What is a robo-advisor? And should you use one?

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In a Nutshell

If you're a new investor, using a robo-advisor could be an easy way to get started with investing.
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Robo-advisors are the latest investment technology that’s shaking up the the financial services industry and offering a new, technologically-driven way for people to invest.

While they’re all the rage right now, they’re still somewhat of an enigma. What are robo-advisors anyway? What do they do? And should you use one? We’re here to break it down for you.

What is a robo-advisor?

When you hear the word “robo-advisor,” you may think of some futuristic robot managing your money, but that isn’t exactly the case. It’s a type of wealth management service that provides automated investment advice, aided by computerized algorithms and minimal human intervention.

Many robo-advisors use Modern Portfolio Theory (MPT), a mathematical formula that aims to help you maximize returns and minimize risk, based your individual risk tolerance. However, according to Barbara Friedberg, an author and former portfolio manager, “robo-advisors aren’t all the same. Some robo-advisors, such as Wealthfront and Betterment, manage your money for you using low-cost index funds. Others, such as Personal Capital, have their own recipe for investing.”

If you’re worried about your investment being managed with minimal human intervention, there are other robo-advising options that have a more human element. For example, Charles Schwab and FutureAdvisor provide software that manages your investment portfolio but also provide access to on-call financial advisors. Personal Capital and Vanguard’s Personal Advisor Services have advisors available to talk to you via phone, email or video conference.

There are even robo-advising options for young people who are just starting to invest in a 401(k) and are confused by their options. Blooom offers professional 401(k) investment help and claims that professional management of your 401(k) can grow your account up to two times more than one that is self-managed.

What are the pros of using a robo-advisor?

Robo-advisors can be a great option for new investors looking to start building wealth. Instead of waiting until you have enough capital to work with a financial advisor, you can put your money to work and start seeing returns sooner rather than later.Friedberg says “A low-cost robo-advisor (such as Wealthfront or Betterment) would allow a consumer to forget about investing and be reasonably confident that his investments are well-managed.”

One potential advantage of robo-advisors is that your portfolio is monitored frequently by computers, rather than occasionally by a flesh-and-blood advisor. What this means is that if the market goes up or down, the robo-advisor may rebalance or reallocate your investments in a way to counter the market changes. However, even though a robo-advisor may make more frequent changes to your investment portfolio, it still doesn’t protect you entirely from market changes.

There’s another big potential benefit of using a robo-advisor, particularly if you’re young and have limited financial resources: Robo-advisors tend to be less expensive than a flesh-and-blood financial advisor. Traditional financial advisors may charge a hefty annual fee — typically one percent of your invested assets. So, for example, if you invested $100,000, your advisor’s annual advisory fee would be $1,000.

Robo-advisors typically have much lower fees, which may appeal to the millennial generation in particular, which is saddled with student loan debt and stagnant wages.

For example, Wealthfront doesn’t charge a management fee for accounts under $10,000 and 0.25 a percent fee for assets over that amount. Another popular robo-advisor, Betterment, charges management fees between 0.15 and 0.35 percent, depending on your account balance. These lower fees could potentially save you a lot of money.

If you had an account balance of $100,000 with Betterment at 0.15 percent, you’d pay $13 per month, compared to $83 per month with a traditional advisor charging one percent. Similarly, Wealthfront advertises a sample annual fee of $225 on a $100,000 investment.

To manage your 401(k) account, Blooom charges $1 per month for accounts with balances less than $20,000 and $15 per month for accounts with balances over this amount.

What are the cons of using a robo-advisor?

While robo-advisors can be a cost-saving alternative to a traditional financial advisor, there are some downsides.

“A disadvantage of most robo-advisors is that their portfolios may be less tailored to an individual’s personal situation than a flesh-and-blood advisor. Consumers need to understand that a robo-advisor won’t protect the investor from the inherent volatility of investing in the financial markets. In short, your investments will always go up and down in value when investing,” Friedberg says.

In other words, your robo-advisor may not be able to tailor your portfolio for something specific like a big life change, such as buying a house or having kids.

Another con is that while some companies’ robo-advisors provide easy access to a human adviser if you ever need it, other companies may limit their robo-communication to online only.

Bottom line

The investment landscape is evolving, and the robo-advisor industry is likely to grow. If you’re a new investor, using a robo-advisor could be an easy way to get started with investing.

However, just because a robo-advisor is convenient and automated doesn’t mean you shouldn’t do your homework about investing.

After all, it’s your money and you want to have an understanding of what is happening in your investment portfolio. As with anything, it’s important to do your research, compare options and find the best fit for you.

About the author: Melanie Lockert is a freelance writer and editor currently living in Portland, Oregon. She is passionate about education, financial literacy and empowering people to take control of their finances. Her work has been f… Read more.