You’ve heard of Robo-cop. You’ve probably heard of Japanese Robo-dogs. But what exactly is Robo-advising?
As the name suggests, robo-advising is a new type of online financial service that provides advice on aspects of portfolio management. The solutions are generated automatically from algorithms that have actually been part of traditional portfolio management for years. Now these algorithms are the sole driver, whereas in the past they were used along with a personal advisor as part of a broader service. With robo-advisors, there’s no human counterpart on the other end.
Robo-advisors are also identified by other names, including “online (or digital) investment advisors,” and “automated investment advisors.” They’re limited to a relatively narrow range of portfolio management, namely, allocating investments among different types of assets (that is, helping you decide where to put your investment dollars for the best returns). They typically don’t apply to wealth management areas addressed by a traditional full-service advisor, such as retirement and estate planning, college savings, or cash-flow planning. And they’re focused on certain types of investments called exchange traded funds (ETFs), as opposed to traditional mutual funds or individual stocks. After the account is set up (created by input from the investor), computers manage the portfolio through ongoing, automated functions such as monitoring allocations and managing deposits and withdrawals.
Demand for this type of service has been increasing, and in recent years a growing number of stand-alone robo-advisor groups have been created (such as WealthFront, Betterment, and Personal Capital); or they have been integrated into services offered by established financial management companies (such as Charles Schwab and Vanguard). They’re popping up all over the world but are most prevalent in the U.S.
How do you know if robo-advising might be right for you? Conventional wisdom says that this type of advising “fits” certain kinds of investors better than others; younger clients who are new to investing, with relatively small portfolios. The rationale being that younger investors are considered more likely to be comfortable with strictly online, automated dealings. Newer investors are likely to be open to the novelty of robo-advising and may be less interested in a wide range of services early in their investing career. Some smaller portfolios haven’t yet reached the minimum amounts needed to qualify for more traditional management options.
If that profile sounds like it applies to you, you might be well-served by this new kind of management tool. However, there are other potential advantages you should consider, even if this description doesn’t match you perfectly.
Here are some aspects of robo-advising that may be attractive to you:
- Robo-advisors charge lower fees than traditional services, and use low-cost, index-tracking exchange-traded funds (ETFs) for their investment portfolios, which tend to produce reliably above-average net returns over the long run. This combination of lower fees and positive returns creates a serious incentive for investors to give them a look.
- Automated advisors have no motive to push clients toward more costly funds (for example, as a way to achieve higher commissions). In this sense they can be considered more transparent and reliable than some traditional (human) advisors may be.
- Some aspects of portfolio management are best-served by the kind of 24/7 monitoring that automated investment managers offer, whereas client portfolios in traditional management services are monitored only periodically. Additionally, continuous automated monitoring catches and sells stocks or funds that have dipped below their purchase price more effectively, delivering better loss management.
- Some argue that these services can be as good or better than those of traditional advisors. The customized questionnaires that set up the accounts are designed by behavioral finance experts, and are geared to investors’ specific profiles and goals. The sophisticated algorithms are derived from application to securities management over many years, and are grounded in modern portfolio theory. In this sense, they have an excellent “pedigree” and offer affordable, direct access to portfolio management tools for middle-class investors who might not have tried investing otherwise, along with the opportunity to grow their wealth.
- Positive experiences with robo-advisors, especially by newer investors, create incentives to save and to continue investing prudently. By offering a cheaper, more efficient way to invest, they can also effectively “train” less experienced investors so that if and when they want to move to a different arrangement, they’ll already understand the importance of managing costs and investing for the long term.
Conversely, here are some points to consider which may make you wary of diving in to robo-advising:
- Some industry experts argue that focusing on ETFs is no more effective than focusing on traditional mutual funds for cost savings and long-term benefits, and that automated investing has been around for decades.
- Relative to what’s offered by traditional asset management services, robo-advisor accounts can be seen as inflexible and limited, not sufficiently geared to the unique needs of individual investors.
- Investors should also consider what level of interaction and communication they’re comfortable with, and whether an exclusively-automated arrangement feels appropriate.
- Some investors are probably going to be turned-off by the very concept and the term “robo-advising.” They may feel short changed by not getting personalized service with a human face, and the judgment that only experience can supply.
Whatever your inclination may be, robo-advising as an industry is growing by leaps and bounds. By providing a low-cost, accessible option to an expanding range of investors, these types of services are probably going to be around for awhile. Take some time to familiarize yourself with their benefits and drawbacks, and consider whether they’re right for you.