In recent years, most industries have gone digital in one aspect or another. It is nothing new. Today, it is quite the norm to shop, do business, trade, attend classes, and even meet spouses online. More recently, financial management has also adapted to the digital trends in the form of Robo-advisors. Financial management is now readily accessible through popular online platforms such as Betterment, Wealthfront, M1 Finance, Wealthsimple, Questrade, etc.
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Have you been considering using Robo-advisors for your investment strategy? This article will shed some light on what Robo-advisors are, their pros and cons, and who they suit best.
WHAT ARE ROBO-ADVISORS?
Robo-advisors are wealth management firms (pared down to reduce costs) that use algorithms to invest and manage portfolios.
As the term “Robo” may be a bit misleading for most people, let’s clarify that first.
Robo-advisors are not robots using artificial intelligence to manage your portfolio. Humans make the algorithms and investment strategies used to run Robo-advising firms. In fact, humans are actively behind the scenes of various Robo-advising aspects, such as portfolio rebalancing and tax-loss harvesting. Robo-advising firms use technology very efficiently to minimize costs by reducing human interaction in wealth management.
In essence, Robo-advisors do what would otherwise be done by human, financial advisors. Sounds so simple and elegant. But let’s explore whether it is as promising as it appears.
A BRIEF HISTORY OF ROBO-ADVISING
The first Robo-advisor was created in 2008 during the Great Recession and launched to the public in 2010. Betterment is the firm that popularized Robo-advising to the public.
Algorithmic investing and wealth management technology, however, have been around for much longer. Before 2008, the use of algorithms for investing purposes was limited to financial advisors and was not available to the public.
Initially, only independent firms provided Robo-advising. The industry saw explosive growth around 2015 when the more traditional financial institutions and big banks adopted the trend.
Robo-advising has been on an upward trend. As more players enter the market, and more people switch to use Robo-advising, the assets managed by Robo advisors have been steadily rising. According to a study completed by KPMG, the projected shift from traditional advisors and new investors adopting Robo-advising will amount to assets of $2.2 trillion (USD) in 2020. Simply staggering!
HOW DO ROBO-ADVISORS WORK?
From a user perspective, all you have to do is fill out an online form, fund the account, and then leave the rest to the bots!
The online form collects data regarding your risk tolerance, age, and financial goals to determine the target asset allocation that best suits your profile.
The Robo-advisor continually rebalances your portfolio to make sure that the target asset allocation is maintained. Future additional contributions to the accounts are also automatically allocated and rebalanced appropriately.
Robo advisors employ a passive investment strategy and typically invest in index Exchange Traded Funds (ETFs). You can learn more about ETFs and index fund investing here.
PROS AND CONS OF ROBO-ADVISORS
1. Ease of use and great for beginners
Robo-advisors are designed for mobile devices and are inherently easy to use and readily accessible. Further, there is little research and portfolio maintenance required, making them highly suitable for beginner investors.
2. Low cost
Traditional professional asset management costs an upward of 1%-3% of AUM. The fees charged by Robo-advisors, on the other hand, are much lower at an average of 0.50%, sometimes even less. These low costs make them readily accessible if you have a small sum to start with or unsure about investing and want to start small.
3. Automatic portfolio rebalancing
Portfolio rebalancing is the practice of buying and selling assets to maintain the desired asset allocation target and risk level. For example, assume that your target asset allocation is 70% stocks and 30% bonds. If the stocks have had a strong performance, their weighting could have increased to say 80%. Rebalancing would involve selling some of the stocks to bring their weighting back to 70%.
Robo-advisors perform automatic portfolio rebalancing, requiring minimal effort on your part.
4. Tax-loss harvesting in taxable accounts
Tax-loss harvesting is a two-step process of selling investments at a loss and immediately buying the same asset type. The purpose of selling at a loss is to offset capital gains tax liability in your portfolio. The practice of replacing the asset sold with a similar investment type helps to maintain your target asset allocation and expected future returns.
Tax-loss harvesting is suitable in taxable accounts to reduce your tax burden. This tax offset does not apply to investments held in a tax-advantaged account.
Check out the below articles to learn more about tax-advantaged accounts:
- RRSP (Canada)
- TFSA (Canada)
- 401(k), Roth 401(k), IRA, and Roth IRA (USA)
In taxable accounts, Robo-advisors perform automatic tax-loss harvesting reducing your tax liability without you ever lifting a finger.
5. Low investment minimums
Robo-advisors have made investing readily available to everyone. Many Robo-advisors have no minimum balance requirements, and as such, anyone can start investing right away. In contrast, actively managed portfolios often have minimum thresholds ranging from $100,000 to over $1 million.
1. Robo-advisors are a middle man/woman
Robo-advisors typically invest in index ETFs provided by firms such as Vanguard, Fidelity, BlackRock, etc. While Robo-advisory fees are relatively low, they include a commission plus the fund companies’ fee. It is cheaper to leave out the middleman/woman and buy index ETFs from the providers. Learn more about ETFs and index fund investing.
2. Do not encourage financial literacy
Robo-advisors automate the processes that would require research for portfolio maintenance. While providing ease of use, automation discourages any incentive to increase one’s financial literacy. Financial literacy would be beneficial to understand whether the algorithms are selecting the best investment choices for you.
3. No face-to-face human interaction
Robo-advisors assist solely over the web. While the investing algorithms do a fantastic job of building a portfolio based on the data provided, they lack the human touch for the more nuanced needs. A Robo-advisor would not be able to improvise and adjust to unique situations as a human advisor would.
4. Limited options for investors
By choosing Robo-advisors, you limit your array of investing options. You cannot select specific investments outside of what is available in the platform. As time goes on, this may change.
WHO SHOULD USE & WHO SHOULD AVOID ROBO-ADVISORS
Robo-advisors are suitable:
- If you are a looking for a hands-off and low-cost investing strategy
- Are a beginner investor looking to test the investing waters
- If you have a small amount to start investing with
Robo-advisors are not suitable:
- If you are a DIY investor who prefers to choose and pick your investments
- For high net worth investors who have complicated tax situations
If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.
“Great achievement is usually born out of great sacrifice, and is never the result of selfishness.” ~ Napoleon Hill