There are many advantages to investing with robo advisors. They can be the perfect middle ground for investors who aren’t interested in managing their own portfolios, but lack the portfolio size to engage the services of a human investment manager.
Why might robo advisors be the perfect place for you invest your money?
1. Hands Off Investing
Do-it-yourself investing gets a lot of coverage in both the financial media and on the Internet. But millions of people have absolutely no desire to manage their own investments even with helpful tools that are available such as Personal Capital Money Management Tool. If you’re one of them, you could invest your money with a professional investment manager. But many investment adivsors charge high fees and have large investment minimums. Fees can exceed 1% – 2% of your portfolio and minimum investments may exceed $250,000.
Robo advisors can offer an alternative solution to investors who may only have a few hundred or a few thousand dollars to invest. And they can do so at much lower fees than a human investment advisor.
Once your account is set up with a robo advisor, they determine your risk tolerance through a series of questions. Armed with that risk tolerance, they build a portfolio.
That portfolio is comprised of several exchange traded funds (ETFs) that are invested in various asset classes, including fixed income, US stocks, foreign stocks, emerging markets, and even real estate. Robo advisors can offer even small investors a fully diversified portfolio. They handle all the details, and free you from the burdens of investment management.
2. Low Fees
Human investment advisors typically charge at least 1% to 2% of the value of your portfolio as a management fee. The percentage may be even higher on a smaller portfolio.
Robo advisors typically charge just a fraction of 1% as a management fee. For example, Wealthfront charges just 0.25% as a management fee – and the first $10,000 is managed for free! Betterment charges a sliding scale ranging from a high of 0.35% to a low of 0.15%. Fees charged by many robo advisors decrease as you have more funds under management.
Why are fees important? Management fees reduce the net return on your portfolio. An annual fee of 2%, can turn an 8% total return into a 6% net return. That will make a huge difference on a portfolio over a decade or more. The fees charged by robo advisors are so small that they hardly impact your net investment return.
*Note: expense ratios are also important. Most mutual funds also charge a fund fee, or expense ratio. This is for the fund itself, and is separate from the management fee charged by an investment manager or robo advisor. Expense ratios can vary significantly, and can easily exceed 1% or 2%. Most robo advisors will help you identify funds with high expense ratios and suggest lower cost alternatives. This helps you further reduce fees and ultimately increase your returns. Keep in mind, individual investment managers may or may not work in your best interests. Some investment managers will keep you in high priced funds if it puts more money in their pockets.
3. Regular Rebalancing
It’s just a question of time before even a well allocated portfolio gets out of balance. Changes in asset categories – either higher or lower – distort your allocation. For this reason, your portfolio needs to be rebalanced. At a minimum, it needs to be done at least once a year. But more frequently is even better, since markets can shift by double-digit percentages in a matter of weeks.
Even if you like do-it-yourself investing, rebalancing is complicated, particularly if you have a very well diversified portfolio. If you have a portfolio where you’re holding 20, 30, or 40 different funds and individual securities, rebalancing will be a complete mess. And let’s not forget that making changes in individual securities usually involves some sort of transaction fee. That can get expensive in a hurry.
You won’t have to worry about any of that if you invest with a robo advisor – they handle it all for you, and do it on a regular basis.
Bonus: Many robo advisors will also work to simplify your investment portfolio to decrease overlap in the types of funds you have, and to reduce the management fees of your holdings. This alone can produce significant gains. See our Personal Capital review for an example of how this works.
4. Tax-Efficient Investing
As every seasoned investor knows, taxes can have a major impact on your investment rate of return. This is particularly true of capital gains, and especially of short-term capital gains since they are taxed at regular income tax rates.
Since they are fully automated, robo advisors are constructed in such a way that they minimize capital gains taxes.
One of the ways they do this is by investing through index based ETFs. Since such funds are based on the underlying index, trading within the fund only occurs when the index changes. Since that happens so infrequently, these ETF’s produce very little in the way of capital gains.
Some robo advisors also offer tax loss harvesting, or TLH. This is a process in which capital gains are offset through the sale of investment positions that have experienced losses. The use of TLH can be engineered in such a way that minimizes capital gains, without materially lowering the performance of the account.
5. Low Minimum Initial Investment Requirements
As noted above, human investment managers often have initial investment requirements of several hundred thousand dollars. Most robo advisors require no more than a few thousand dollars. Some have no minimum requirements at all.
Betterment is just such a robo advisor. They have no minimum initial investment requirements, as long as you commit to funding your account with at least $100 per month*. That gives you an opportunity to open up a professionally managed investment account even if you have no starting capital.
The $100 per month investment requirement can also help you get into the habit of saving money for investments purposes, if you have been unable to do this. And in that way, you can build a very large account over time.
*The $100 per month requirement is waived if you invest with a larger starting point.
Bonus Benefit – Robo Advisors Can Save Your from Yourself
One of the most valuable benefits may not be obvious at first. Robo advisors can save investors from making serious mistakes. For some people, saving money isn’t a problem. Instead, they struggle to decide what to do with their investments.
Some people trade too frequently, trying to time the market, or otherwise reacting to changes. This can cause people to make one of the worst investing sins possible – buying high and selling low.
Other people make the mistake of waiting to get into the market, instead playing things too conservatively. Perhaps they sit on too much cash, or they fail to rebalance their portfolio because they fear they may make a mistake.
Robo advisors take the guesswork and timing out of the equation. They rebalance at set intervals, based on your predetermined risk tolerance. They stick to the plan. And in the long run, this can save many investors from making costly mistakes.
Robo advisors can be the perfect investment alternative for people who are not interested in do-it-yourself investing, but don’t have the capital required by human investment managers.
Have you ever invested with a robo advisor, and if so, which ones do you recommend?