Robo advisors are a relatively new choice for investors, but you might be wondering what they are and if they’re right for you. While they use algorithms to manage your portfolio so you don’t have to, using one without having a holistic financial plan could be a risk.
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“Robo advice in its simplest form is an algorithmic portfolio management,” says Yvette Butler, president of Capital One Investing (NYSE:COF). “You can add a lot to it — financial planning, asset allocation, lots of bells and whistles — but it’s algorithmic portfolio management where you’re using technology to implement modern portfolio theory.”
In layman’s terms, modern portfolio theory ensures you’re in the right asset allocation and getting compensated for the risk you’re taking. “If you take more risk, you don’t want to get undersized performance for the risk you’re taking,” says Butler.
Robo advisors take the best thinking about investing and make that accessible to Main Street investors. It’s not about beating the market, but helping your portfolio make returns inline with the various benchmarks.
Using a robo advisor in a vacuum isn’t the best strategy for many people though as you need a solid financial plan that includes goals for future income, long-term care and philanthropy, and an estate plan to guide you. As you decide whether to incorporate robo advisors into your investment plan, here are some questions to consider.
What are robo advisors?
“A robo advisor is an online service that automates certain aspects of investment management, like the rebalancing, the portfolio selection and loss harvesting [which offsets a capital gains tax liability by selling securities at a loss],” says Jean-Luc Bourdon, certified public accountant and principal at Bright Path Wealth Planning. “Different service providers have different offerings.”
These automated trading systems will invest your portfolio in ETFs, index funds, actively managed funds and in a few cases, individual stocks. Fees depend on the amount invested and range from zero to as much as 0.50% of your invested amount annually.
Can you rely solely on a robo advisor?
Thinking you’ve got your financial life covered because you’re using a robo advisor could be a risk, experts say, since they only cover one part of your financial plan: investing. Even so, as some advisors have minimum portfolio size requirements starting at $500,000, robo advisors are a good option for people who don’t have a sizable savings.
“[Robo advisors] provide some features that are generally difficult to obtain otherwise with a smaller account,” says Bourdon. “They make features like rebalancing and loss harvesting available to smaller accounts.”
While robo advisors can help you stay on track for a long time, if you don’t check in with an advisor from time to time, your portfolio and goals may begin to diverge. “The biggest risk is that you let the technology take over and that you don’t have those check-ins and communications with an advisor — plans, markets, goals change, you might get a new job, your kid might go to college, a lot in life happens,” says Butler.
Many advisors take clients who meet minimum asset requirements, but if you don’t qualify, experts suggest using an advisor who charges by the hour or plan. “People deserve and require advice around a financial game plan,” says Kim Jenson, managing director and Chicago complex director at UBS Wealth Management (NYSE:UBS). “If you’re going down the path of using a robo advisor, supplement that with real professional advice.”
Does your investing strategy meet your needs?
“Most people will benefit from personalized advice and financial planning, but if you’re just starting out, are new in your career and are beginning to save and invest, it could be a good way to get educated on asset allocation and investing tactics,” says Jenson.
Consider whether your situation is complex. If you’re looking for investment management in isolation, a robo advisor makes sense. “If there’s the coordination of tax planning, investment management with retirement planning and estate planning, then it takes the help of an expert professional with the comprehensive background to combine all those pieces and create strategies with that level of complexity,” Bourdon suggests.
A robo advisor isn’t enough for someone with a sizable portfolio though. “There does get to a point that the line can be drawn for different people,” says Butler. “Bigger portfolios need to protect from downside risk, and that’s when you want to add investments that make it less volatile.”
Which robo advisor should you use?
Experts suggest finding a robo advisor with an investment methodology that’s best suited for your situation.
“Your situation may call for gain harvesting rather than loss harvesting and you may miss out on a tax benefit,” says Bourdon,” and if rebalancing is not integrated in your cash deposits or withdrawals from your account, you may have more trading activity than you need.”
As with any emerging service, there is risk of consolidation within the industry too. “Look for an advisor with standing power and one that’s established,” says Bourdon. “Look at the leading robo advisors and those associated with long established companies.”