A robo advisor is a digital platform-based financial advisor who uses data algorithms to come up with an automated financial plan for investors with little or no human interaction.
A robo advisor will provide a list of basic finance and investment questions, based on your age and current assets, accumulated debt, investment-risk tolerance and long-term goals. When the questions are answered, the robo advisor will tailor a unique investment plan for the respondent, including the creation of an investment portfolio usually filled with low-cost exchange-traded funds (known as ETF's.)
The idea behind robo-advisory investing is to simplify the investment process using technology to build wealth-creating and risk-managed investment portfolios that are also tax efficient and that offer low fees.
Leading robo-advisory firms include WealthFront, Betterment, Wealthsimple, Ellevest and SoFi, among others. Prominent investment firms like Vanguard and Charles Schwab have also rolled out their own robo-advisory platforms.
Should You Use a Robo Advisor?
If you don't want to be directly involved with your finance and investment management, and don't require any human interaction when making financial decisions, a robo advisor could be for you.
Or, your life could be so busy with a growing family, demanding job, or health considerations that hamper your ability to pay close attention to your personal finances. If that's the case, a robo advisor could also be for you.
Pros of Robo Advisors
There are many benefits of using a robo advisor, such as:
Robo advisors give you access to good portfolios at a low price
Exchange traded funds are low-cost, with management fees of about 0.25% for so-called "index funds." Compare that figure to traditional mutual funds, which usually charge 1.00% or more in fees. What's more, ETF's also match up well against mutual funds in terms of performance.
Robo advisors are user-friendly
All you really need to do to open a robo advisory account is sign on with a robo-advisor online, deposit money in an account, answer a few questions, and you're good to go with a new investment portfolio that's matched to your unique needs.
Robo advisors are good on taxes
Robo advisors make tax efficiency a priority, leveraging tax-friendly strategies like tax-loss harvesting, which uses investment losses to hedge against portfolio gains that would otherwise be taxable.
Cons of Robo Advisors
Robo advisors involve no human interaction
When you sign on to a robo advisor, you may be getting good-performing, low-cost portfolios, but you lose the human touch in the process. There's no advisor on hand to get to know you personally, talk you through tough decisions, and you can't interact with financial planners who have been certified as a professionally credentialed investment specialist.
It's not easy to merge life changes into a robo account
With a human advisor, you can pick up a phone and tell your financial planner you're getting married or starting a new business. With robo advisors, you'll need to log into your account and change your profile, often with no guarantee that the robo advisor firm will acknowledge your life change and make any necessary investment portfolio changes.
No advanced risk management
Digital investing platforms often can't properly drill down and weigh important risk considerations beyond conventional questions about overall investment risk assumptions. Key risk channels like liquidity risk, inflation risk and market risk may get short shrift with a robo advisor.
How to Choose a Robo Advisor
If you're considering a robo advisor, get educated, kick some tires, and ask the right questions before signing on the dotted line.
For instance, do you want a complete digital investment platform with no human interaction, or do you want a robo advisor that offers at least some access to human investment specialists? You may pay more for the latter scenario, but having access to a human financial advisor may be worth the cost.
You'll also want to ask any robo advisor if their products and services go beyond basic stock and bond funds. For example, you may want an investment advisor who also offers real estate funds and investments, or one that has a big collection of international and emerging market funds. You'll want to know your investment options going into any robo advisor experience.In addition, always ask about pricing and fees, especially if you're a beginner investor. Robo advisors typically charge less than traditional portfolio managers, but you'll want to be sure. While you're at it, ask about any minimum balance requirements. You don't want to get excited about a robo advisor with a $100,000 investment minimum.
Also, check the robo advisor's reputation for efficiency, security and regulatory compliance. Check with the Better Business Bureau or with the Financial Industry Regulatory Authority (FINRA), which maintains a web database (called BrokerCheck) of robo advisors who have been accused of misconduct.
As always when vetting a professional services company, ask for references and check them out. Any robo advisor who refuses to provide references or client feedback is a robo advisor to avoid.
No doubt, robo advisors are becoming more pervasive on the financial planning landscape. That said, all robo advisors aren't the same and you'll need to do your homework to fund the best robo advisor for your unique financial needs.