Robo-advisors are a relatively new invention in the world of investing. As such, budding investors would not find them mentioned in any of the mainstream investment books and learning resources. However, their quick adoption and integration into the financial world has caused many people to take note. So much so that many people are starting to question if robo-advisors are better than financial advisors.
Today, I will attempt to answer this incredibly complex question. First, I will take you through what robo-advisors are and how they work. After that, we will tackle the myth of robo-advisors being unsafe investments. In the end, we will take a look at why they might be better than financial advisors.
What Are Robo-Advisors?
Traditionally, passive investors who do not want to excessively engage in selecting their own investments use a financial advisor. A good financial advisor can magnify the return on your capital by a huge amount.
However, not all financial advisors are ‘good’. This is evidenced by the fact that most actively managed funds (funds managed by a financial advisor) have underperformed when compared to the market average over the last 15 years.
These professionals are known as fund managers. Rather than the standard financial advisors who cater to an individual’s needs, fund managers oversee an entire fund in which individual investors or institutions can invest. Even Warren Buffet, perhaps the most successful investor of all time, has shown his disdain for financial advisors through the years.
This is not to say that all fund managers are bad at their job. In fact, the most successful fund managers have spent decades consistently beating the market averages. The problem is that it is very difficult for a new investor to pool their funds with them. This is mainly because successful funds are in very high demand and have a very high ‘minimum investment threshold’ (which is the minimum amount you must invest in order to avail the services of a fund).
Can Robo-Advisors be the Solution?
Robo-advisors have recently become possible due to the advancement in technology and the advent of fin-tech applications. Simply put, a robo-advisor is online software that will automatically build you a portfolio according to your needs. In order to guide the application, you will need to set a target allocation.
Your target allocation comprises of stocks, bonds, and any other investment that you are concerned with. All you have to do is to input the amount of risk that you are willing to tolerate into the robo-advisor and the application will do the rest. To put it simply, the application will invest your funds for you based on your preferences and long-term investment goals.
The best thing about a robo-advisor is that it removes the tedious part of investing from the process. It will automatically select the investments that are perfect for your needs. On top of that, it will adequately diversify your portfolio to make sure your investments are protected. Lastly, it will automatically adjust your portfolio to make sure it stays true to your target allocation.
Many robo-advisors have advanced features that will help maximize your returns. For example, there are applications out there that automatically make trades on your behalf to make sure you have to pay as little capital gains and income tax as is possible. If you are someone who is new to the world of investing and do not understand concepts such as tax-loss harvesting, then having a robo-advisor to assist you is a great idea!
Are Robo-Advisors Safe?
It is quite normal to feel something akin to fear when it comes to investing, especially if you have a computer program doing your investing for you. Also, with the amount of investment-related scams running rampant on the internet, it is no surprise that investors harbor distrust for anything that claims to help you make money through the financial markets.
The Algorithms
If we take a look at some of the most well-known robo-investors currently in the market such as WealthFront, we see consistent success for people who used them. This is because contrary to popular belief, robo-advisors ensure safety for their investors by incorporating human elements into their software.
An algorithm is a set of instructions that is followed by a computer as a means to an end. In the case of robo-advisors, the Artificial Intelligence uses certain algorithms to invest cash in an automated way. This way, there is no need for an advisor to manually decide each investor’s portfolio.
Robo-advisors may be automated, but the algorithms that they use to invest are engineered with help from some of the most successful investors of our time. For example, Betterment utilizes the services of Eugene Fama and Robert Shiller, winners of the Nobel Prize in 2013. Who better to ensure that your robo-advisor keeps your capital safe, right?
The Human Element
Perhaps the most prominent investment advice available on the internet is to follow through with your investment strategy. What this means is that you should never let your emotions get the better of you. Many investors cause their own downfall by being too conservative or too liberal with their cash. The only way to make money, in the long run, is by carefully plotting out your investment strategy and then sticking to it.
Even financial advisors with years of experience under their belt often start to panic if the market temporarily turns against them. They end up making decisions that preserve your cash for now but hurt your returns later on. However, robo-advisors do not suffer from such psychological limitations. For this reason, robo-advisors become even safer when the markets are volatile.
Whereas a financial advisor may cause you to lose money in the long run by moving away from a proven strategy during times of crisis, robo-advisors will continue to strictly adhere to the defined target allocation unless directed otherwise.
The Excessive Diversification
The standard practice for robo-advisors is to invest in Mutual Funds and ETFs, not individual stocks. These funds could be invested in anything from real estate to bonds to stocks. Because of this, robo-advisors end up having two-tiered diversification.
The first level comes from the fund itself that the robo-advisor is invested in. The second level comes from investing in multiple different ETFs. This way, your portfolio is well diversified and a lot less prone to capital loss.
As I have stated before on this blog, diversification is the best way forward for investors who lack expertise in the craft. When you couple this with the fact that your robo-advisor will pretty much do all the diversification for you, hiring a professional to manage your finances starts to look pointless.
It is also important to remember that if you are a long-term investor looking to build wealth, then index funds can help you achieve a similar level of diversification. Specifically, an index fund based on the S&P 500 will be very well diversified and practically guaranteed to cause capital appreciation in the long run.
Robo-Investors vs. Financial Advisors
When we compare robo-advisors to financial advisors, robo-advisors are not only safer but also seem to have a few inherent advantages in the way they are set up. While experienced investors with massive amounts of capital at their disposal will probably be better off with financial advisors, new investors might see a greater benefit in utilizing robo-advisors.
Low Fees
Since robo-advisors are automated, this means that their fee structure is a lot more sympathetic to the investor. Even some of the industry-leading robo-advisors such as Betterment offer you their services for free for one year. After that, the fees are still incredibly low. Betterment, for example, only charges you 0.25% of assets under management. It is possible for you to find financial advisors who charge 1% or so for managing your assets. However, these advisors are incredibly rare and they usually have incentive fees on top which rake off a percentage of your profits.
Nowadays, you can also get the best of both worlds. You can hire a financial advisor for a small fee who will monitor your robo-investor to make sure you get the most out of your investment. This can be a good option for people with more money to invest who do not want to leave all of their capital with an automated system.
Low Entry Barriers
People who have extremely small amounts to invest often have trouble finding financial advisors since they usually have a minimum capital requirement. However, you can find robo-investors that have no minimum balance requirements. Even robo-advisors with capital requirements usually only require you to invest a few thousand dollars to get started.
Higher Control
Financial advisors are humans, and they have limited time. Your financial advisor may not be able to discuss your portfolio at length with you every month. However, you have complete control over your robo-advisor. You can set targets for anything from large-cap stocks to small-cap stocks to bonds.
Not only that, but many robo-advisors such as Motif offer you prebuilt portfolios to invest in. For example, you can choose whether you want to be invested in real estate funds or debt instruments. You can then go on to mix and match investments until you have a portfolio that you are satisfied with.
There is no Reason to Fear Robo-Advisors
In short, robo-advisors have numerous advantages over financial advisors. The most important of which are:
- Robo-investors have low fees, which mean that you get to keep the returns on your investments.
- They are passive investments. However, you still have ample control over your portfolio.
- Portfolio diversification occurs in an automated manner, saving your valuable time for other things.
- They have none or low minimum balance requirements.
- There is no fear of them suffering from psychological limitations that may inhibit your returns.
- You can use them along with a financial advisor for a hybrid solution that brings you the best of both.
If you are still unsure whether or not you should use a robo-advisor, then fear not. In my next post, I dive deep into the process of choosing between a robo-advisor and a financial advisor. Not only that, but I also take a look at how you should select a robo-investor that fits your needs. If you’re not willing to wait, then feel free to contact me. I look forward to hearing from you!
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