you might not want.

Keep in mind, there are additional fees associated with the exchange traded funds (ETFs) that robos purchase on your behalf.  Often times these are not obviously stated.

Are robo advisors worth it?

If you don’t feel comfortable leaving your finances in the hands of a robo advisor, don’t do it. You can also look for firms that don’t rely on 100% automation and instead offer a human-assisted service.

If you’re looking for a ‘go-to’ person, or a close relationship with your financial advisor, robo advisors are not for you. Even at Vanguard or Schwab, you’ll get a different person each time you call with a question. And for some clients, that’s not worth the discount

Best robo advisors?

There are a ton of options available if you’d like to use an automated investment advisor.  That said, with so many out there, it can be difficult to figure out which to try.  

Here is a list of Robo advisors based on popularity, the robustness of offering, user adoption and how long they’ve been out.

  1. Betterment
  2. Wealthfront
  3. Personal Capital
  4. Vanguard Personal Advisor
  5. Wealthsimple

What you should do next

In short, robo advisors can be a great enabler for a lot of people who have relatively straightforward financial planning needs, but don’t have time for day-to-day investment management. They are a 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 investing, you should have a strong financial foundation before you dive into the robo-advisor space. Here are a couple of tips for people who are just starting off: 

If you’re ready to learn more about investments, check out our Investing section!

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