May 31, 2022
What is a robo-advisor?
A robo-advisor is a digital financial advisor that automatically builds and manages your portfolio based on your investment preferences. These algorithm-driven platforms often rely on passive index investing strategies to reduce buying and selling while investing on your behalf. Robo-advisors are built to consider your risk tolerance and financial goals in order to invest with minimal guidance from a human financial advisor for portfolio management. Robo-advisors can be a less expensive, more accessible avenue for investors who don’t want to cover the cost of a personal financial advisor.
In this article, we’ll cover:
- A brief history of robo-advisors
- How robo-advisors work
- Advantages of robo-advisors
- Disadvantages of robo-advisors
- Finding the right robo-advisor
A brief history of robo-advisors
In 2008, the global financial crisis hit, and the entire U.S. economy was in turmoil. Major financial institutions began filing for bankruptcy, and many individual investors were unsure where to turn for investment management. Startup companies focused on emerging technologies in financial services saw an opportunity to provide an alternative to traditional investing. The concept of robo-advisors wasn’t entirely new; human financial advisors had been using software to help manage their clients’ assets since the early 2000s. But when the technology became publicly available in 2008, robo-advisor firms found success among everyday investors who had lost faith in Wall Street. Today there are over 100 robo-advisor services available.
How does a robo-advisor work?
Robo-advisors use algorithms to assign investing strategies and portfolios based on investors’ financial goals, preferences, and risk tolerance. The process usually begins with a detailed questionnaire. Your robo-advisor then uses your demographic and financial information to create your user profile and determine the portfolio that best fits your needs and investment goals.
Robo-advisors, like Smart Portfolio, typically create portfolios of exchange traded funds (ETFs), as they’re among the least expensive ways to invest, and there are a vast array of options available to build a diversified portfolio tailored to your investment goal. Some robo-advisors may offer more customized investment options for more advanced investors or individuals with larger account balances.
Once you put funds into your portfolio, most robo-advisors provide the following automated services:
- Portfolio management: Selecting and overseeing asset allocation, a group of investments on your behalf
- Portfolio rebalancing: Automatically moving funds between different investments to maintain the right balance for achieving your financial goals without compromising your risk tolerance
- Tax-loss harvesting: Automatically selling securities in your portfolio to deliberately incur losses to offset any capital gains or taxable income, thereby allowing you to pay the lowest taxes possible within IRS guidelines
Defining your investment goals
When setting up your robo-advisor account, it’s important to clearly define your investment goals. The introductory questionnaire will require information about your age, current financial situation, future financial goals, your investment horizon for retirement, and tolerance for risk. Your answers to these questions determine how the robo-advisor will build and manage your portfolio; thinking them through can also help you get a true sense of where you are now and what a realistic road to retirement might look like. Before you fill out the questionnaire, it might be helpful to use a retirement calculator to get a clearer idea of your investment goals.
Assessing your risk tolerance
Risk tolerance refers to the amount of risk you’re prepared to take when making a financial decision. Defining your risk tolerance helps shape your entire portfolio and overall investing strategy. Factors that may influence your risk tolerance include your age, timeline, financial goals, and how much you can afford to invest. Your robo-advisor will usually define your risk tolerance as one of three levels:
- Conservative: You prioritize avoiding losses over making gains, choose the safest investment options, and have the lowest overall tolerance for risk. This approach tends to focus on long-term financial growth over short-term returns.
- Moderate: You take some risks when investing but balance more volatile investments by putting funds into less risky asset classes to reduce the chance of suffering large losses when the market falls.
- Aggressive: You focus more on short-term gains and are willing to take on a higher degree of risk in exchange for potentially higher returns. This is the highest tolerance for risk and can result in both large gains and losses.
Benefits of using a robo-advisor
Many investors, especially beginners, find that robo-advisors offer several advantages over a human advisor or traditional brokerage.
- Lower fees: Most robo-advisors charge fewer fees in general, and the fees they do charge may be lower.
- Lower minimum balance requirements: You can usually get started investing with a robo-advisor with a lot less money up front.
- Easily accessible: All you need to get started with a robo-advisor is an internet connection, and you can access it 24/7.
- Less human bias and conflicts of interest: As good as any human advisor may be, they are subject to their own potential biases, emotions, preferences, or conflicts of interest. The robo-advisor is subject only to the algorithm for automated investing in a set portfolio aligned with your goals and risk profile.
Bottom line: Robo-advisors can make it easier and more economical to invest, which can be especially attractive if you’re new to investing or don’t have a lot of funds to invest at the beginning.
Disadvantages of robo-advisors
While many investors value the convenience and automation of robo-advisors, the “robo” part of the equation is a downside for some.
- Less personalization: While you give a robo-advisor information about your financial goals and circumstances, remember that it is making decisions for someone like you, not you specifically.
- Limited flexibility: The portfolio a robo-advisor assigns you may not be customizable to your specific needs. You’re getting automated investment management, which may not provide much flexibility.
- No human interaction: Many robo-advisors provide a wealth of educational materials about investing, but there’s rarely a chance to develop a relationship with a person who can give personal advice.
Bottom line: A robo-advisor takes into account the data you supply, but not the human qualities that make you, well, you. If you have complex circumstances or lots of questions, you might prefer a human touch.
|Pros of robo-advisors||Cons of robo-advisors|
|Lower fees||Less personalization|
|Lower balance requirements||Limited flexibility|
|Easily accessible||No human interaction|
|Less human bias than actively managed accounts|
Things to consider when researching robo-advisor services
What is a robo-advisor’s role in your financial planning and investing? To determine how, or if, a robo-advisor belongs in your investing toolkit, consider the following questions:
- Are you comfortable with a more hands-off approach to investing, or do you need the personal support of a financial advisor?
- Do you let emotions drive your investment decisions? Would you be better off if you could take some of the emotion out of investing?
- How much are you willing to pay in fees for portfolio management?
When you decide to invest with a robo-advisor, you have a lot of options. Some questions to consider as you compare them include:
- What specific services and/or account types are available?
- What types of investments are available?
- What fees does it charge? Does the app clearly disclose all the fees you’ll pay?
- What’s the minimum amount you have to invest? Can you purchase fractional shares?
- Is the app easy to use? Does it follow security best practices?
- Does it offer financial literacy resources, calculators, and other tools and guidance?
- Can you get support from a real person if you have questions or concerns? How easy is it to reach someone?
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How to start investing with a robo-advisor
Financial planning and portfolio management is becoming more accessible for ordinary investors every day. With a robo-advisor, you don’t have to choose between the expense of a financial advisor and the often-confusing route of figuring out how to invest with no guidance.
You can invest with a robo-advisor from the comfort of your couch. Once you’ve thought through your risk tolerance and financial goals, you can just grab your phone or laptop and get started. A robo-advisor like the Stash Smart Portfolio could be a convenient and accessible way for you to start investing in your financial future.
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