Do you want to jump into the world of investing, but not sure about picking your own stocks and managing your own portfolio? A robo-advisor can do all that for you.
A robo-advisor is a digital platform that uses computer algorithms to build and manage a diversified portfolio based on your risk tolerance, financial goals and other personal factors. It also automatically rebalances your portfolio based on market conditions and your investment goals. While that sounds neat, a robo-advisor can pose some big risks. Before you invest, you need to weigh the pros and cons.
The benefits of a robo-advisor
Robo-advisors continue to grow in popularity. According to a study by the international consulting firm Deloitte, assets managed with the support of robo-advisors may grow to more than $16 trillion by 2025 — about three times that of BlackRock, the globe’s largest asset manager. Indeed, robo-advisors may offer several features that would appeal to investors seeking a hands-off, no-hassle approach.
Costs: A human financial advisor may charge an assets under management (AUM) fee of 1% or higher. Robo-advisor AUM fees can range from 0% to 0.40%. To put that into perspective, an annual 1% AUM fee on a $10,000 investment crunches out to $100. A 0.25% AUM fee on a $10,000 investment is just $25 a year.
Diversification: Most robo-advisors provide you with a questionnaire about your financial goals, risk tolerance, and more. An algorithm uses these answers to recommend an investment mix.
Automatic rebalancing: Market conditions can shake up your investment mix, and they may leave you too concentrated on one asset class — leaving you open to major risk should it face a downturn. When this happens, robo-advisors rebalance your portfolio back to its original investment mix, sometimes by selling off investments that rose and using proceeds to buy ones that dipped.
The downside to robo-advisors
Despite the hype, robo-advisors have their potential drawbacks:
Hidden costs: Even though robo-advisors generally charge much less in management fees than traditional advisors, your money still gets eaten up by expense ratios or fees charged by funds in your portfolio. Some may argue that you can simply open a discount brokerage account and invest in these funds yourself, avoiding the AUM fee altogether. There are plenty of online asset allocation tools that can recommend a customized investment mix, similarly to how a robo-advisor uses a questionnaire.
Fluctuating fees: Some robo-advisors may increase their AUM fees as your balance increases. The more you invest with them, the bigger the cut they take.
Little-to-no human interaction: If you’re on a premium plan or pay an extra fee, some robo-advisors give you access to financial planners who can help you meet other financial goals like paying off high-interest debt. But many plans offer no access to human advisors at all. For those who seek a hybrid service that lets you speak to a human advisor when you want to, your options may be limited.
Is a robo-advisor right for me?
If you’re comfortable with handing off investment management to an advanced algorithm and professionals, accepting limited investment options in exchange for a potentially low fee, then a robo-advisor may be up your alley.
But if you’re experienced or have a little bit of time to build your investment acumen, building and managing your own portfolio may be a better bet.
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Fool contributor Javier Simon holds no financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.