Everything seems to be getting smart these days: smart cars, smart TVs, smart thermostats, even smart refrigerators. It feels like anything can be automated, from a robot vacuum cleaner to a lawn mower that cuts the grass on a schedule.
But what about investing? That's where robo-advisors come in.
What is a robo-advisor?
A robo-advisor is a digital investment portfolio that uses algorithms to guide a preselected mix of investments. Human interaction or input is often limited beyond creation.
It's relatively easy to set up a robo-advisor account. Investors answer online questions about their investment goals, current financial situation and risk profile. These answers guide the robo-advisor's recommendations.
Robo-advisors can offer a range of services, including goal planning, portfolio management and limited financial planning. I say limited because robo-advisors focus on your investments. They won't conduct a thorough analysis of your cash flow and tell you that you need to cut down on dining out or that you should redirect some retirement savings to pay down high interest rate credit card debt.
Robo-advisor benefits
Robo-advisors can provide low-cost and accessible investment management services. The two most common comments I hear when talking with people about their investments are, “I don't know how” or “I don't' have time.” A robo-advisor can help with both of these concerns and offer other benefits as well.
Affordable, accessible investing
The entry price can be low. Some robo services start at $3,000, while others are at $5,000, and a few don't have an account minimum. Some financial advisors may have much higher asset minimums or a flat fee that can reach thousands of dollars to become their client.
Also, robo-advisors are available when you are. They can be accessed around the clock, as long as you have an internet connection. But keep in mind that since these are investments, purchasing and selling will occur during trading hours.
Portfolio diversification
Depending on the model used by the robo-advisor, the portfolio can provide built-in diversification. But if the robo-advisor only represents a portion of your overall portfolio, then you might not have appropriate diversification.
For example, let's say an investor has a 401(k) worth $100,000 and a robo-advisor IRA that has $25,000 in it. If their 401(k) is all invested in one stock, then the robo-advisor, even though it might be well diversified, can't make up for the concentration in the 401(k). Their overall portfolio isn't diversified.
To better understand the value of diversification, check out our article on how to diversify your investments.
Portfolio rebalancing
Most robo-advisors automate and optimize passive indexing strategies using modern portfolio theory. They maintain a mix of investments that's based on the user's personal profile, financial goals and risk tolerance, which they provide during the introductory questions.
When the mix is out of tolerance, robo-advisors automatically rebalance the portfolio. This can be a benefit since many investors may not have the experience or time to rebalance as needed.
But make sure to read the fine print. Understand how much the portfolio is allowed to stray out of tolerance before the robo-advisor would make an adjustment. Some have higher thresholds than others.
Professional management
While there's little to no human involvement when a robo-advisor investor account is created, professionals are still involved. They determined the rules the robo-advisor follows, and they manage or select the investments the robo-advisor uses.
Investments can include cash, passive and actively managed mutual funds, exchange-traded funds (ETFs), and more.
Tax-loss harvesting
Tax-loss harvesting involves selling securities at a loss to offset a capital gain tax liability on other securities. The goal is to reduce the investor's overall tax bill.
For example, if one fund in the portfolio has lost value, the robo-advisor can sell it, thereby locking in the loss to help offset gains made through the sale of another fund in the portfolio. This is especially valuable if the robo plans to replace the fund that has lost value anyway.
Some robo-advisors provide tax-loss harvesting services at certain asset levels. For example, an account value of $50,000 might qualify for this service, while those below this threshold don't. If tax loss harvesting is important, keep this in mind when selecting a provider.
Emotion-free investing
Humans are prone to making emotional decisions like panicking when the stock market is volatile. How did you react when the Dow Jones lost 37% of its value between Feb. 12 and March 23, 2020, due the volatility fueled by the pandemic? Did you sell in a panic?
A computer running an algorithm doesn't have emotions. It follows logic and a pre-determined set of guidelines and rules. A level headed robo-advisor can be a benefit in a highly charged emotional environment, unlike some less rational investors or financial advisors.
Robo-advisor risks
As with any investment, using robo-advisors has some risks. Some of the other considerations of investing through a robo-advisor include the following.
Ill-equipped to deal with personal crisis
Robo-advisors are agile, but they're not well-positioned to deal with unexpected personal crises or financial setbacks.
For example, if an account holder loses their job or faces a surprise medical expense, the robo-advisor won't automatically change its strategy. Rather than pivoting to provide personalized advice, the robo-advisor will proceed with its scheduled actions.
Since the robo is set on auto pilot, this could leave the account owner short on funds at a critical time. The robo-advisor only responds to the inputs it receives. So at some point, you're responsible for making sure what's happening is what you need to happen. This same situation could occur with any automatic investments, not just working with a robo-advisor.
Doesn't view your entire portfolio
A robo-advisor can only manage what it has access to, so that's the investment account it is in charge of. A robo-advisor won't know what investments you have in other accounts that it should take into consideration. Making all these assets work together is up to you or your financial advisor. Now, this isn't a factor if the only account you have is with the robo-advisor.
Does a robo-advisor replace a financial advisor?
It's important to note that a robo-advisor isn't for everyone. Some people may not feel comfortable with the one-size-fits-all approach, and others may prefer to have more contact with actual humans.
But, while an automated platform can do many of the same tasks as a person, it can't replace the person completely. Unlike a robo-advisor, a human advisor can provide comprehensive financial planning that extends beyond investments.
A human financial advisor can help clients craft budgets, evaluate life insurance needs, and develop retirement savings and distribution plans. On the other hand, robo-advisors usually have a singular focus: investment portfolios.
A human financial advisor can take into consideration all the investments their clients may have and personalize advice and recommendations as needed.
Financial advisors can also help clients navigate complex or uniquely personal financial situations, such as lifelong care for a special-needs child. Those needing or desiring more sophisticated investing strategies, such as options or limited partnerships, might be a good candidate to meet with a human financial advisor.
Of course, it might not be an either-or situation. Financial planners can use robo-advisors to help manage their clients' investment portfolios, while handling other financial concerns themselves. Want to learn more about working with a financial advisor? Read 5 questions to ask your financial advisor about retirement.
How can a robo-advisor contribute to retirement planning?
While people can benefit from consulting with a financial advisor for retirement planning, robo-advisors can still be part of that plan.
For example, a Roth IRA can encompass many different investments, some with higher risks and the potential for higher returns and others with slower growth and hopefully less volatility. A robo-advisor can help manage accounts with different investment goals. It also can manage investments in a traditional IRA or even a regular taxable account.
For questions about the difference between a Roth IRA and a traditional IRA, read our Quick guide: Roth vs. traditional IRA.
Is a robo-advisor the right choice?
This is the ultimate question, and every investor must answer that for themselves. Weigh the pros and cons when deciding whether to use a robo-advisor. A robo can be a great way to manage investments, especially for those who prefer a hands-off approach to rebalancing or for those who aren't comfortable making investing decisions.
It's important to make sure any financial decision — including using a robo-advisor — is a good fit for your personal financial goals. That includes carefully considering the risk tolerance, investing timeline and fees.
Think a robo-advisor might be right for you?
Check out automated investing through USAA.