There’s a new breed of financial advisor taking the investing world by storm – “robo-advisors,” who promise to provide an automated, low-cost investing management service with minimal hands-on maintenance required of the client.
While robo-advisors are growing in popularity, the portfolio management service certainly isn’t for everyone.
What is a robo-advisor?
Robo-advisors are online sites that automatically invest money for you based on the proprietary algorithms they’ve established. They provide asset allocation, portfolio rebalancing and regular account maintenance, among other investment services.
They often invest in index funds that track the market, or low-cost, exchange-traded funds (ETFs). With robo-advisors, dividends are reinvested automatically and your portfolio is rebalanced periodically to optimize returns and minimize risk.
Robo-advisors seek to maximize your gains with a passive investing strategy. These sites can also potentially lower your taxes with tax-loss harvesting, which refers to the selling of securities that have dropped in value to offset capital gains.
There are several online investment management sites providing such services, including Palo Alto-based Wealthfront, New York-based Betterment, and FutureAdvisor, which has its headquarters in San Francisco.
Who should use a robo-advisor?
Should you use an automated investment advisor to manage your portfolio or retirement fund? The answer to this question depends on the type of investor you are, as well as your age and financial goals. Here are a few points to consider before making a decision.
Robo-advisors can be an attractive solution for people who don’t want to learn how to invest or don’t have the time to manage investments themselves, since your money is invested automatically based on a computer algorithm. This automated service can also be an attractive option for someone who simply doesn’t have the time to manage his or her own portfolio.
Robo-advisors look attractive for investors who prefer a lower-cost alternative to financial advisors and big mutual fund companies, and for those who just don’t have a whole lot of money to invest.
Wealthfront requires a minimum of $5,000 to open an account, and manages your first $10,000 for free and for .25% above $10,000, with no commissions or account fees. On a $100,000 portfolio, monthly fees work out to just $18.75, or $225 per year.
At Betterment, annual expense ratios are .35% if you deposit a minimum of $100 per month. However, deposit less than $100 per month and your cost is a flat rate of $3 per month. With a $10,000 minimum balance the expense ratio is .25%; on a $100,000 minimum balance portfolio, the expense ratio drops to just .15%.
Most investment advisors and planners charge 1% per year to actively manage a portfolio, according to a Forbes article. This means a $100,000 portfolio would cost $83.33 per month, or $1,000 per year—quite a bit more than what you might pay for a robo-advisor. For the expense-conscious investor, robo-advisors look like a good choice.
For those who like to take a hands-off approach to investing, want a low-cost portfolio management service and feel comfortable investing money online as opposed to dealing with an actual person, a robo-advisor can be a solid choice.
Who should use an investment advisor?
Robo-advisors look like they provide a valuable investing service, but here a few reasons to choose investment advisors instead:
Someone with a high net worth might not feel comfortable forking over $1 million or more to a robo-advisor. Instead, this type of investor might prefer to sit down in person with a professional, creating a more personalized plan with regular check-ins over the phone or in person.
For those who want a personal touch, investment professionals still look like the better choice. Human interaction is still important for many people, especially when it comes to investing for retirement.
This is an issue that two companies -- Personal Capital and Rebalance IRA -- are trying to address. Personal Capital, with offices in Redwood City, California, offers financial advisory services and wealth management for those with more than $100,000 in assets. Palo Alto-based Rebalance IRA provides one-on-one advisor-client meetings for help with retirement planning.
(Two investment experts who play a prominent role at Wealthfront also sit on the advisory board at Rebalance IRA.
(Dr. Burton Malkiel, a professor, economist and author, is chief investment officer of Wealthfront and serves as an advisory board member at Rebalance IRA. Charles Ellis, founder of a consulting firm called Greenwich Associates, serves as an advisor at Wealthfront and also sits on the advisory board at Rebalance IRA. Malkiel and Ellis co-authored a book called The Elements of Investing).
Investors with a higher risk tolerance and those who want to be more involved with their investments will most likely not want to use robo-advisors. This is because these online investment management sites invest in index funds for their clients. This type of client may wish to invest in individual stocks instead.
While stock and bond ETFs may provide consistent returns that track or slightly outperform the market, they will most likely not provide the type of “home run” potential that individual stocks can provide. So if you think you’ve found the next Apple or Google, or if you think you have the time and knowledge to choose your own investments, you might be better suited for investing in individual stocks in a brokerage account or working with an investment broker.
Investors who want to try to time the market definitely shouldn’t use robo-advisors. That’s because these sites make trades infrequently and attempt to follow the market rather than trying to time it, according to Wealthfront.
The bottom line: robo-advisors work for certain investors
Robo-advisors can provide a valuable service for the right type of investor—especially those who want a low-cost, automated investing plan to “set and forget it,” as an article on Business Insider put it.
Still, the service may turn off investors who want a human element to investing and retirement planning, and those who prefer to be more actively involved with their finances.
Steve Nicastro is a financial writer for NerdWallet.com, where he covers topics such as investing, credit cards, mortgages and insurance. Previously, Steve was a local editor at Patch.com and a contributor for Seeking Alpha and GoBankingRates.com.