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Robo-advisory

Making investment decisions is difficult. It requires a lot of knowledge and experience. Oftentimes those who have the resources to invest are not necessarily equipped with the skills and knowledge to make trading decisions, choose investment products and create a portfolio. Traditionally, these people hire financial advisors. The job of financial advisors is to create a balanced portfolio for investors based on their needs. This process is often costly as the demand on financial advisors is high. Developers have created online software products called robo-advisors who are automated solutions for making investment decisions. The first robo-advisor was launched in the aftermath of the 2008 financial crisis. Since then, robo-advisory companies have raised tens of millions of dollars from large institutional investors. Largest companies providing this service have over a billion dollars worth of assets under management. In 2017, the combined worth of these assets for robo-advisory companies was over $200 billion.

Robo-advisors will automatically choose investment products for investors and create a portfolio. Not only that, but a robo-advisor will continue to manage the portfolio, rebalancing it so that it always matches investor’s preferences. Understandably, these products are a lot cheaper than their human counterparts. Because there are no human hours involved, robo-advisors are not limited in time, so they do not need to charge as much. Investors simply pay a fee for the service as well as the cost of the investment. Fees on robo-advisors can be fixed or given as a percentage of the total investment. Fixed fees will range from $15 to $250 per month while percentage fees can be as low as 0.2% if a large investment is concerned. For an investment of $50,000, this would come out at $100. There is an option of automating the payments. When the returns have to be distributed to investors, robo-advisors will simply take out the fee first and then allocate the funds.

Robo-advisors are usually funded with cash only. This could be considered as one drawback of the solution as financial advisors would usually be able to accommodate these kinds of demands from investors. If robo-advisors already use the investment instrument a person is trying to transfer, it might allow them to do so. Otherwise, the investments have first to be sold and turned into cash. Robo-advisors are also not suitable for investors with complex demands that need tailored advice. Although some solutions offer live assistance, this is only minimal compared to a financial advisor. Robo-advisors are more suitable for beginners who want to put their investment process on auto-pilot.

Robo-advisors today are filling the niche that was created by the large fees of traditional wealth management solutions and financial advisors. Investors that were looking to invest relatively modest sums of money were left unserviced. This is clearly shown from the fact that a minimum investment for robo-advisors could be as low as a few dollars in some countries (In the United States a minimum of $500 is more likely to be encountered), while a minimum investment for financial advisors could reach over $50,000.

What investment instruments do robo-advisors use?

Robo-advisors can choose from different products when creating a portfolio. These could be more traditional instruments like stocks and bonds, as well as commodities, futures and so on. Most often, it is the case that robo-advisors choose exchange-traded funds and mutual funds to invest in. ETF is a form of security that tracks an index or a basket of assets. It is traded on a stock market just like a typical common stock. Mutual funds, on the other hand, pool together investments from various sources and then invest in a portfolio comprised of different assets. Such funds are usually managed by managers. The reason robo-advisors are choosing ETFs and mutual funds over less complex instruments is that they offer more diversified risk. It is less likely that prices on all assets underlying these instruments will fall together. Thus, robo-advisory companies take advantage of the experts who comprise and manage ETFs and mutual funds to add to the benefits of their solutions.

Robo-advisory

Advantages of robo-advisory

One obvious advantage of robo-advisory is the convenience it offers. It is often stressful for new investors to pick out the investments and then monitor them daily to make the necessary adjustments. With robo-advisors this problem is eliminated as the trusted management solution will look after the investments on its own. As investors have more trust in software that was developed by professionals they do not need to be anxious about the future of their investments.

Another very clear advantage is the elimination of human error and mistakes caused by inexperience. New investors could fall into many trading traps, like buying on highs and selling on lows. Furthermore, they might not be able to research and pick out the right investment instruments. Robo-advisors can take over this process completely. They only need to be funded and the rest is automated through some algorithms and programming.

Low fees are another advantage that allows robo-advisors to exist in the world of sophisticated financial advisors and wealth management companies. Not only are the limits for investors lower with robo-advisory solutions, but they also have to pay lower fees for the services. These fees can sometimes be up to ten times lower than those offered by alternative solutions.

Because financial advisors are humans, they can only serve a certain number of investors. Consequently, those with the top results, knowledge, and experience are almost inaccessible for investors. With robo-advisors, the algorithms behind investment decisions could be designed by the biggest experts in the fields. For example, many solutions are using methods designed by Nobel Prize winners.

How to choose a robo-advisor?

Choosing the right robo-advisory solution is not an easy task. Depending on investor’s need different solutions could be more applicable. The first thing to do is to decide on the size of the investment. Then, depending on how big the investment going to be it is easier to choose the most beneficial fee schedule. Comparing fixed fees with percentage fees will also become possible. Nevertheless, this is not enough to decide on which robo-advisor to buy services from. There are other steps that need to be taken as well.

Tax advantages are very important for many investors, especially if they have invested a large sum. Some robo-advisors have automatic reinvestment options that lead to the most tax-efficient results. This is called tax-loss harvesting and will usually be emphasized by providers who are offering it.

It is also important to study what assets the robo-advisor is investing in. It is understandable that a new investor will not have the knowledge to make the right judgment when it comes to which instruments are more suitable for them. It is after all why they start using robo-advisors at all. Still, they can do some research to see in general if the type of assets the robo-advisor invests in is something they want to hold in a portfolio. Mutual funds and ETFs also offer indicators for their past performers, which is easy to look up. This could be helpful when comparing multiple robo-advisors.

One easy way to compare robo-advisors is to look at their past performance. For promotional purposes, these services will often display the most attractive features for investors. With a little more research it will be possible to get a more comprehensive look at the provider’s past performance. This could make it easier to decide which solution to purchase services from once all the other factors are considered.

Additional services are very important when it comes to robo-advisors. These could include online support. Oftentimes new advisors are very careful and observant when it comes to their investments and could have many questions that need clarification. In these cases, it is important that the solution has some staff allocated to answering such questions. Some providers offer a better support than others and it can be seen on their websites and in their offers. There are also goal-based tools with some providers that motivate investors to save more. These services set certain return goals or other performance indicators and motivate users to invest more money to reach those goals. Others allow linking credit or debit cards to accounts to draw funds from in case there are not enough funds on balance to make a purchase. This could be important not to miss out on good investment opportunities.

Lastly, many robo-advisory services offer free trial versions for a limited period of time. Investors could use these first, as a way to get acquainted with the services and see how they work, but, also, as a tool to choose a robo-advisor. They can sign up for the trial version for several service providers, and then see which one they will be more drawn towards. This will facilitate the decision-making process even further. In addition, investors will be more comfortable with their choice once they decide to invest their money and will not worry about alternative providers that could offer better services.