Do you want to jump into the world of investing, but not too sure about picking your own stocks, managing your own portfolio, and rebalancing it yourself? You may be interested in a robo-advisor.
What is a robo-advisor?
A robo-advisor is a digital platform that uses computer algorithms to build and manage a diversified portfolio based on your risk tolerance, financial goals and other personal factors.
It also automatically rebalances your portfolio based on market conditions and your investment goals. Sounds neat, right? But there’s more than meets the eye. A robo-advisor can pose some big risks, so you need to weigh the pros and cons.
The benefits of a robo advisor
Robo-advisors may offer several features that would appeal to the novice investor. Here are some to consider.
Costs: A human financial advisor may charge an assets under management (AUM) fee of 1.0% or higher. Robo-advisor AUM fees can range from 0% to 0.40%. To put that into perspective, an annual 1% AUM fee on a $10,000 investment crunches out to $100. A 0.25% AUM fee on a $10,000 investment is just $25 a year.
Diversification: Most robo-advisors provide you with a questionnaire about your financial goals, risk tolerance and more. An algorithm uses these answers to recommend an investment mix.
Automatic rebalancing: Market conditions can shake up your investment mix and may leave you too concentrated on one asset class - leaving you open to major risk should it face a downturn. When this happens, robo-advisors rebalance your portfolio back to its original investment mix, sometimes by selling off investments that rose and using proceeds to buy ones that dipped.
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The downside to robo-advisors
Robo-advisors continue to grow in popularity. According to a study by the international consulting firm Deloitte, assets managed with the support of robo-advisors may grow to more than $16 trillion or about three times that of BlackRock, the globe’s largest asset manager by 2025.
But despite the hype, robo-advisors have their drawbacks. Here are some potential pitfalls to watch out for.
Hidden costs: Even though robo-advisors generally charge much less in management fees than traditional advisors, your money still gets eaten up by expense ratios or fees charged by funds in your portfolio. Some may argue that you can simply open a discount brokerage account and invest in these funds yourself, avoiding the AUM fee altogether. There are plenty of online asset allocation tools that recommend an asset mix similarly to how a robo-advisor uses a questionnaire.
Fluctuating fees: Some robo-advisors may increase their AUM fees as your balance increases.
Limited investment options: Many robo-advisors build portfolios with a set list of exchange-traded funds (ETF). These are diversified baskets of securities like stocks and bonds. This isn't necessarily a bad thing, especially since they're known for low fees. But if you wanted to diversify your portfolio with more options like real estate or cryptocurrency, you’d be left out.
Is a robo advisor right for me?
If you’re comfortable with handing off investment management to an advanced algorithm and professionals for possibly a low fee and limited investment options, then a robo-advisor may be up your alley.
But if you’re experienced or have a little bit of time to build your investment acumen, building and managing your own portfolio may be a better bet.