Pros and Cons of Hiring a Robo-Advisor
Over the past recent years, the Robo-advisor market has witnessed rapid growth in the United States, particularly because it is the first country to launch automated financial advisor services. As per Statista, the total assets under management (AUM) in the Robo-advisor segment are expected to reach $937,109 million in 2021. Further, statistics reveal that the global number of investors using Robo-advisory services grew by nearly 5.5%, reaching approximately 70.5 million in 2020. This number is expected to double in the following years, reaching nearly 147 million by 2023.
Undoubtedly, Robo-advisors are the latest investment technology solution that has strong potential to disrupt the entire financial services industry. Robo-advisors are capable of providing a technologically driven, efficient, and cost-effective way of investing. They are easily accessible and simple to use. Further, they also lower the barrier to entry for investing, by providing easy and quick investing services.
However, despite these advantages of such strong growth, and promising future numbers, Robo-advisors are still far from becoming the one-stop solution for all financial advisory needs. This is primarily because Robo-advisors are limited by the information you give them. And, as your finances become more complicated or intricate, you would need to rely on a human financial professional. Robo-advisors are not human, and no matter how efficient their services are, their abilities are limited. That said, undeniably Robo-advisors are here to stay. Hence, it is important to understand the concept they are built on, their advantages and disadvantages, and if they fit your needs.
Here what you need to know about Robo-advisors and their pros and cons:
What are Robo-advisors?
Robo-advisors are digital platforms that deploy advanced computer algorithms to create a sound investment strategy aligned with your goals and risk preference. Robo-advisors offer automated investment advice with little or no human intervention.
These advisors gather information about your financial goals, objectives, risk preference, savings limit, etc., through a basic online questionnaire. Once you provide the required information, the advisor runs it through a defined computer algorithm to offer sound investment advice and build an optimally diversified portfolio that meets your specifications.
After making the investments, the Robo-advisors monitor your portfolio at a defined frequency. These advisors also rebalance the asset allocation to ensure it meets your specified criteria. Some advanced but rare Robo-advisors also offer tax optimization and tax-loss harvesting tactics.
Overall, Robo-advisors offer these services to you:
- Build a portfolio as per your specifications.
- Monitor and regularly rebalance your portfolio, automatically or at defined intervals.
- Offer financial planning tools like retirement calculators.
- Use tax-loss harvesting or other comparable tactics on taxable accounts.
However, if you want more in-depth and personalized financial advice such as estate planning, tax optimization, retirement planning, inheritance handling, etc., standard Robo-advisors might not be able to offer any assistance. In this case, it is advisable to engage with a human professional financial advisor to get the required financial services.
What are the pros and cons of using a Robo-advisor?Pros of using a Robo-advisor
- Low fees: Irrespective of whether you pay the professional financial advisor as per a fee-based model or a fee-only model, you give away a large sum of your hard-earned money towards financial advisory services. Most professional financial advisors usually charge 1% of the assets under management (AUM) every year. So, for a $250,000 worth portfolio, the charges could add up to $5,000 annually, which can cause a significant financial burden. However, Robo-advisors have brought a shift in the market paradigm. Robo-advisors are known to offer efficient and low-cost financial advice and are suitable for cost-conscious investors. Most Robo-advisors charge anywhere between 0.25% to 0.5% of the total portfolio value. This means that for a $250,000 worth portfolio, a Robo-advisor fee will be between $625 and $1,250, which is one-eighth of the cost of a professional advisor. Further, unlike some human advisors, Robo-advisors do not charge any fee or commission to buy or sell assets or to rebalance your portfolio as per your original allocation.
- Low minimum balance: Robo-advisors are primarily advantageous for people with a small net worth. Many Robo-advisors offer services even to investors with zero-minimum balance. Other Robo-advisors start offering services with a balance of $1,000 to $5,000. This has helped increase the market penetration for financial advisory services. Earlier, first-time investors, young investors, or those with low budgets would not opt for professional financial advice because of the high costs. However, with Robo-advisors, even these categories of investors have opened up to the idea of professional investment advice. Robo-advisors are easily accessible and charge a low sum for professional financial management services. Hence, more people get expert advice, enabling them to achieve better portfolio returns.
- Comprehensive investment models: Robo-advisors offer services based on the modern portfolio theory (MPT). MPT is a popular, award-winning investment theory that is specifically beneficial for risk-averse investors. Robo-advisors help low-risk investors build a portfolio that aims to maximize returns with a defined level of risk. Portfolios structured as per MPT minimize risk for a precise rate of return.
- Automated rebalancing: A major benefit of working with a Robo-advisor is that they offer automated rebalancing of your portfolio. This ensures that at no time your portfolio drifts outside its target asset allocation. For example, suppose your original asset allocation is 90% stocks and 10% bonds. However, stocks had a bad year, and by the end of the year, your portfolio comprises 85% stocks and 15% bonds. In such a scenario, your Robo-advisor will correct the asset allocation even if you do not intervene. The advisor will likely buy more stocks and sell some bonds to return the portfolio to its original division. Further, Robo-advisors can also, over time, adjust your portfolio as per your age, risk tolerance, and other factors. As you get older and approach your retired years, your portfolio should ideally become more conservative rather than aggressive. In such a scenario, your Robo-advisor will gradually shift your asset allocation as deemed fit for your investment profile.
- Tailored advisory models: Robo-advisors work with you to understand your preferences and financial objectives better. Accordingly, they build a portfolio that meets your expectations. These advisors use advanced algorithms to ensure the portfolio is precisely aligned with your requirements. For instance, if you wish to allocate more funds in a specific industry, the Robo-advisor will help you build that particular industry-sector-focused portfolio. If you want a highly diversified, low-cost portfolio, a specialized robot advisor will assist you with low-fee ETF options. Some advanced platforms also offer tax-loss harvesting services.
- Easy availability and accessibility: Robo-advisors are available 24/7. You only need an internet connection and a valid subscription to connect with them. This easy availability helps you tap on their investment expertise anytime and grab lucrative market opportunities. Moreover, apart from being readily available, Robo-advisors are also highly efficient. If you wish to execute a trade, the Robo-advisor will do it within a few clicks from the comfort of your home or anywhere else in the world.
- No emotionally-driven decisions: In many cases, investment decisions underperform in the market because of emotional investing. Many investors tend to react to what has happened in the market recently rather than taking a long-term view. After the market has risen in value, they think of venturing again because it appears safe. However, this may not be a wise decision as the market is the least safe in such instances and is instead, overinflated and in need of a correction. Similarly, many investors fall prey to the vicious cycle of stock market highs and lows. However, robots do not engage in emotional or panic made decision-making. Robo-advisors use advanced algorithms along with sound and long-term investing principles.
Cons of using a Robo-advisor
Despite all these advantages, Robo-advisors are not perfect. They fall short to cater holistically to an investor’s needs. Some of the major drawbacks of Robo-advisors are:
- Limited personalization: It is true that Robo-advisors use algorithms and work to understand your preferences and investment goals. However, even then, Robo-advisors are not 100% personalized. As an investor, your needs, financial goals, long-term and short-term visions are strikingly different from others. Moreover, you could likely change any of these factors, which could impact your investment decisions time and again. And while many Robo-advisors gather information about your goals and preferences through an online questionnaire, they are not as efficient. Robo-advisors fail to provide services or understand your financial concerns in several areas, where human advisory services are incomparable. Further, in market-volatile situations, Robo-advisors cannot provide you sound advice or the much-needed comfort and motivation that a human advisor can offer. A human financial advisor will understand your concerns, counsel you, ease your fears and work with you to ensure you stay afloat during such critical times. Moreover, apart from monetary matters, a human advisor can also work with you to ease your financial worries and help you identify additional sources of income, part-time work during retirement, etc.
- Limited expertise: Robo-advisors function as per set algorithms that might not be ideal for your financial concerns. Even experts have pointed that Robo-advisors-driven algorithms might not be able to answer all investment concerns. Moreover, Robo-advisors lack the required expertise in complicated financial matters like estate planning, inheritance planning, tax management, charitable donations, succession planning, and more. In such cases and more, a human advisor will prove more useful because of their expert management and experience in these areas. Also, a Robo-advisor has no know-how of specific investment spheres, such as call options and individual stock purchases. This becomes highly restrictive and you would need to engage with a professional human advisor to ultimately resolve your concerns.
- Restricted flexibility: Robo-advisors are built for the masses. Their decisions are based on investing profiles and not as per the individual concerned. This means that in most cases, Robo-advisors only let out a handful of investment choices like aggressive growth or income-oriented growth. Most of these advisors either offer you a targeted plan that you can choose or another plan that might not fit your needs. You have no option to customize your investment plan in such cases, even if both the offered plans do not suffice your requirements.
- Costs are competitive with many human financial advisors: Robo-advisors are preferred for their low fees. However, today, many human advisors charge as low as the Robo-advisors. Human financial advisors offer a host of services at a highly affordable monthly fee structure. Further, some financial advisors also offer an hour-based or a specific fee-based arrangement. This allows you to pay consciously only for the service you want.
- Dated investment theory: Robo-advisors are primarily advantaged because they help create a diversified portfolio at a low cost. However, these advisors only help to create an optimally diversified portfolio and not the ideal one as per your needs. Moreover, most Robo-advisors work as per MPT or a similar investment principle. Experts have criticized MPT for being outdated and catering only to risk-averse investors. The theory focuses on building a portfolio that generates returns while reducing the risk or maintaining a defined level of risk. This undermines the maximum return potential of a portfolio. Further, MPT diversifies assets into uncorrelated classes. However, unless this correlation is predictable or known, the objective of risk mitigation is lost. This has been further evident in situations like the COVID-19 pandemic. The COVID-19 situation established that the correlation of asset classes varies unpredictably and without any warning. Further, the theory also assumes that an investor is always rational and risk-averse, which is not always the case. All these limitations make MPT not an ideal foundation theory.
- No human interaction: Robo-advisors are typically computer programs and algorithms. There is no personal contact or any human interaction. While this might work in some situations, it can be extremely stressful in times like volatile market fluctuations or when you are experiencing a major life change such as marriage, divorce, etc.
To sum it up
Robo-advisors have carved out their space in the market. But the changing demographics, economically volatile situations, and the various disadvantages of Robo-advisors establish human advisory services as the preferred choice. That said, Robo-advisors can be a great option for some investors, but they are not a wholesome solution for everyone. Typically, novice investors, low-net-worth investors, investors that are highly comfortable with technology, or investors who wish to set instructions and forget, can benefit from the use of Robo-advisors. However, as human advice becomes more important, most investors will likely switch to a hybrid model or completely rely on the expertise of professional financial advisors to get guidance tailored to their specific needs.