Robo Advisors 101: All You Need to Know
We live in a world where almost everything is turning digital. Why should investment advisors be left behind? Recently, more and more investors have started selecting low cost software tools known as ‘robo-advisors’ which perform the task of automatically managing people’s financial portfolio. Robo-advisors cost significantly less than human financial advisors. As a result, they are an extremely attractive tool for specific types of investors. In this post, we will discuss all you need to know about robo investing and whether you should select them for managing your financial portfolio.
Robo Advisors: All You Need to Know
As things stand in the world of investment and finance today, investors have the ability to build and manage their financial portfolio in either of these three ways::
- Hire a financial advisor to create an expertly curated portfolio.
- Do your own research, select your own investments and build your own portfolio.
- Sign up with a robo advisor to build a portfolio from scratch.
This post will be focused on the third method.
What are robo advisors?
Robo advisors are software products that can help you manage your investments without the need to consult a financial advisor or self-manage your portfolio. You usually open a robo-managed account and then supply basic information about your investment goals by filling an online questionnaire. After you supply your information, robo advisors crunch the data to provide an asset allocation approach and build a portfolio of diversified investments for you that meets your target allocation percentages for those investments.
Can robo advisors rebalance portfolios?
Once your funds are invested on an ongoing basis, the software can automatically rebalance your portfolio—that is, make the changes to the investments needed to align your portfolio back to a target allocation. Some robo advisors can even sell certain securities at a loss to offset gains in other securities. This process is called tax-loss harvesting and it can help reduce your tax bill.
Who Should Consider Robo Advisors?
Robo advisors can be a great solution for the following types of investors:
- Beginner or young investors: These investors may not yet have the financial knowledge needed to make informed investing decisions but may be comfortable managing their portfolio online with limited or no human assistance.
- Busy professionals: These individuals may not have time to actively manage their fund and may want to put their portfolio on “automatic.”
- Investors with simple strategies: If you have a simple asset allocation (60% stock and 40% bonds, for example), you may not need guidance from a financial advisor to continually rebalance your account.
- Investors who don’t want to hire a financial advisor or go at it alone: If you don’t have the assets or the desire to hire a financial advisor, but no longer wants to select investments on your own, you may want to choose a robo advisor to select investments, rebalance them, and place trades on your accounts.
Conversely, an automated portfolio-management solution with the help of robo advisors is not ideal for these types of investors:
- Investors who prefer human assistance: Some robo advisors offer live assistance (this usually costs slightly more), while others interact with you almost exclusively through the web. If you are the kind of investor who likes hearing a reassuring and familiar voice when it comes to investments, a robo-advisor is probably not right for you.
- Investors who hold multiple investment accounts: Some people’s investment needs might require them to coordinate 401(k)s and company benefit packages with some other accounts. In such scenarios, the automation offered by robo advisors isn’t really sufficient or suitable.
- Investors who need a tailored approach: Robo advisors won’t offer customized planning or advice on how much to save, whether to use a Roth IRA or Traditional IRA, or how to allocate investments in other accounts, such as your 401(k).
What are the benefits of using a robo advisor?
- These are the key advantages of using robo advisors to manage your portfolio:
- You can avoid investing mistakes. It has been documented many times that one of the biggest reasons investors get poor outcomes is because of their own behavior. On quite a few occasions, investors make emotional decisions which are dictated by market highs and lows depending on gut feelings. While they can be rewarding at times, they can also be extremely punishing. A software based investment tool however, will never make such mistakes.
- You can automate the investing process. Once you open your account, the robo-advisor software takes care of the investment process. You don’t have to worry whether you should make changes to your portfolio or invest more or less in a given market sector. You don’t even have to log in to the account and place trades.
- You can invest a smaller amount at a lower cost. Advisory firms generally require a higher amount to initially invest and impose fees that are often higher than those charged by robo advisors. What’s more, you don’t have to worry that a broker or other financial salesperson is making a recommendation that isn’t in your best interest.
How much does a robo advisor cost?
You’ll generally pay one of these robo advisors a service fee that may be structured as a fixed monthly fee or as a percentage of your assets. With robo advisors that charge a fixed monthly fee, the fee typically ranges from about $15 per month to $200 per month depending on portfolio value. With a percentage of assets structure, you’ll see fees in the range of about 0.15% to 0.50% of your account value per year. If you had $50,000 invested in your portfolio, a 0.50% fee would end up costing you up to $250 a year.
You will also need to pay for any of the expenses which are associated with the robo advisor’s investments. For example, mutual funds and exchange-traded funds have expense ratios. This type of fee is taken out of the assets of the fund before returns are dispersed to the investors.
How do investments work in a robo advisor-managed account?
Most robo advisors use mutual funds or exchange-traded funds rather than individual stocks to build your portfolio. They typically follow an index fund or another passive investment approach based on modern portfolio theory research, which emphasizes the importance of your allocation in stocks or bonds.
With your asset allocation determined, you can focus on the underlying stock asset classes for your portfolio, such as large-cap, small-cap, or international stocks. Then, you can settle on the underlying bond asset classes to include short, intermediate, or long-term bonds.
How do taxes work for a robo-managed account?
Your tax liability for assets managed by a robo advisor is dependent on the account type which holds your assets:
If your assets are held in an IRA, Roth IRA, or another type of tax-deferred retirement account, you don’t need to pay any tax until you make a withdrawal. Rollovers or asset transfers from your existing account to a robo advisor are not considered to be withdrawals.
If you own investments in a taxable account, then you will be required to pay taxes on your earnings. The annual 1099 form reports interests, dividends and any capital gains made by your investments. You will need to report those on your tax return and pay tax on these types of investment income.
If your robo-managed account allows you to transfer existing investments, those investments can be sold and incur a tax liability as a result of that. Unless the portfolio designed portfolio has already utilized certain investments, they can all be sold. If these investments are not inside retirement accounts when they are sold, any capital gains (or losses) realized through their sale will result in a tax bill.
What is the best robo advisor?
Once you have decided that automated portfolio management is the way to go for you, you might wonder what is the best robo advisor. While there is no objective answer for that since you take your personal needs and requirements into account while choosing one. A robo advisor might be great for one person while bad for the next. So before you sign up with a robo advisor, you should do the pre-requisite research and sign up with one that really works for you.
In any case, these are some of the most famous and widely used robo advisors today: Betterment, Vanguard Personal Advisor, Fidelity Go, WealthFace, Wealthsimple, WealthFront.
All of these robo advisors come with varying levels of human assistance.
Is a robo advisor worth It?
Robo advisors can help investors build and manage diversified portfolios and also allow them to project how their account’s growth over time. Robo advisors tend to be significantly cheaper than traditional financial advisors and carry lower account minimum rates as well. Hence , robo advisors are great for investors who don’t want to dish out a lot of money for a financial advisor or spend the necessary time or effort required for investing the money themselves.
While often equated with digital financial advisors, robo advisors aren’t financial planners. They don’t have the ability to provide customized solutions required to create and successfully implement unique investing strategies. In addition, once you are near retirement, the allocation models used in the robo-advisor tools may not help you align your investments with the withdrawal phase. For this particular reason, investors who are interested in availing the services of a robo advisor are better off using them at an early stage of their career and then seek the help and advice of a professional retirement income planner as they grow older.