Should You Use a Robo-Advisor? 5 Advantages & 4 Downsides

By Chika

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Last Updated: January 13, 2022

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Robo-advisors first appeared a decade ago with much buzz on the financial scene.

Today, a growing number of financial organizations provide automated portfolios, which are believed to offer their clients a safe, cost-effective approach to investing, while minimizing market and behavioral risks.

There has been a raging debate on whether the use of sophisticated computer algorithms is sufficient enough to evade market risk. There is also skepticism whether Robo-advisors can meet the wide range of demands that investors may have over time.

However, considering that Robo-advisors come with lower fees and do not require minimum balance requirements, it provides a much-needed option for investors with little capital.

Before deciding if these shiny new investment platforms are worth it, it helps to understand how they work in order to weigh the pros and cons. So let's dig in and find out how Robo-advisors can potentially benefit your financial situation.

 

What is a Robo-advisor?

Robo-advisors are simply computer algorithms and advanced software which are designed to provide automated investing services.

They are used to build and manage your portfolio according to the investor's preference without human supervision or interference.  

Robo-advisors work by collecting information from clients about their current financial situation and future financial goals through a questionnaire. It thereafter uses artificial intelligence to create financial and investing solutions for the client.

Robo-advisors provide a broad range of services which include portfolio rebalancingtax optimization, retirement planning, etc. 

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5 Advantages of Using a Robo-advisor

1. Cost-effective

The key benefit of Robo-advisors is that they are less expensive than traditional financial advisors.

The automated digital platforms can provide the same services at a fraction of the cost by removing human labor. They are also cheaper to set up and do not require a minimum account balance to get started. 

Most companies charge between 0.25% and 0.50% as an annual management fee, though some offer free options. On the contrary, most human advisors do not take on clients with less than $100,000 in investable assets, especially those who are well established in the field. 

2. Easily accessible

Robo-advisors are easily accessible which increases the efficiency of trade execution.

For instance, if a client wanted to execute a trade using a human advisor, they would have to call or physically meet them to explain their needs. There is also paperwork involved and a waiting period before the trade is executed. 

With a Robo-advisor, all of this cumbersome process is by-passed as the investor can execute their trade immediately with the click of a few buttons, and from the comfort of their home, thereby saving time. 

3. Diversification

Robo-advisors are effective tools for diversification based on the client's needs. 

The AI financial tool relieves the customer of the hassles of trying to find the best mix for their portfolio. In addition, the algorithm automatically rebalances the portfolio over time, according to market conditions and the investor's goal. 

Saving for financial goals

You can use a Robo-advisor for short- or long-term financial goals.

They can be used to save for an emergency, college, or mortgage down-payment. Most Robo services offer traditional retirement accounts like regular IRAs or Roth IRAs and can be used to set up automated deposits towards financial goals. 

Tax Optimization

Some Robo-advisors provide tax-loss harvesting services for their users.

This is a strategy where investment losses are applied to gains to minimize taxes. Such a strategy is usually difficult even for experienced portfolio managers. By offering this service, Robo-advisors can save their users tons of money, considering the potential cost of taxes over time.

 

4 Disadvantages of Robo-Advisors

1. Limited investment options

Most automated portfolios have limited options for investors.

The typical assets offered on these platforms are low-cost, index ETFs. This mixed option of investable assets reduces the options for portfolio diversification, also affects how well the portfolio can grow over time. 

2. Little or no Personal Advice

Robo-advisors do not have a personal touch since they are merely run by computer programs.

This characteristic is disadvantageous because you can't rule out the role of human interaction and communication in deciphering the underlying unique needs of a client. 

A human advisor would be able to have a more detailed picture of his client because of the close physical interaction, and as such may be in a better position to know which portfolio mix would be suited for his financial goals.

3. Inability to factor unexpected events

Robo-advisors operate on the assumption that all factors would remain the same.

Their services are also ill-equipped to deal with unexpected events or emergencies. As such, during such times, the algorithms may execute trades that may not be beneficial to the investor.

For example, at the height of the pandemic in March 2020, when the U.S stock plummeted by over 30%, Robo-advisors executed sell orders and exited positions because of the steep fall in the market.

Considering the fact that the market not only recovered but also set new highs in the history of the U.S stock market, the actions of the Robo-advisors were executed poorly. A human advisor, on the other hand, would have dollar cost averaged on assets and restructured portfolios accordingly. 

4. Performance

Though Robo-advisors are commonplace and are considered to be reliable methods of investing, this does not imply guaranteed higher returns.

In some cases, human advisors can generate more returns for their clients based on the flexibility of their trading decisions and the ability to react to market movement in a more dynamic manner.

Results from a study that analyzed the performance of 30 U.S.-based Robo-advisors showed that in an annualized portfolio returns based on a 60-40 allocation averaged between  6.51% to 10.98%. This may be considered conservative in comparison to some portfolio managers that aim for a 30% ROI. 

 

Is a Robo-Advisor Suited For You?

If you are considering if a Robo-advisor is right for you, there is no clear-cut answer.

It all depends on your investment needs and unique financial situation. However, to enable you reach the most suitable answer, there are a couple of questions you need to take into account the following:

What are your investment goals?

You have to clearly identify the purpose for the investment.

Is it for retirement, a new house, or your kids' college tuition? After you have clarified this, you should look if there are better alternatives to using a Robo-advisor. This will help you make your decision.

What is your investment style?

Robo-advisors are more suited to conservative investors who are more concerned with the protection of their investment than profits.

The returns from Robo advisors may not suit aggressive investors who have an eye for high returns. Clarifying your need would help you to decide if a Robo-advisor is a vehicle that can take you to your financial goals or not. 

Do you need financial services?

Though Robo-advisors are a viable option for investors who do not have the time or technical expertise, they may not be suited for everyone.

Some people are better off investing on their own than using a Robo-advisor based on their knowledge and experience. So if you feel confident in your investing skills, then you may not need a Robo-advisor. 

What value is being created?

Identifying the value which the Robo-advisor would create for you is important.

This goes beyond consistent portfolio returns as you can get that from investing yourself or using a financial advisor. What extra features does the Robo-advisor bring? Perhaps it may provide tax-loss harvesting, or save you time through automatic rebalancing of your portfolio.

Remember it is a service you want to purchase, so you need to identify what value it is giving you in return for your money. 

 

Key Takeaway

Despite being relative newcomers in finance, Robo-advisors have become an established part of the asset management industry.

These automated investment portfolios offer a reliable, cost-efficient investment option for investors who may not have access to accounts with traditional firms.

Though Robo-advisors are far from replacing human financial advisors, they can save investors a lot of stress and hassle by automating certain tasks.

They can add value to retail investing by providing a diversified group of investments that align with an individual’s goals; automatically rebalancing the portfolio over time; using tax-optimization strategies that may help reduce portfolio costs.

However, its usage should solely depend on how it fits with your long-term financial goals. 

Photo by Andy Kelly on Unsplash

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