If you have recently researched investment management services, chances are that you have come across the term “robo-advisor.”
Who are these robo-advisors and can you trust them with your financial future?
A robo-advisor is an online investment platform that uses algorithms to determine asset allocations for investors and manages their investment dollars with minimal human intervention. Because it utilizes technology rather than active management by a human, robo-advisors charge significantly lower fees than what most financial advisors typically charge.
“It’s a fast growing business today, with something close to $20 billion in assets under management,” says David Larrabee, director at CFA Institute, the association of investment professionals. “Robo-advisors are here to stay and have demonstrated there is demand.”
According to recent research by A.T. Kearney, approximately $2 trillion will flow into robo-advisor platforms over the next five years.
What is driving the explosive growth in the robo-advisor marketplace? Experts point to the demographics, account sizes, and low costs as the main factors.
Demographics: Investors of all ages are using robo-advisors, but not surprisingly, they are especially popular among millennials and Generation Xers who grew up with technology and would feel just as comfortable firing off an email or texting as they do talking to a human being.
Lower account minimums: Furthermore, most wealth management firms require investors to have a minimum of $100,000 or more in investable assets. Robo-advisors have investment minimums in the low four-digit numbers; some have none. “The traditional investment advisory accounts’ minimum of $100,000 puts these advisors out of reach for a lot of investors,” says Larrabee. “Robo-advisors are stepping up to fill that void.”
Lower fees: Last but not least, robo-advisors are inexpensive. While traditional wealth management services charge 1% of assets under management or more, the typical fee charged by a robo-advisor is 25 basis points or lower, depending on account size.
How Robo-Advisors Work
With a robo-advisor, clients open an account and typically start by answering a series of questions about their age, tolerance for risk, and investment goals. The platform provides an asset allocation based on their answers. An older investor nearing retirement, for example, will be recommended a more conservative asset allocation than a younger investor who will be working for decades to come.
Low-cost index investing keeps emotions out of your investment strategy
Robo-advisors typically do not trade individual stocks or offer specific stock trading advice. Rather, they tend to invest in low-cost ETFs, which provide instant diversification, as well as tax efficiency.
Most robo-advisors adhere to a buy-and-hold, passive investing strategy. They do not pick stocks or try to time the market. Instead, robo-advisors are charged with figuring out the exposure investors should have to stocks, bonds, international investments, and other asset classes, and use each individual investor’s age, expected retirement date, and risk profile to come up with an asset allocation and stick to it, regardless of day-to-day market movements.
Account rebalancing keeps your investment goals on track
Although robo-advisors do not react to stock movements, they do track the markets on a daily basis. If market swings move clients’ portfolios out of balance with respect to their recommended asset allocation, they rebalance accordingly, while being mindful of creating taxable events or incurring trading fees.
As a result, investors with these platforms do not have to get on the phone with their money manager if one company is driving an entire sector down. They can rest assured that, provided that they are in a properly diversified portfolio, they will be able to stay the course and ride out any market downturn.
Investors who need estate planning or have complex investment portfolios may want the hand-holding that comes with a financial advisor, or simply find a good lawyer and then choose low-cost index funds or ETFs on their own. For many investors, however, robo-advisors offer a way to grow their investment nest egg without getting hit with high costs and fees.