Robo advisors and automated investment tools
What is a robo-advisor? An introduction to automated investment tools
What is a robo-advisor? An introduction to automated investment tools
Simply put, a robo-advisor is a company (or service) that offers investment management with a minimum of human input. Traditional financial advisors are all about human interaction. Robo-advisors are not.
A traditional financial advisor helps her clients get clear on their goals, then offers advice about how the clients can best manage their money to achieve those goals. Plus, the advisor acts as a sort of voice of reasons as the market rises and falls.
A robo-advisor, on the other hand, does none of this. In fact, I’d argue that the “advisor” portion of the term “robo-advisor” is a complete misnomer. Robo-advisors offer no advice. None. Zip. Nada. Sure, they might have blogs on their websites, but they deliberately steer clear of giving specific recommendations to clients. Robo-advisors are not financial advisors.
Well then, what do robo-advisors actually do?
Robo-advisors might be more accurately described as automated investment-management tools.
Let’s use Betterment as an example. Here’s how Betterment describes itself:
Betterment helps you manage your money through cash management, guided investing, and retirement planning. We are a fiduciary, which means we act in your best interest.
We’ll ask a bit about you when you sign up. We’ll also gather information when you sync your outside accounts. Then, we’ll help you set financial goals and set you up with investment portfolios for each goal.
For your long-term financial needs (like retirement, next year’s vacation, or a down payment), our investment strategy is built on low-cost ETFs (exchange-traded funds) and a risk profile based on how long you plan to invest.
So, Betterment offers investment portfolios built on exchange-traded funds — index funds that you can trade like a stock. It appears that the company offers several pre-constructed portfolios, or allows individual investors to build their own from a small universe of ETFs. Here’s a screenshot that I pulled directly from the Betterment page on how their portfolios work.
Most robo-advisors offer a variety of accounts. You can start a regular, taxable investment account. You can contribute to your IRA. And a few allow you to contribute to your 401(k). I think Vanguard Digital Advisor is set up for this. I know that Blooom was specifically created to be a 401(k) robo-advisor.
So, the bottom line is this: Robo-advisors are not advisors. They’re simply platforms that make it easier for people to get started investing.
Note: I often hear Robinhood mentioned as a robo-advisor. It’s not. Robinhood is a DIY investment platform, much the same as Sharebuilder was fifteen years ago, but it’s decidedly not a robo-advisor.
I think it’s important to note that traditional investment companies have begun to launch their own products to compete with the robo-advisor industry. In fact, currently the largest robo-advisor of all is from The Vanguard Group, the mutual-fund company so popular (and justifiably so) with the early retirement community. Charles Schwab has the second-largest robo-advisor.
The Pros and Cons of Robo-Advisors
The biggest advantage of robo-advisors is that they take care of portfolio maintenance for you. Once you’ve selected an investment strategy, the robo-advisor will take care of everything else.
Whenever you make a contribution, the robo-advisor allocates the funds according to your plan. When you sell, the robo-advisor sells according to your plan. And, perhaps best of all, the robo-advisor will monitor your asset allocation and make adjustments, if needed.
Rebalancing your investment portfolio — the process of shifting your money around so that you maintain your target asset allocation — can be tedious and complicated. (It’s so annoying, in fact, that I don’t do it at all. It helps that John Bogle, one of my investing heroes, believed that rebalancing is optional.)
Another advantage of robo-advisors is that they’re a “good enough” solution.
Too many people are paralyzed by indecision. They fail to invest because they don’t want to make a mistake. Or they want to make the best possible choice.
Well, robo-advisors aren’t the best possible choice, but they’re fine. They’re good enough. Investing with Betterment or M1 Finance or Wealthfront will give you smart, affordable options.
The biggest downside to robo-advisors that I can see is cost.
As you probably know, costs are the second-largest drag on investment performance for the average person. Study after study has shown that the best predictor of long-term investment growth are the total fees for any given investment vehicle. So, adding fees to your investing doesn’t make much sense.
That said, there are a couple of reasons you might not mind paying these fees.
First, robo-advisor fees are typically much less than what you’d pay a traditional financial advisor.
Second, while fees are the second-largest drag on investment performance, the number-one barrier to performance is investor behavior. Generally speaking, you are your own worst enemy when it comes to making your money grow. And if paying a fee will help prevent you from sabotaging your future, then it’s probably worth the cost.
If you’re already set up and running and managing your own investments, keep doing what you’re doing. You don’t need a robo-advisor. And if you’re self-motivated and willing to spend some time on self-education, it’s perfectly possible to replicate the services a robo-advisor provides without using one. Nowadays, the major mutual fund companies allow you to buy and sell ETFs (or, better yet, index funds) via an easy-to-understand web interface. That’s what I do at Fidelity!
But not everyone learns to ride a bike without assistance. Some kids need training wheels, and there’s absolutely nothing wrong with that. In my mind, robo-advisors are like training wheels for people learning to invest. They serve a purpose.
A Final Word of Warning
When reading online reviews of robo-advisors, take them with a grain of salt. This is a growing industry that’s advertising heavily. People are paid to promote these companies.
So, if you go to a popular site and see that every robo-advisor earns 4.5 stars, that should make you skeptical. It makes me skeptical, anyhow. And note that nobody talks about Vanguard Digital Advisor, the largest robo-advisor out there. Why not? Because Vanguard doesn’t pay commissions for sending people their way. Ah, that thin green line makes it so difficult to trust financial websites sometimes!
Comments
Bryan Great article, though I’m afraid it misses the elephant in the room with respect to robo-advisors: Mutual funds already do all this. There are a bazillion mutual funds out there with risk levels specifically targeted to what you want, some with glide paths to automatically readjust as time goes on. Typically, an index-driven passive mutual fund is going to cost less than a robo-advisor. I’ve yet to meet someone who really needs the extra customization that a robo-advisor could offer. So what can robo-advisors offer that mutual funds can’t? Automated Tax Loss Harvesting. One whitepaper (I believe it was Betterment)…
For those who are interested, here’s the white paper : Betterment’s tax-loss harvesting methodology.
2 Natalie
Going to share a personal experience here: I used Wealthfront for about a year while I was learning more about investing. You are right to call it “training wheels”. When I was ready I transferred everything to Vanguard and began managing on my own. The process was not difficult. Pros: fees were not too bad, the app was easy to use, and the investment selection was reasonable. The transfer process to Vanguard wasn’t a hassle (I have heard that transfers from Betterment can be). I actually kept most of the ETFs that Wealthfront had selected after the transfer.
0 Reply JC Webber III JC Webber III 1 year ago Yea, I don’t see the advantage. Not even of the Vanguard robo advisor service. Tax loss harvesting? What’s so complicated about that? Sell your losers if you’ve lost confidence that they will recover (personally, I have never experienced a tax-loss opportunity with any of my index mutual funds). And what about Tax GAIN harvesting? That’s a thing (which I have taken advantage of with my AAPL shares acquired while employed at Apple in order to raise my cost basis). They don’t offer that service. And rebalancing? You have the option of going with Target Fund funds that will do that… Read more »
Reply Big-D
If you are using the Schwab Intelligent Portfolios (SIP), they are free to you in terms of fees (The individual investments/funds may have fees). They make money by having somewhere from 8-20% of your investments in cash so they can make interest on that in other places in the organization. If you are using Schwab Intelligent Advisory services (which are an add on to SIP), I don’t know the fees but I know there is one based on previous discussions. Like you, I have an advisor for my taxable account, and have my IRAs (Roth and Rollover) in SIP.… Read more »
Reply Kristen
I didn’t realize that Vanguard had one, and I excitedly went to the site to look it up to be disappointed to find a $3,000 minimum. While my husband and I diligently save, his sister has yet to open a retirement account (age 44). The barrier is the $1,000 minimum to open an account. If we could get her to save that $1000, I believe we could get her to start saving a little bit each month afterward. But that initial thousand bucks is a big barrier to entry.
Adam
The best use case for roboadvisors might be for novice investors. Services like Acorns and Betterment get your feet in the water and expose you to having a dog in the fight. This type of exposure will build momentum and future interest in having additional funds in the market and creating more sophisticated diversification. Great post!
Chris
One of the benefits that interest me would be tax loss harvesting for the rebalancing in the portfolio. I wonder if this would cover the added fees.
Mark Kelly
The tax loss harvesting alone has more than covered the fees I have with Betterment. Personally, I’ve tried Ally, Acorns, Stash, & Betterment. I just started with Ally robo advisor so can’t comment on it yet. Acorns is the weakest of the bunch in my mind. I love the concept of putting spare change away and not noticing it, but their returns have left me very underwhelmed. I’ve been with Betterment for several years and have grown to love it. Stash is new one in my arsenal and so far I like it as well as you can buy whatever…