What is a Robo-Advisor? Should you trust a robot with your money?

What is a Robo-Advisor. Should you trust a Robot with your money?

Robo-Advisors are really nothing new. However, they recently have started to become much more popular due to the low starting financial requirements compared to a traditional financial professional. Also, the use of a Robo-Advisor seems to be on the rise as a result of the increasing distrust of financial advisors.

With the growing popularity of the Robo-Advisor, are they a good option compared to a conventional financial professional?

What is a Robo-Advisor?

First, it is important to understand what exactly a Robo-Advisor is. They really aren’t actual robots that handle investor money. A Robo-Advisor, in reality, is a computer software program that builds client investment portfolios based on algorithms. The software builds a client’s portfolio based on individual preferences by asking questions including; risk preferences and investment goals.

Once a client fills out a questionnaire for a Robo-Advisor, the software then returns the results with a diversified investment portfolio that is built on the client’s preferences. There is little to no human interaction for the entire process. Thus, this is where the term Robo-Advisor comes from.

Robo-Advisors have been slowly replacing many traditional investment advisors due to a much more cost-efficient way for investors to manger their money.

Robo-Advisors are not new

Although Robo-Advisors have only become more popular in the last decade or so, the computer software used by the Robo’s is nothing new. The only difference is now the software many financial professionals have been using is available to the general public. The truth is if you have had a traditional financial professional manage your money for some time now there is a good chance you are already receiving the help of a Robo-Advisor also.

The secret for many financial professionals is they have been using advanced financial and portfolio software for some time now. The result is if you have been using a human being to manage your money, there is a good chance a Robo-Advisor is helping them. For many financial advisors following a new client meeting, they will just plug a bunch of information from a questionnaire into a computer and magically a suggested investment portfolio is built.

Robo-Advisors are not new. The truth is your financial advisor has likely been getting help from investment and portfolio software already.

The actual human beings that have been managing money for some time now have had the assistance of Robo-Advisors and they still do. The result is a client will pay an advisor in many cases to use computer software. The outcome of this is an investor pays a higher fee for a human being in many cases compared to just using a true Robo-Advisor.

Also, think of the target-date mutual funds that have been around for a while now. These investments adjust as time goes on and they are similar to a Robo-Advisor. For example, a retirement target-date mutual fund automatically rebalances risk as an investor nears retirement to retain portfolio investment earnings. The Robo’s have been at work for a while with these investment products.

Should you trust a Robo-Advisor with your investments?

Using a Robo-Advisor really comes down to personal preference and there are numerous advantages to working with one. Trusting your money with computer software might appear easy to do, but it is important to remember that people write the software for Robo-Advisors. Although they are not human, it doesn’t mean they won’t make mistakes.

The computer software and algorithms Robo-Advisors use are only as good as the software written by the developers.

What are the pros of using a Robo-Advisor?

Low cost to start

The challenge today with a traditional financial advisor is the investment minimums many of them have for a new client. It is not uncommon for advisors to require an investor to have at least $250,000 in investible assets to be a client.

With the changing securities laws and commission structures often being lowered or completely eliminated, most financial advisors do not have the time to work with investors that do not have a sizeable portfolio. It just doesn’t make financial sense for an advisor to take on a client that might have for example only $10,000 to invest.

Not only can it be challenging to find a qualified financial advisor to take on a smaller account, if they do the client often does not get the service they need or believe they should get. The truth is most successful financial professionals make a majority of their living off of their wealthier clients. There is nothing wrong with this, but it is important for investors with small accounts to realize this.

Because Robo-Advisors are not human beings that need to put food on their table, they can often be used by opening an initial account with a very low balance.

Lower fees compared to a traditional financial advisor

Although just a small change in fees doesn’t seem like much, it can make a difference over twenty plus years in an investment portfolio. One of the big attractions for using a Robo-Advisor is low fees. Where a traditional financial advisor might charge something like an ongoing 1%-2% annual fee each year based on a client’s investments, a Robo-Advisor’s fee could be as little as .25% or less.

Robo-Advisor Fees can be much lower compared to a traditional financial advisor

An example of fee differences between a Robo-Advisor and its human comparison would be with a client that might have 300k to invest. The traditional financial advisor that charges a 1% fee would make $3000 off the 300k. The Robo-Advisor that charges a .25% fee would make just $750. This is a $2250 difference for just one year.

For someone that has only a few thousand dollars to invest the fees can really start to make a difference.

Robo-Advisors can help an investor stay on track

A Robo-Advisor can be ideal for an investor’s goal. With the help of automated portfolio rebalancing, it can be much easier to stay on track rather than an investor working on their own having to occasionally rebalance their investments.

A Robo can also be very good at looking for tax losses and making trades to benefit an investor at tax time. Not to say a human could not do this as well, but with a Robo-Advisor they can be automatically told to do this.

A Robo-Advisor can be good for a novice investor

For a beginner investor or one not very knowledgeable, a Robo-Advisor can be a good alternative opposed to investing on their own. They can also be a good traditional advisor replacement for someone that doesn’t want to work with a human being and pay the higher fees.

Robo-Advisors have really become very popular with millennials who do not have the high deposit amounts to open a traditional investment account with a financial advisor. This is similarly even the case many times for more experienced younger investors that either doesn’t trust a traditional advisor or want to stay clear of the high fees.

Robo-Advisors can be good for experienced investors

Most people like to believe that a Robo-Advisor is only for inexperienced investors. This isn’t always the case. The Robo can also be a good choice for a very experienced investor. The reason for this is the Robo-Advisor can be automatically set up to trade and rebalance. For an experienced investor that does not have the time to manually work with their own investments, a Robo-Advisor can be a good choice.

Don’t want a traditional financial advisor

Just like any professional industry, there are good and bad sides to it. The financial industry is no different and it certainly has gotten some very damaging press over time. Stories on Ponzi schemes and fraudulent financial professionals have not been limited. This is in addition to the high fees and commissions financial advisors are known to charge.

With all of the bad press and the abundance of it available, it should not come as a surprise that many people have a difficult time trusting a financial advisor with their money. For this reason, a Robo-Advisor can be a good option for someone that does not want to manage their own investments.

Are there disadvantages to using a Robo-Advisor?

With all of the advantages of using a Robo-Advisor, it would appear challenging to come up with reasons why an actual financial advisor might be a better choice. However, there are some instances where it might make better sense to hire an actual person to manage your money.

Robo-Advisors and human assistance

Some investors may not want to work with a Robo-Advisor. These people would prefer interaction with someone and the opportunity to build a relationship. There are Robo-Advisors that offer a little bit of both, but it really never will be the same as having a dedicated financial advisor.

There are people technology opposed and they prefer the interaction with a human being. A Robo-Advisor will probably not be a good fit in this situation.

Multiple investment accounts

Although Robo-Advisors are getting better at working with an entire investment portfolio consisting of several accounts, there can be situations where the Robo is not able to do this. Someone that has a lot of investment accounts that can’t be consolidated into one big relationship to work with a Robo-Advisor might be better off with a traditional financial advisor.

One of the biggest mistakes of investing that many people make is not having a big picture with all of their investments. Without this, it can be challenging to make good investment choices not knowing what is occurring with all accounts.

Investors with a need for true customization

Investors that require a truly customized investment portfolio to diversify their investments extremely well and take advantage of any tax savings might be better off with a financial professional they can sit down with a few times a year. Also, having one an investor can call on the telephone that knows them personally can be beneficial.

The truth is the types of investors many times that meet the criteria to have a personal financial advisor are the affluent ones. People that have wealth often have their money in many different places. It is also not uncommon for these people to have the largest tax obligations. Thus, they have a real need to try and minimize their taxes.

Most people likely do not require a financial advisor they can sit down with regularly. However, wealthy people can often benefit from the true value of a financial professional. They also will have the money to do it and the most wealth at risk requiring a lot of attention.

People nearing retirement might also be able to truly benefit from sitting with a traditional advisor at least at the beginning of retirement or when getting close. This can help get their finances in order to properly prepare for retirement. It can also help with knowing what to expect.

Is investment performance better with a Robo-Advisor compared to a traditional money manager?

When it comes to investment performance Robo-Advisors generally match the performance of an Index. They do not beat the market, but many times will at least match it or come close. There are some Robo’s that are trying to beat market averages, but they typically will not.

The human financial advisors do not also beat the market consistently. There might be a few that beat it every once in a while, but overall, they won’t. Not even most mutual fund managers themselves beat market averages in a 15-year period over 80% of the time.

Contrary to what several investors might believe, hiring an actual advisor is not for the purpose of getting exceptional investment returns. An investor should hire a traditional advisor for the added value previously mentioned, which includes more portfolio customization.

Is a Robo-Advisor right for you?

There is no right or wrong answer to figuring out if a Robo-Advisor is right for you. It really depends on the investor, their situation, and what they expect out of it. For most people, I believe a Robo-Advisor can be a good choice if they do not want to use a traditional financial advisor.

The reality is that most people likely do not need a true financial advisor. This is particularly the case for educated investors that do not have a sizeable investment portfolio to warrant the needs of a traditional advisor. The savings in commissions and fees alone by using a Robo-Advisor can be well worth it.

If you are considering a Robo-Advisor, Investopedia has a good summary containing some of the better Robo-Advisors available. Not everyone needs an advisor either Robo or non-Robo-Advisor and here is a previous article on some of the reasons everyone does not need an advisor – Does Everyone Need a Financial Advisor?. For investors that want a true financial advisor, it can be a challenge finding one that is both trustworthy and experienced. Here are 25 questions to ask a potential financial advisor that should be helpful.

What are your thoughts on Robo-Advisors vs a Traditional Financial Advisor?

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