Today’s retail investors are spoiled for choice when it comes to working with a robo-advisor. Gone are the days when everyday investors had to walk into the office of a financial advisor, fill out physical paperwork and put their trust in someone else to manage their money. Nowadays, all you have to do is turn to your smart phone’s app store, search “invest” and download a robo-advisor to start saving for your financial future right away.
But, somehow, with so many robo-advisors from which to choose, there still seems to be limited product differentiation. Doing your research is critical to make the most out of the digital investing platform you ultimately choose.
What is a robo-advisor?
Robo-advisors are today’s version of financial advisors. Boiled down, they’re digital platforms that provide automated and algorithm-powered financial planning services. Most of them have little human supervision, if any at all. Though many of them offer help centers and some provide access to on-call financial advisors, usually for a fee.
Robo-advisors collect their clients’ personal information, financial goals and other relevant details. They then use that data to extend financial advice and invest clients’ assets.
What are the advantages of using a robo-advisor?
Robo-advisors are ideal because most of them have easy account setup processes in place and automatically manage your money for you. Some of the major benefits of using robo-advisors include, but are not limited to, the following:
- Simple setup questionnaires
- Financial goal planning
- Portfolio management
- Security features
- 24/7 account services
- Finances at your fingertips
- Transparency into your funds
- Typically lower fees than financial advisors
What are the disadvantages of using a robo-advisor?
While robo-advisors are great alternatives to financial advisors, there are some setbacks. The cons of most robo-advisors include, but are not limited to, the following:
- Many robo-advisors charge commissions and other hidden costs (even when they promise fee-free trading).
- Some robo-advisors require high opening balances that make investing inaccessible to most everyday investors.
- Not all robo-advisors offer portfolio rebalancing so investors can survive market swings.
- Few robo-advisors provide truly personalized portfolios and customization options so investors can achieve their unique financial goals.
Currently, just a few firms control the $25+ trillion fund management industry. In fact, nearly 75 percent of the $21 trillion mutual fund industry is under the helm of just three companies, and five firms manage 90 percent of the $5 trillion ETF marketplace. This means limited product differentiation and a whole host of investing barriers for the average person.
That’s why it’s important to do your homework on investing platforms before blinding trusting just anyone (or any bot) to manage your money.
5 Questions to Ask Before Deciding on a Robo-Advisor
Here are five questions you should always ask before deciding on a robo-advisor. Knowing the answers can help you know what’s the best platform for you.
1. What will I be charged?
Even if the platform claims to offer free trading, most robo-advisors charge an annual flat fee of 0.2% to 0.5% of your total account balance. Here are some other potential fees of which you should be aware:
- General Trading Fee: This is the bare minimum you need to trade under a brokerage service
- Account Maintenance Fee: This is the fee you pay just to have your account managed
- Commission Fee: This is a percentage a broker may take off the top, often according to the total assets under management or per new contribution
- Stock Trade Fee: This may be a flat or share-based fee for stocks
- Broker-Assisted Trade Fee: Some brokers who operate by phone may charge their own fees
- Mutual Fund Trade Fee: You may have mutual fund trade fees depending on the type of fund you plan to trade
- Front-End Load Fee: This is the fee you’re charged upon purchase of mutual fund share
- Back-End Load Fee: Brokers charge back-end load fees when you cash out your fund
- Base Fee: This is a flat rate per option trade
- Per-Contract Fee: This is a fee that may have several tiers depending on your option trading
- Exercise Fee: Some online brokers charge a fee for exercising, rather than closing, your option(s)
- Assignment Fee: If you have an option automatically bought or sold based on certain conditions, you may have an assignment fee
2. Is there an account minimum?
While many robo-advisors offer expense ratios as low as .25 percent or less, depending on how much you invest, many also have investment minimums that can be upwards of $10,000. Looking into whether or not you can even afford to get started is critical before wasting your time researching the rest.
3. Does it offer tax-loss harvesting?
Tax-loss harvesting refers to the investing strategy of selling your securities at a loss in order to offset a capital gains tax liability. This is because short-term capital gains are typically taxed at a higher federal income tax rate than long-term capital gains.
Though you’ll still pay out a portion of your profits, there are ways to minimize your tax burden in investment situations. Currently, you can deduct up to $3,000 per year in net capital losses. (And, if you sustain more than that in losses per year, you can “carry forward” the loss into future tax years.) Just beware of the wash sale rule that states, if you sell and repurchase a “substantially identical” security within a 30-day period, any favorable tax consequences are null and void.
Some robo-advisors handle tax-loss harvesting for you. If saving on taxes is one of your financial goals, this is worth looking into before deciding on a platform. That said, note that there are other ways to minimize your tax burden if tax-loss harvesting is not an option.
4. What are my investing options?
While there is a wealth of robo-advisor options out there, many of them only allow you to invest in stocks, not strategies. We’ve said it before, and we’ll say it again: Stock picking is risky. No matter how well a company has performed in the past or how positive of a trajectory you predict for its future, investing in individual stocks means taking a chance. And that’s precisely why you should invest in diversified strategies instead. Portfolio diversification in terms of both assets and strategies is key in managing risk while capitalizing on gains.
Portfolio rebalancing is also a major plus. After all, one chief reason for using the platform is to get help managing your portfolio. So it makes sense to want your investments looked after and adjusted throughout inevitable market volatility.
5. How have other portfolios performed?
A robo-advisor can easily make a lot of bold claims, but can it walk the walk? While knowing the platform’s assets under management (AUM) is helpful in understanding how many other investors trust it with their money, it’s not enough. You should always dig deeper to see how their portfolios actually perform.
For example, take note if one robo-advisor’s returns are substantially different from the competition. And, if available, make sure to look at long-term returns, not just short-term returns. While many robo-advisors have not been around for very long, you can get the bigger picture on those that have been by looking at how they’ve performed over the last five or more years.