The other day I was driving home and I had an extreme craving for some pizza. I got on my phone and said, “hey google, find some pizza near me.” My phone then brought up a map of 5 pizza places all within a couple miles of my current location and I was able to fulfill my craving in minutes.
Technology is constantly improving and making things easier in all aspects of our lives. When we think of what areas of our lives that have improved, we sometimes forget that technology is changing the investment world as well. In the past few years, most brokerage firms have come out with a new product known as a Robo Advisor to automate investing for you. In today’s article, I’m going to be explaining how the Robo Advisor operates and the benefits it offers. When I was a broker at Charles Schwab, I took part in the first roll out of their Robo Advisor, known as Schwab Intelligent portfolios. Most of my knowledge on this topic comes from that product and research on competitors’ products in the industry.
How it Works
To initially set up the product, you first take a questionnaire that assesses your goals, risk tolerance, and time horizon for investing. Once the questionnaire is complete a target asset allocation is made for you based off of your answers. If you do not recall, an asset allocation is just the percentage mix of your money into different asset classes. Think of your portfolio as a pie and there are different slices (asset classes) that add up to make the pie whole. In most cases, the questionnaire can be completed without actually opening an account or investing any money so it is good to take advantage of just to see what your personal asset allocation would look like.
Minimum Deposit 5k
After you complete the questionnaire, most brokerage firms have a minimum deposit of 5k into the account. They believe this cash value is needed to keep the account properly diversified.
Mix of Etfs
After you deposit the 5k or greater investment, your funds are automatically invested into a variety of ETF’s based on your custom asset allocation that was generated from the questionnaire. If you don’t recall what ETFs are, check out my article “Buying Instant Diversification.” These ETFs trade all throughout the day and provide you with diversification across many asset classes.
After you have deposited your funds, your account is basically on autopilot. The Robo Advisors use advanced technology with algorithms designed to constantly rebalance your account to stay within your target asset allocation. The Robo Advisor buys and sells the etfs when needed to always keep you in line with your goals. For example, let’s say your asset allocation was a mix of 60% stocks and 40% bonds. If the value of your stocks goes up considerably, you may now be out of balance because the stocks are more heavily weighted in your portfolio. The Robo advisor will automatically sell some of your equity etfs and buy more bond etfs to rebalance your portfolio.
If you do not have the time or energy to invest then this is a great product for you. With a Robo Advisor you get the benefits of professional investment selection and constant rebalancing to stay on track with your goals. Robo advisors naturally appeal to younger investors because of this simplicity. Wealthfront said 90% of its 30,000 clients are under the age of 50 and 60% are under 35.
There are no hidden fees, no advisory fees, no account service fees, and no commissions charged. The only fees you pay are the operating expenses on the ETFs in your portfolio—these are the same as if you’d invested on your own and they select ETFs with some of the lowest operating expenses in the industry.
You would think that you would be getting more tailored investment advice working with a financial planner but in my experience in the industry, your investment picks are going to be about the same as you would get with a Robo Advisor. Think about how many clients some financial advisors have. They do not have the time to make individual investment picks so they pick investments such as mutual funds and etfs that have performed well to give you diversification and exposure to the targeted asset classes. The benefits of the Robo Advisor are that you avoid all the advisory fees that you would get with a Financial Advisor and you avoid fees from loaded mutual funds that many financial advisors put you in. I am only speaking to the investment side of your finances though so do not discredit the other services a financial advisor can provide you in addition to these services such as estate planning and tax loss harvesting.
Keeps You Diversified
As I stated before, the Robo Advisors will constantly rebalance your portfolio to keep you in line with your asset allocation. For those of us who don’t keep up with our investments, it is nice to know that you will not be taking on more risk than you are comfortable with.
Helps You Save
Most of the Robo Advisor accounts allow you to make automated contributions to your portfolio. When the funds come in they are automatically invested across your different asset classes evenly. This allows you to put everything on autopilot and make a plan to save. Even if you only contribute $20 dollars a month, it will pay off handsomely with the compounding power of investing.
At the end of the year many of your positions in the account might have a high unrealized gain. The account automatically sells positons that are losers to offset those gains so that you don’t have to pay as much in capital gains tax. This whole process is known as tax loss harvesting.
How Does the Brokerage Firm Make Money?
After reading the Low Cost portion of the benefits section, I bet many of you are asking yourself, “if the firm does not charge any hidden fees, advisory fees, account service fees, and commissions, then how do they make money? There has to be a catch.” This is a great question! I am very familiar with Schwab’s Intelligent portfolios so I will speak to that and I know it will be very similar to others in the industry.
Schwab affiliates earn revenue from the underlying assets in Schwab Intelligent Portfolios accounts. This revenue comes from managing Schwab ETFs, providing services relating to certain third party ETFs that can be selected for the portfolio, and from the cash feature on the accounts. Revenue may also be received from the market centers where ETF trade orders are routed for execution.
I believe that Robo Advisors can be a great product for you to invest in if:
- You don’t have time/energy/knowledge to invest
- You want to be hands-off with your investments
- You want professional investment decisions without the fees
While these are great benefits, one drawback I do see currently is that there is no long-term proven track record of success. This product has only been out a few years and performance has been ok with the market environment we have been having. Personally, I like to be in control of my investments and I want to try to greatly outperform the market. This is a daunting task but I put a lot of time and efforts into each trade that I execute. If I didn’t not have this time or drive to invest, I would likely put my money into a Robo Advisor product.
Homework: Follow the link to the Schwab Intelligent Portfolios page and take the questionnaire to see what your asset allocation would look like in this stage of your life.