What is a Robo-Advisor and Should you use one?

 In the year 2020, more than 10 million brokerage accounts were opened by investors in America, despite the coronavirus pandemic. The economic shock induced by the pandemic also drove more and more investors to seek professional guidance on money matters than ever before. According to a Nationwide report, one in four respondents to their survey sought to engage with a financial advisor for the first time during the pandemic.  Moreover, a majority of these investors opted for automated investment guidance with Robo-advisors.

Robo-advisors are the latest revolution in the investing sphere that have the potential to disrupt the financial service industry, providing people with a technologically driven, efficient, and cost-effective way to invest their money safely. However, although Robo-advisors are finding quick traction and gaining popularity, many skeptics are still wary and think of this technology as an enigma.

In this article, we break down the role and benefits of Robo-advisors and whether a Robo-advisor’s service is suitable for your financial needs.

What is a Robo-advisor?

A Robo-advisor is a form of wealth management service that offers investment services with little or no human intervention. It is a digital platform that uses advanced software and algorithms to create and manage your investment portfolio. The system, i.e., the Robo-advisor, asks you some simple questions or does a short survey to better understand your financial profile, requirements, and future goals. The Robo-advisor then leverages this information to offer you sound advice suitable to your profile and automatically invests your assets upon receiving your go-ahead. The supporters of this concept applaud the fact that there is no human involvement in the decision-making; the investment suggestions are purely technical and mathematical and are uninfluenced by human behavior and emotions. Some Robo-advisor platforms, however, also offer human guidance as a supplementary service. But they are increasingly transforming into fully-automated platforms. Robo-advisors are also known as automated investing services or online advisors.

Who governs Robo-advisors?

Robo-advisors have the same legal status as their human counterparts. All Robo-advisors must be registered with the U.S. Securities and Exchange Commission. These advisors are also subject to the same securities regulations and principles as traditional broker-dealers. Most Robo-advisors are affiliates of the Financial Industry Regulatory Authority (FINRA).

Assets managed by Robo-advisors are considered securities held for investment purposes, not bank deposits. Hence, these assets are not insured by the Federal Deposit Insurance Corporation (FDIC). However, there are other avenues by which Robo-advisors can ensure clients’ assets, such as the Securities Investor Protection Corporation (SIPC).

How do Robo-advisors work?

Robo-advisors are driven by advanced computer algorithms and use numbers to create an investment strategy that optimally aligns with your financial goals and risk tolerance. Some of the best Robo-advisors offer a range of financial services such as easy account opening, robust goal planning, various account services, portfolio management, retirement planning, automatic rebalancing as well as tax optimization. Further, these advisors offer attentive customer service, comprehensive financial education and come at a much lower cost than human financial advisors. This makes Robo-advisors a much more lucrative option for investors from all categories.

In most cases, Robo-advisors automate and optimize passive indexing strategies based on mean-variance optimization. When you sign up for a Robo-advisor service, you have to fill in a basic online questionnaire that will enable the program to understand your investment goals, life stage, investment preference, and more. The questions will typically revolve around your investment timelines, risk appetite, savings balance, etc. Once you equip the Robo-advisor with the necessary information, the advisor runs them through the computer algorithm to offer an optimum asset allocation strategy. It then builds a diversified portfolio that helps you meet your financial goals within the shortest horizon, or within your investment timeline, as defined by your profile.

If you are satisfied with the options provided, you may give it the green signal to proceed. The Robo-advisor will then make the investment on your behalf – all back-end jobs such as documentation taken care of by the system. After the investment is made, the robo-advisor also monitors the portfolio as per a predefined frequency, and also automatically rebalances your portfolio to ensure that it is aligned with your targets and risk preferences. Rebalancing is the process of moving around your assets within your portfolio such that the investment from the least performing asset will be pulled out and the funds diverted to the highest performing assets. This ensures that your losses if any, are trimmed and your portfolio yields good returns for you. Some Robo-advisors also offer tax optimization strategies. These advisors may use tax-loss harvesting tactics to sell specific securities at a loss to offset the gains in other securities in order to minimize your overall tax outgo.

What services do Robo-advisors offer?

Most Robo-advisors work on a standard formula that automates investment management to do it better via a computer at a lower cost. At most, Robo-advisors can do the following for you:

· Build a portfolio as per your requirements

· Monitor and regularly rebalance your portfolio, automatically or at set intervals

· Provide financial planning tools like retirement calculators

· Deploy tax-loss harvesting or other similar strategies on taxable accounts

However, if you wish for a more comprehensive set of financial services like estate planning, inheritance handling, etc., standard Robo-advisors might not be able to offer much assistance.

How do Robo-advisors rebalance portfolios?

Most Robo-advisors use modern portfolio theory or a similar variant to create a passive, indexed portfolio. The modern portfolio theory (MPT) is based on how risk-averse investors can build portfolios that aim to maximize potential returns given a specific level of risk. Portfolios based on MPT minimize risk for a specific level of return.

After creating a sound portfolio as per your requirements, Robo-advisors continue to monitor and rebalance your portfolio to ensure the asset weightage is optimal and as per your requirements even when the market fluctuates. The advisors assign a target weight and a tolerance range to each asset class or individual security. For example, let us assume that as per your financial preference, your portfolio structuring includes 35% in top-grade domestic companies, 20% in market stocks, and the remaining 45% in secure government bonds. Now, overtime or because of a sudden market shock, if the weightage of any of these securities shifts, the Robo-advisor pitches in and shifts the allocation mix around to rebalance the entire portfolio to eventually reflect your original target allocation.

In the past, consistent rebalancing wasn’t recommended due to the high-costs involved. However, with Robo-advisors, portfolio rebalancing has become more efficient since it is done automatically and is virtually free of cost.

How do Robo-advisors execute tax-loss harvesting strategies?

Tax-loss harvesting implies selling some of your securities at a loss to offset a capital gain to reduce the tax liability in similar security. This tactic is primarily used to minimize the short-term capital gains and, thereby, the corresponding liability. A Robo-advisor applies the same fundamentals to harvest the losses and reduce the tax burden on capital gains. Robo-advisors use algorithms and reserve two or more stable ETFs (exchange-traded funds) for each asset class. Through this method, when one S&P 500 ETF faces a loss, it is immediately and automatically sold to register the loss and harvest it by investing in another S&P 500 ETF. However, multiple rules govern the tax-loss harvesting mechanism, such as the wash-sale rule and more. An efficient Robo-advisor is well-versed with the rules and applies strategies while following the standard practices and ensuing rules and regulations that govern the industry.

How do Robo-advisors charge for their services?

Generally, a Robo-advisor’s fee is structured in two ways – fixed monthly charges or a percentage of assets. In the case of fixed monthly charges, you can expect to pay as low as $1. However, in terms of the percentage fee, a Robo-advisor can charge anywhere between 0.15% and 0.50% of your investment assets.

However, these charges are in addition to the fees associated with your investments. For example, if your Robo-advisor invests your money in mutual funds or exchange-traded funds, these will come at a cost that includes their expense ratio in addition to the overall charge of the Robo-advisor, whether fixed-monthly or asset-based. The investment fee is subtracted from your returns before they are distributed to you.

That said, many online platforms allow you free trial access to Robo-advisors, enabling you to experience their services before you pay for them. These advisors are a great option for you if you prefer to pick and choose investments on your own.

What are the advantages of using Robo-advisors?

Currently, Robo-advisors have become an increasingly popular way to access the market, especially for ordinary and low-balance investors. The main advantage fueling the popularity of these types of advisors is that each company has its algorithms that set aside emotional biases from investing, providing you an opportunity to get higher returns at lower costs as compared to human financial advisors.

Key advantages of using Robo-advisors include:

· Low fees: Professional financial advisory services can cause a significant financial burden. Irrespective of whether you pay your human advisor via a fee-based model or a fee-only model, you direct a huge sum of your hard-earned money towards financial advisory services. However, Robo-advisors have brought a shift in the paradigm.Today, the market is full of several efficient and low-cost Robo-advisors that offer sound financial advice and are most suitable for the cost-conscious investor.

· Comprehensive investment models: Most Robo-advisors use algorithms based on the modern portfolio theory (MPT). This is a widely popular theory that particularly caters to risk-averse investors and how they can build portfolios that aim to maximize potential returns given a specific level of risk. Portfolios based on MPT minimize risk for a specific level of return.

· Increased market penetration for financial advice: Generally, first-time investors, young investors, or those that have restricted budgets tend to not opt for professional financial advice owing to its cost. However, with Robo-advisors, the market has expanded to cater to these investor sections too. Robo-advisors provide easy access and charge a low-fee for offering professional financial management services. Hence, more consumers get expert advice, enabling them to achieve better returns than a DIY model.

· Customized advisory models: Robo-advisors do not function on a one-size-fits-all approach. Instead, they engage with you to better understand your preferences and financial goals, and accordingly, create a portfolio that aligns with your needs. Further, these Robo-advisors have advanced algorithms for different types of clients. For example, if you want a specific industry or sector-focused portfolio, a specialized Robo-advisor will assist you. But if you wish to build a highly diversified, low-cost portfolio, a specific Robo-advisor can help you in this case with low-fee ETF options. That said, some Robo-advisors might excel in offering portfolio rebalancing and tax-loss harvesting services. Some platforms also allow you to choose a single approach or a hybrid-style Robo-advisor.

· Low minimum balance requirement: Professional Robo-advisors are a boon for investors that have low-net investment worth. Many Robo-advisors offer zero minimum account balance functionality, while several others offer services with no minimum balance as well. Alternatively, some other Robo-advisors are accessible to investors with a minimum balance between $1,000 and $5,000.

· Better availability and efficiency: Robo-advisors are more accessible than human advisors. They are available 24/7. This allows you to take advantage of the investment expertise anytime and grab lucrative opportunities in no time. That said, Robo-advisors also have the upper hand in terms of efficiency. In the case of a human financial advisor, if you want to execute a trade, you have to physically call the advisor and explain your requirements, fill out the paperwork, and wait for them to do the rest. But in the case of a Robo-advisor, you have all the accessibility within a few clicks from the comfort of your home or anywhere else in the world.

What are the disadvantages of using Robo-advisors?

Some of the critical disadvantages of using Robo-advisors include:

· Not 100% personalized: Even though several attempts and numerous algorithms have been developed, the Robo-advisors are not yet 100% personalized.As an investor, your needs are different, your long-term and short-term vision changes, and several factors impact your investment decisions. And while many Robo-advisors allow you to list and then later edit your goals, preferences, etc., they are not as efficient presently. Moreover, in case of market volatility gripping your investments, Robo-advisors cannot offer the much-needed comfort, unlike a personal human financial advisor. A human financial advisor can counsel you, ease your fears, instill confidence in you, and ensure you stay afloat during tiring times. Further, your human advisor can work with you more comprehensively than a robo-advisor. Apart from integrating your finances, taxes, retirement plans, and estate plans, your human advisor can also help you with matters beyond just ‘monetary’ concerns. On the other hand, your Robo-advisor has no expertise in specific investment areas like call options and individual stock purchases. Sometimes algorithms cannot answer all your investment concerns, and hence, you might have to engage with a human advisor.

· Competitive pricing with several human financial advisors: Robo-advisors are known for their low fees. However, many human financial advisors charge as low as the Robo-advisors while offering similar services. Some human advisors only take 1% of the assets under management (AUM) for the services, which is almost equivalent to the average cost of engaging a Robo-advisor. Moreover, some human financial advisors bill you on an hourly basis or a specific fee for a service. This allows you to choose to pay consciously only for the service you want. Besides, with the advancement of digital platforms, many web-based personal human advisors are offering financial help at a much lower cost than those available offline.

· Not the sole option for small investments or new investors: Robo-advisors are most attractive to new investors or those with a small amount to invest. However, many human financial advisors offer a host of services at a highly affordable monthly fee structure. Paladin Registry helps you to find vetted financial advisors for your needs without any charge. The platform finds the best advisors for your financial needs and vets their background.

· No personal interaction: Robo-advisors are run by computer programs and algorithms. There is no human element or any interaction. So, if you are someone who likes to have one-to-one personal conversations with your advisor, Robo-advisors are not suitable for your needs.

When should you use a Robo-advisor?

A Robo-advisor is a great choice for you if you are new to financial planning or if you are someone who finds it difficult to trust another human being with your financial needs. Also, if you do not wish to enter into a full-time financial advisor contract, Robo-advisors might work well for you. Robo-advisors are less complicated and do not require monthly or quarterly human reviews, allowing you to chart your course leveraging technology.

Further, if you are young with higher risk tolerance and a considerable amount of time at hand until retirement, you can take advantage of the Robo-advisor and get simple and equity-centric allocations. If you are restricted on time and/or monetary resources, Robo-advisors may be a good option for you.  Robo-advisors only charge 0.25-0.35% of your investment assets per year to create your portfolio within no time of you answering the basic questionnaire.

When should you not use a Robo-advisor?

Without a doubt, Robo-advisors offer easy, automated, and low-cost advice. However, despite their benefits, human interactions have their strengths. Apart from offering skilled and professional financial advice on investing and money management, human advisors are also adept at providing emotional support. Financial matters are extremely personal and individualized, and a human advisor is valuable in tailoring your portfolio to fit your personalised financial requirements.

Moreover, human advisors can add substantial value in extreme and unexpected market conditions, like the COVID-19 pandemic induced financial stress. You can speak to your human advisor about the effects of the pandemic and how your monetary situation has altered ever since. The advisor can then accordingly make adjustments to your portfolio if necessary. Additionally, human advisors can appraise you of the upswings and downswings in the market before-in-hand.

If you are an investor with a low-risk tolerance, it is best if you work with a human financial advisor as they can offer you emotional reassurance during critical times. Besides, if you take help from a Robo-advisor to build a low-risk portfolio, the algorithm will most likely create an extremely conservative portfolio that will, in turn, limit your returns.

Likewise, if you are only five years from retirement or already retired, you can consider engaging with a human financial advisor. In such cases, a Robo-advisor might not be able to effectively balance the human and financial factors involved.

That said, if you are a high-net-worth investor or have complicated estate, tax, or legacy planning considerations, you will benefit more from a human financial advisor than a Robo-advisor.

To sum it up

The suitability of a Robo-advisor’s services depends on an individual’s financial needs and goals. However, presently, the drawbacks of a Robo-advisor outweigh its advantages in some key financial service areas. Even though the Robo-advisor industry has experienced explosive growth, projected to reach US$7 trillion worldwide by 2025, multiple areas still lack expertise and specifically require competent human financial advisor support.

If you are not sure where to start looking for a financial advisor, use Paladin Registry’s free match service to find 1-3 qualified financial advisors to manage your finances. You may also view the advisor’s credentials, ethical standards, and business practices and make an informed decision on which advisor is the most suitable for your financial needs.

To learn more about the author William Hayslett view his short bio.

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