The world of personal finance has made huge strides over the past 20 or so years. The creation of exchange-traded funds, low-cost online brokerages, and the advent of free stock trades have provided more choice and saved investors money. But none of these products offered the guidance many yearned for. The advent of robo-advisors has changed that.
According to Schwab, a robo-advisor is an “online service that provides automated portfolios based on your preferences.” After you answer a series of questions about your goals, time horizon, and comfort with market risk, the robo-advisor offers a portfolio based on computer algorithms that align with the best practices of the industry (such as modern portfolio theory and/or efficient market hypothesis). For example, if you’re young and not risk averse, the resulting portfolio may suggest an allocation of 90% or more in various stock funds while keeping little or no money in cash.
Additionally, the robo-advisor will provide a list of individual investments and show the percentage of your funds that will be invested in each. Over time, your account will be rebalanced automatically to keep the correct percentages in each fund. Robo-advisors can be used for taxable and tax-deferred accounts so you can save for different goals at the same time.
Features
Automatic investing. Like most other financial products, you can set up automatic contributions to your robo-advised account, whether from an automatic payroll deduction or a bank account debit.
Automatic rebalancing. Rebalancing is something that many investors either forget or don’t have the time for. Robo-advisors provide automatic rebalancing. Some will take your new contributions and automatically invest more in the funds that haven’t done well and less in the outperforming funds, while others set a certain date (perhaps once per year) to rebalance.
Human financial planning. Many accounts offer the chance to talk with a person if your account is complicated or you have specific questions. This may be included in the cost of the robo-advisor or provided as an add-on service.
Tax advantages. If you’re deciding between two similar robo-advisors, choosing the one that offers tax-loss harvesting may be a prudent move. Tax-loss harvesting means selling investments to reduce capital gains taxes, often selling a losing investment to balance out the gains you received from a winning investment. This is offered free with some accounts and as an add-on with others.
Investment minimums. Many robo-advisors are targeted at beginning investors or those with smaller account balances. While some require $500 to $1,000 at signup, several have no balance requirements. As stated above, the add-ons you select may be included depending on your account balance or require you to pay extra. Similarly, those companies that offer no-minimum accounts may not offer all the bells and whistles you need. Make sure you’re getting everything you want if you sign up.
How to open an account
Open an account with the financial services company. Before you do this, you might want to check if your current providers offer a robo-advisor option. If nothing else, completing the questionnaire with one of your current financial institutions will give you a baseline for comparison if you decide to try out other robo-advisors. Also research your options so you’re not opening an account with a firm you won’t want to do business with long-term or one that charges high fees.
Answer a few questions. With the account I opened, the questions fell into two broad categories – my goals and time horizon for the money, and my comfort with risk. Answer honestly; if the idea of losing 10% of your account would keep you awake at night, don’t brush off the question about how you handled the last downturn in the economy.
See the results. Given my experience with investing, I wasn’t surprised to see an 88% stock allocation for investments with a 15-year time horizon, especially after taking into account my level of comfort with risk. However, I was shocked to see a list of 16 investment options, 12 under the stock portfolio alone. I would expect to achieve similar diversification with a smaller number of funds.
Fund the account. Most allow low-cost or free wire transfers for the initial funding and will also accept checks either deposited digitally or mailed to open your account.
Fees
Fees usually range from free to 0.50% of your account balance. Some robo-advisors that advertise free accounts may require you to keep part of your money in cash (without interest) or only offer free accounts with larger account balances. Again, do your research to make sure you understand what you’re getting and what you’re paying.
Don’t forget – these fees are just the fee for the robo-advisor account. Depending on the investments you’re given, you may pay fees to the same company as you invest money in their proprietary funds. Or you may end up paying more for their fund when you could find an index fund that costs less. When looking at fees, compare the total fee structure between accounts – including fund fees – before sending any money.