Should You Invest With a Robo-Advisor?
Robo-advisors offer a hands-off approach to investing.
Constructing your own portfolio of index funds is fairly easy. I covered that here. But still, some people start investing before they’re comfortable with a DIY approach. If you open a Roth IRA or a taxable brokerage account at Vanguard or Fidelity, there’s no one to hold your hand. You make all the investment decisions. You have to select which stocks, mutual funds or ETFs to buy once you fund your account.
Up until a few years ago, there were two ways to invest: the DIY approach described above or hiring a wealth manager to invest for you. There are a couple of downsides to a wealth manager. For one, sometimes you need to invest a minimum amount of money that the average person simply doesn’t have starting out. Second, there are often high fees involved, sometimes a 1% annual fee or greater. And many advisors receive large commissions by investing you in high-fee mutual funds that underperform the market over the long term.
But in recent years, a middle approach has emerged thanks to fintech companies: robo-advisors. They’re algorithm-driven platforms that automatically invest your money according to your goals, age and risk tolerance.
Some popular robo-advisors include Betterment, Wealthfront, SoFi, M1 Finance and Acorns. But more recently, legacy financial firms have started offering robo-advisor services, including Vanguard, Fidelity, Charles Schwab and Goldman Sachs.
Robo-advisors typically charge a 0.25% to 0.35% assets under management fee, or in some cases just a few dollars a month. That’s much better than the fees charged by a human advisor. But more importantly, robo-advisors invest you in a portfolio of index funds like the ones from Vanguard and iShares.
Overall, robo-advisors offer beginners a low-cost way to invest for the long term. This is especially important for those who would be otherwise too scared to invest. You can think of a robo-advisor as training wheels to help you get started which you can graduate from at a later date when you feel more comfortable.
In fact, as I first started learning about investing, I decided I would take the middle approach and use a robo-advisor. So I opened a Roth IRA with Betterment and began investing. I still have my Roth IRA at Betterment, even though I could easily move it to a DIY brokerage and construct my own portfolio. I’ll move it at some point in the near future, but for now I just love the convenience of depositing money and having it automatically invested. I also love the slick, modern interface that just doesn't exist on a platform like Vanguard and Fidelity.
Let’s take a deeper dive into the pros and cons of robo-advisors.
Pros of Using a Robo-Advisor
There are a lot of great reasons new investors can benefit from using a robo-advisor.
Everything is Automatic
Every time you add money to your account, the money is divided up between each fund in your portfolio automatically. Most robo-advisors also rebalance your portfolio for you, meaning if one fund starts to drift from the target weight, the robo-advisor will correct it.
Low Fees Compared to a Human Advisor
Robo-advisors charge low fees relative to human advisors, with most of them in the 0.25% to 0.35% range. In the case of Betterment, the 0.25% fee is in addition to the fees on the underlying investments, which are low-cost index funds.
Research-Based Portfolios
Many robo-advisors design their portfolios based on the Nobel Prize-winning research of Harry Markowitz’s Modern Portfolio Theory and offer a simple default mix of U.S. and international index funds. Betterment takes this a step farther and introduces Eugene Fama and Kenneth French’s Three-Factor Model to create a diversified portfolio with a tilt toward value stocks — overlooked stocks with low prices relative to their value.
You Can Still Customize
While robo-advisors let you take a hands-off approach so you don’t have to think about your investments, they’ll often let you play around with the portfolio weightings and sometimes even add different funds. This lets you dip your toes into DIY investing while giving you the ability to retreat to the safety of the model portfolio they create for you.
Low Minimums
You don’t need to have a lot of money to start investing with most robo-advisors. You can usually get started with $100 or less.
Cons of Using a Robo-Advisor
Robo-advisors aren’t without their downsides.
Limited Fund Options
If you’re looking for maximum customization, robo-advisors might not be for you. This is at least true for Betterment. Wealthfront does allow you to pick from a broad range of ETFs, and Acorns recently announced a new feature that will let users customize a part of their portfolio. But if you want more freedom, the DIY route might be better for you.
Even Small Fees Compound Over Time
Even though robo-advisor fees are reasonable compared to human advisor fees, they will still reduce your return over long periods of time. As an example, if you invest $6,000 a year at a 7% average rate of return for 40 years, 0.30% in fees will cost you nearly $100,000. Over a 50-year period those fees will cost you about $260,000.
Copying Their Approach is Easy
Anyone with a robo-advisor account can simply look at the underlying portfolio and copy it in a DIY approach. Sure, you will have to do the work to allocate your dollars to each fund appropriately and manage rebalancing, but you’ll only be paying the low fund fees rather than the annual investment fee.
Target Date Funds Are Cheaper
Target date funds offer a one-fund option for those who want to set and forget their portfolio. Vanguard offers great target date funds with expense ratios between 0.12% and 0.15%, which make them cheaper alternatives to robo-advisors. You get all the benefits of a hands-off approach and automatic rebalancing without the added investment fee on top of what the underlying fund charges.
Some Robo-Advisors Stray From Their Mission
While some robo-advisors, like Wealthfront, offer more customization, this can come to the detriment of investors who choose a robo-advisor to be guided toward a more rational approach to investing. Wealthfront has also recently begun dabbling in crypto, which might not be best for a beginner investor.
Should You Invest With a Robo-Advisor?
If you still don’t know a lot about investing or you’re uncomfortable with a DIY approach but you want to get started somehow, a robo-advisor is a great place to begin. It can take away a lot of the anxiety at the beginning and slowly get you more comfortable with managing your own investments, which will save you money over time. Or, you can leave your money with the robo-advisor for the long term if you want to think about your investments as little as possible. Just be aware of the added fees and the fact that you’re giving up customization.