Robo-advisors are an automated investing service that builds and manages investment portfolios using computer algorithms and advanced software. Its services are automated and require little to no human interaction — which can be both a pro and a con of robo-advisors.
Whether or not robo-advisors are worth considering as an alternative to traditional investing tools and wealth management services is up to you. Read on to learn more that can help you decide.
What Is a Robo-Advisor, and How Does it Work?
A robo-advisor is a digital platform designed to apply user input in order to make or recommend, financial decisions on your behalf. It will begin by asking you a series of questions to determine factors such as your financial goals and relative risk tolerance.
Algorithms will then pair this information with presets such as passive index investment strategies (minimal buying and selling) and modern portfolio theory (MPT) to deliver an automated investing experience. While there is some monitoring involved, the automated system is designed to operate with minimal human supervision.
Because robo-advisors are designed to offer automated operation, they are something of a one-size-fits-all approach to investing. While these platforms can customize your experience based on your inputs, they’re still an automated service — meaning they have a limited amount of tricks up their sleeve when it comes to building and managing your investment portfolio.
Robo-Advisor Strategies
First and foremost, robo-advisors tend to run on Modern Portfolio Theory (MPT), which is a system designed to maximize returns while taking risk tolerance into account, typically through tactics like diversification.
For example, an investor who accepts a medium level of risk could potentially maximize returns by investing in low, medium, and high-risk stocks rather than just medium-risk ones while enjoying a collective risk tolerance that is acceptable to them.
Other strategies common to robo-advisors include the use of rebalancing bands, which adjust weights (types of investments) within the portfolio as the market fluctuates based on preset ranges, or bands, designed to maintain set risk tolerance levels. Tax-loss harvesting, or selling at a loss to offset capital gains that will result in greater tax liability (money owed on income taxes), may also be employed.
Robo-Advisor Pros and Cons
The Pros
The major advantage of using a robo-advisor is that they typically have little to no minimum balance requirement. This sets them apart from traditional investors. Robo-advisors make the process of getting started quick and easy. The automated platform asks you targeted questions and then gets to work investing on your behalf. You can set up your account and essentially forget about it.
Another pro of robo-advisors is that they operate solely on algorithms, so they can make decisions on your behalf without consulting you. This streamlines the investment process and limits the amount of time you have to put into managing your investments.
The Cons
With that being said, there are a lot of potential downsides to relying on a robo-investor instead of a trained financial advisor. To start, you need to be either a little tech-savvy or at least put in the time to make sure you’re comfortable with the platform so that you don’t accidentally make choices or allocations that don’t suit your financial goals or risk tolerance.
There are limitations to be aware of when you use robo-advisors. For example, the platform will select investments for you. Even if you do your own research, you can’t choose the stocks or mutual funds you invest in. This could mean you miss out on opportunities for growth. Alternatively, you may find yourself supporting companies that aren’t aligned with your values — for example, an advocate for clean energy may not be pleased if their investments are funding a company with a large carbon footprint.
Rest assured, robo-advisors are required to register with the SEC, just like human brokers, and they must follow the same laws. However, these platforms are not immune to compliance issues, so you’ll want to do your homework before choosing a platform to trust with your sensitive personal and financial information.
Robo-Advisors vs. Wealth Management Services
When it comes to robo-advisor performance, the biggest problem is that these platforms are essentially one-trick ponies. If you prefer the idea of a simple investment process managed by technology, then a robo-advisor is essentially your entry-level option.
What if you want a range of financial planning services, including retirement planning, estate planning, trust fund management, and more? Robo-advisors don’t offer these services, and they may not be particularly helpful when emergency situations arise.
Suppose that you have an emergency: a tree falls and crushes your roof, you lose your job, or you suffer another financial hardship. If that happens, an automated robo-advisor will need to be manually stopped from drawing funds from your account.
A robo-advisor will also expect you to have some investment knowledge going in; the platform will ask you a lot of questions, but it is not designed to educate you about financial terminology or concepts.
Are Robo-Advisors Worth It?
Before you choose a robo-advisor, make sure you can afford the solution you select. For some, the process may be a little too automated. After considering the robo-advisors pros and cons above, you’ll notice this relatively simple investment option offers easy entry and low maintenance. If you’re mildly tech-savvy and seeking a hands-off approach to investing, robo-advisors will accommodate you.
However, the process may be a little too automated. The concept of “set it and forget it” may be helpful for a daily alarm, but not for something to do with money coming out of your account. That’s not necessarily a dealbreaker, but it is something you’ll need to stay on top of in case you can’t afford the withdrawal amount for a month.
Either way, it’s essential to do your research. Make sure you’re choosing a robo-advisor system that you understand and trust with your investments.
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This article was originally published September 2, 2015.