What is a Robo-Advisor?
The term “robo-advisor” is everywhere but what exactly does it mean? Put simply, a robo-advisor is a computer or robotic financial advisor. Using algorithms and computer-generated rules, along with some minimal human oversight, a robo-advisor develops and manages your portfolio for you with minimal fees. As is the case with so many industries that have been “disrupted” (taxis, food delivery, law, medicine, etc.), the robo-advisor has disrupted the investment or financial management space by opening up what was previously the realm of wealthy individuals with large sums to invest. Now, any sort of investor, with any sort of money to invest, has access to tools through a robo-advisor that were previously only available via human interaction for large fees through a financial advisor. The main drawback of a robo-advisor would be in the case of a sophisticated investor with large sums to invest and more complex issues surrounding their investments (such as tax issues, estate planning, foreign ownership). This sort of investor may not get the same advantages out of a robo-advisor and may prefer a more human focused interaction. However, no question, the robo-advisor and the ability for consumers like you and I to use the portfolio management tools without the high fees is revolutionary for the financial world.
Hand in hand with the concept of the “robo-advisor” is knowing the difference between passive and active investing strategies. Active investing is done with the goal of “beating” a particular market index. Using one’s experience or skill with the stock market, shares are actively bought and sold with the end goal being that of outperforming a particular benchmark or index. As one would expect, this takes skill and knowledge, and this is typically what you are paying a financial advisor to do in many cases. You will also be paying a correspondingly higher fee for all this work the advisor is doing on your behalf.
In contrast, passive investing is like it sounds – stocks are not actively bought and sold in a quest to beat the market, rather, the goal is to match the performance of the stock market as a whole. Passive investors buy securities that match an index. We have talked about various indexes on this site previously. Also, as in the case of ETF’s as you will recall from our discussions of these on the site, they also aim to replicate a particular index. Given there is not a great deal of buying and selling as one does with active investing, passive investing has lower management costs and lends itself to the robo-advisor approach. An algorithm is very capable of performing these passive investing tasks. Using this approach, there is no need to perform a great deal of company research and stocks are bought and sold much less often.
In short, with the rise of robo-advisors, there are now three ways for you to invest: DIY, robo-advisor and traditional financial advisor. The robo-advisor provides a good middle of the road approach for beginner investors with not hugely complex advice needs. However, I did find an interesting article by Felix Salmon from Wired about how some robo-advisors, in the interests of growing and making more money, have moved away from their “early ideals of low-fee passive investing”. I recommend this article as it sets out some pitfalls to be aware of with robe-advisors and it is overall an interesting article about this tool. There are numerous robo-advisor companies to research and look into but check out this review by NerdWallet for a complete evaluation of the many robo-advisors available for 2018.
A robo-advisor service, like the ones set out by NerdWallet, may be a good fit for most of us that have basic investment strategies that don't warrant the full fees of a financial advisor. Having said that, everyone's situation is different so it is worth your time to consider all three approaches - DIY, robo-advisor and human financial advisor.
*** Top photo by Max Ostrozhinskiy on Unsplash