It wasn’t until fairly recently that investing in the stock market became accessible to so many people. For decades,investors would need to call up a broker to buy and sell stocks or to get the most up-to-date stock quote. But with the rise of online trading apps and robo-advisors, it’s easier than ever for practically anyone to invest.
The first robo-advisor was introduced in 2010, and the space has grown notably since: It’s predicted to manage over $16 trillion by 2025, according to a report by Deloitte. While this technology still fairly new, it’s important for investors to understand what a robo-advisor is, how it works, and the factors to consider before using one to invest in the stock market.
What is a robo-advisor?
A robo-advisor is an online financial service that offers investment advice and automated portfolio management based on the information you share when you set up your account or sign up for the service.
Robo-advisors provide these services at a low cost, which makes them an attractive option when compared with some traditional advisory firms that can require clients to have anywhere between $25,000 and $200,000 or more to open an account and have access to an expert who will help you manage your investments.
How do robo-advisors work?
There are more than 100 different robo-advisors to choose from, with most following the same basic working structure (see which ones made Fortune Recommend’s top list). Robo-advisors ask new users to fill out a short questionnaire when setting up their account, and based on those answers, automatically select investments using an algorithm.
The questionnaire will typically ask for your age, risk tolerance, and how long you plan to work before retirement, as well as gauge how you might react to the ups and downs of the stock market. All these data points are used to determine your portfolio’s asset allocation, which typically includes a combination of stocks, bonds, and uninvested cash that will still earn a fixed return.
From there, the robo-advisor will select and manage your investments with periodic adjustments to your portfolio over time, which generally includes rebalancing the portfolio and tax-loss harvesting. This process will take place automatically, with little to no action required on your part.
In addition to creating an automated portfolio, robo-advisors can also offer their customers the following benefits:
- Lower fees compared with a traditional financial advisor
- Lower capital required to start
- The ability to avoid human error and bias
- Automatic rebalancing
- No need to set up meetings or worry about scheduling
- Can pull information from outside accounts automatically so you can see them all in one place
“The biggest advantage they provide is low cost,” says Max Pashman, a CFP and owner of Pashman Financial. “You can have your portfolio managed for a very low management fee compared to the average rate of an advisor that typically charges 1% or more to invest [your] money,” he says. “There is generally no required minimum to open an account with a robo-advisor and less paperwork and research, making it a good starting point for new investors.”
The cost of a robo-advisor depends on the company you choose, but any fees will usually include…
- A management fee: This is a fee that is paid directly to the robo-advisor.
- An expense ratio: There may also be a fee for the funds the robo-advisor selects on your behalf.
Management fees are typically around 0.25% per year, which would amount to $5 for every $1,000 invested. There are some robo-advisors that do not charge a management fee at all.
Expense ratios are built into each of the specific ETFs (exchange-traded funds) that are selected for your portfolio and collected from the creator of the ETF, not the robo-advisor. Expense ratios for most of the ETFs provided by robo-advisors can range from 0.05% to 0.25% each year, which is between $0.50 and $2.50 for every $1,000 invested. There are a handful of robo-advisors that do not charge expense ratios.
Some robo-advisors offer optional access to human advisors for an additional fee of about $30 per month.
Robo-advisor vs. human advisor
There are multiple ways to gauge whether a robo-advisor or a human advisor is best to help you manage your finances. If you’re looking for an automated, low-cost way to manage your finances, a robo-advisor might feel like a natural fit. For those who want the one-on-one attention and a more tailored approach, a human financial advisor may prove the better option. Below are additional comparisons between the two.
Fortune/Nick Rapp
One understated advantage of a human financial advisor is they could help you avoid making any rash decisions that override conventional investing wisdom when the market is experiencing a downturn.
“An investor may be tempted to pull all their funds out on their own, influenced by fear in the market,” says Pashman. “By consulting with a human advisor first, the advisor can calm the client and prevent them from prematurely selling off too soon, which turns out to be more common than we’d like.”
What to consider before trying a robo-advisor
Before making the choice between a robo-advisor and a traditional advisor you may want to take inventory of your finances. What are the areas where you could use more guidance or automation? What are your expectations for an advisor?
“What people should consider here is more outside the realm of what the investment portfolio looks like; it is the emotional connection you have when a real-life advisor helps walk you through a tough financial transition,” says Patrick Bobbins, CFA, a financial advisor at Wealth Enhancement Group. “All of these more emotional and physical characteristics should be considered—not what optimal asset allocation is generated by the computer algorithm.”
Keep in mind that your choice isn’t set in stone, and as your financial situation changes over time you can switch to the option that works best.
- Financial goals: Knowing your goals can be one of the most important determining factors in deciding between a robo-advisor and a human one. While a robo-advisor can be efficient in managing your investing decisions, a human advisor may be best for more complex decisions like helping you choose the right student loan repayment plan or comparing compensation packages for a new job.
- Cost: If cost is a factor, robo-advisors typically win out here. But make sure you quantify the value you’re getting for that cost as well as any required minimums.
- Investment style: Are you a hands-off investor who enjoys the “set it and forget it” model? Or do you prefer to invest in stocks? These questions are important to consider given the limitations of what robo-advisor platforms offer in terms of investment options.
- Specialization: Do you have special considerations that could impact your finances? For example, business owners have different retirement plan options and estate planning considerations.
The takeaway
Choosing between a human advisor and robo-advisor comes down to the level of complexity in your financial situation. For those who have more straightforward goals, a robo-advisor may be a good fit.
But for those who have complex financial needs and want more of a personal touch, a human advisor may prove the best option.
In other words, robo-advisors are great for running in a straight line, but human advisors may be better at turning corners.
