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This is a relatively new industry, which is why we’ve included this robo-advisor FAQ.
The goal here is to help you better understand the industry and make an informed decision for your specific needs.
The following FAQ will help you understand these new services.
What is a Robo-Advisor?
A robo-advisor is a computerized financial advisor. Influenced by sophisticated computer algorithms it will create and manage an investment portfolio for you.
The key here is automation. After the user provides the robot with a series of answers about the desired investment goals and level of risk aversion, the robo advisor will then manage the clients portfolio on autopilot.
The strategy most robo advisors are based on, is modern portfolio management theory.
Sometimes, the service of a robo-advisor will also include access to human financial advisors.
What are the differences between the many robo-advisors?
We have dedicated an entire article to the differences between robo advisors, to give you an overview however the following list should suffice:
Here are some of the ways that robo-advisors differ:
- Account minimum
- Types of investments
- Active / Passive – is there additional human advice?
- Rebalancing or tax loss harvesting?
- Other services such as lending
- Support and Platform / UX
How much do Robo-Advisors cost?
The biggest cost that comes with the services of a robo advisor is the annual fee on the invested amount. Most common fees are any from 0.25% – 0.5%, however since there is so much competition some companies like M1 Finance actually offer their service at 0.00% to diversify.
Besides these fees, an investor will also be charged for the underlying investment products. In the case of Exchange Traded Funds (ETFs), these fees might be as low as 0.25% charged on the invested amount per year.
Mostly, these fees are much lower and easier to understand compared to the costs of traditional investment advisors. These costs combined can amount to 2.5% – 3.5% on the invested amount per year.
Who benefits from using a Robo-Advisor?
Like any new technology, in the beginning robo advisors were geared towards the early adopter, tech-savvy crowd.
All of a sudden it was possible to “play with the big boys” with low investments. The typical target audience where investors with little money and less complex financial situations. But as older generations started get to know the benefits of robo advisors, this soon changed.
Interestingly, nowadays even human financial planners use robo advisors to automatically rebalance their clients’ portfolios.With over 200 different services available, there is really a robo advisor for everyone. Among those who
- are looking for low fees
- lack the time or interest to actively manage their investments
- are into DIY investing and want to get their feet wet
What’s the difference between a Robo- and a Human advisor?
…and which one is better?
This is probably the first thing that new users ask themselves. The answer is, it entirely depends on your situation.
Moreover, it is impossible to say which one is better. In some cases actually, a combination of the two can be your best bet.
In most cases, a robo-advisor platform invests in a limited number of low fee ETFs or mutual funds. A human advisor on the other hand can work with many other types of investments. Most robo-advisors also do not help with your insurance, taxes or estate planning.
The greatest benefit of a human financial advisor is that this person usually develops a relationship with their client and can be contacted at their convenience. Their fees however, are typically higher. As previously mentioned some robo-advisors like Schwab for example, also partner with human financial advisors.
Why invest with a robo-advisor?
The benefits of investing with a robo advisor are too many to name in a simple answer. Actually, we have dedicated a whole article to the different benefits of robo advisors.
However to keep things simple, the main benefits are the following:
- Lower fees than traditional human advisors
- Access to investment management anytime, anywhere
- Transparency over your finances
- Anyone can now invest in a way that used to be reserved for the wealthy
Why not invest with a robo-advisor?
If you feel that a human advisor is better at understanding the needs of your specific situation, a traditional advisor is the way to go.
Especially if your portfolio consist of many alternative investments like real estate or inheritance, a human advisor can be beneficial and help you out with a more holistic strategy.
Do robo-advisors offer human support?
When speaking about robo advisors, it can sometimes seem like there is no human involvement at all. This, however, could not be further from the truth.
Despite the main focus being on providing automated investment advice, a lot of robo-advisor offers human support as well. Usually the ways to get in touch with a human are by phone, email, chat and even SMS. What you will not find however, is support staff sitting around in branches or visiting you at home.
Certain robo-advisors offer hybrid models.
Communication is possible via online video chat with a real person. You can then ask all the questions you have, especially about aforementioned alternative investments which are assets that can not easily be included in your robo portfolio.
The hybrid models are more labour-intensive and therefore usually more expensive.
What happens if a robo-advisor goes bankrupt?
This is an important question.
It depends. Some robo advisors will just sell your assets and give you your money back at a lower performance. Most however work with custodians which means they merely act as the intermediary between you and a bank. You will then have the option of moving to a self-directed account with the custodian company.
Therefore, if your robo-advisor goes bankrupt, your money will be still be sitting safely in your bank account at the respective custodian.
The law states that the advisor is not allowed to access your money for any purpose other than investing it in your best interest.
But of course that sounds all fine and dandy, but regardless you should really look at the fine print and the TOS to get the best understanding of the bank (or custodian) that is responsible for your account.
Does my bank offer a Robo-Advisor?
Lately it seems like every day a new bank jumps on to the robo band wagon. More and more banks are beginning to understand the potential robo-advisors offer.
Keep in mind however, if your bank approaches you with an offer, that all that glitters is not gold. Banks have a lot of personnel that needs to get paid and the money has to come from someone. Requesting full transparency in this case is paramount.
What is Asset Allocation?
Asset allocation is strategy in which investment portfolios are divided between different assets. The categories are typically stocks, equities, bonds or cash. (Things like art, real estate or commodities are alternative asset categories)
Asset is allocated in different categories to minimize risks. So on one hand you would have stocks which usually come with a bigger risk (and higher potential returns) and on the other hand you have fixed assets such as bonds which have the opposite characteristics.
So if you are young and more aggressive in your investment strategy, you would typically opt for a higher percentage of stock assets, whereas and conservative investor would hold a portfolio with more fixed assets.
What is Rebalancing?
Rebalancing is the process of realigning your portfolio of assets. Basically, it means selling some winners and buying more of your losers.
This is usually done periodically. It keeps your investments in line with your risk profile and gives you a better chance at increasing your overall returns. Most robo advisors will do that automatically for you.
What is Tax Loss Harvesting?
Tax loss harvesting is the practice of selling a security that has experienced a loss since its purchase. By realizing a loss, you are able to offset taxes on both gains and income.
The sold security is then replaced. It is replaced by a similar security, that way you can maintain an optimal asset allocation. This usually happens 30 days after the sale.
Why 30 days you may wonder:
Waiting 30 days allows you to avoid the wash sale rule. The wash sale rule is a rule that forbids the immediate purchase of the same security.
What is an ETF (exchange-traded fund) or mutual fund?
This is what makes up the biggest part of your typical robo advisor’s portfolio. An ETF is a type of investment which groups together many individual stocks or bonds into one package or fund.
One great benefit of ETFs are that the risk is comparatively speaking very low. By combining the stocks and bonds of many different companies, the risk is diversified. The other great benefit is that ETFs generally mirror popular ‘indexes’ like the the S&P 500 and charge very low management fees.
Are there any risks associated with investing in ETFs?
Yes, any investment will be associated with a certain amount of risk. ETFs however are considered to be a low-risk way to invest. Granted, this is not say that they lack any criticism at all:
In times of market stress, a so called “bid-offer spread” can occur. What happens is, the price of an ETF can be different to the sum of the prices of its securities. This occurs anytime the fund managers are not able to bundle or unbundle the ETFs as quickly as the market requires.
That is why it is incredibly important to choose a reputable ETF manager and this is where a robo-advisor can provide invaluable support.
Also keep in mind that there are thousands of different ETFs to invest in, not all of them will have the best returns. Especially for beginners it can be tricky to differentiate the good from the bad.
What is a robo-advisor fund’s management expense ratio?
A robo advisor typically invests a large amount of your asset into ETFs.
ETFs are usually not managed by the robo advisor, but by a different company.
So this company will charge you a small fee, usually around 0.05% – 0.1% for managing the fund.
What does SRI mean?
Socially responsible investing. Some services give you the option to invest in companies with good social reputation and value. This can be done by investing in individual stocks/companies or through a socially conscious mutual fund or exchange-traded fund (ETF).
Michael is a senior writer at The Robo Investor. He earned his master’s at the Craig Newmark School of Journalism at CUNY, and is currently taking CFP courses at the University of Scranton. He has been an avid finance enthusiast ever since he started investing at the age of 23. Meet the Team