In the last few years, robo-advisors have become more popular.
Robo-investing promises to help you start investing your money with minimal fuss. In many cases, robo-advisors have low (or no) account minimums. There are even robo-advisors that allow you to invest your pocket change.
But is robo-investing a good idea? Before you entrust your money to a robo-advisor, make sure you understand how robo-investing works and decide whether or not it’s right for you.
How does robo-investing work?
Robo-investing works with the help of formulas based on Modern Portfolio Theory (MPT). This is an automated investing style that relies on asset allocation rather than any method of individual stock picking.
Asset allocation focuses on investing riskier assets while you are younger and have a higher risk tolerance. As you age, your risk tolerance changes. Robo-advisors automatically rebalance your portfolio for you. They adjust your asset allocation from more volatile stocks and move more of your investments to dependable bonds.
Today, asset allocation is mostly accomplished with the help of index funds and index ETFs. This is true whether it’s done by human money managers or robo-advisors.
When it comes to robo-advisors, the preferred investment choice is usually the index ETF. Shares of ETFs trade like stocks. However, they represent collections of assets, providing more diversity in one trade.
If you use a robo-advisor, you have to trust their index ETF choices. An advisor such as Betterment, for example, allows you to choose your asset allocation, but the robo-advisor makes the actual investment choices. With most robo-advisors, you won’t have much chance for true personalization unless you maintain a higher balance.
Are robo-advisors safe?
For the most part, robo-advisors are just as safe as any investment broker, as long as you look for those registered with the Securities Investor Protection Corporation (SIPC). Many online mortgage brokers that act as robo-advisors are SIPC members, which can protect your account if the advisor ends up in financial trouble.
There is no protection against losses incurred due to market drops or general investment losses if an ETF turns out to be a dud. However, it’s worth noting that the use of index ETFs can help you avoid some of the losses that come with individual stock picking.
Stock picking reduces your portfolio’s diversity and can potentially expose you to more short-term risk. Many robo-advisors choose ETFs that focus on large swaths of the stock or bond markets. This kind of diversity and long-term investment strategy can limit your overall losses.
When you rely more on long-term market trends inherent in the diversity of using indexes, you are more likely to be somewhat insulated with index investments. You can see my Betterment portfolio composition as an example:
The largest portion of my portfolio includes index ETFs that cover a broad portion of the market, including international markets. Although market events can be stressful in the short-term, in the long-term trend lines tend to even out.
The chart below illustrates the overall trends in stocks. Robo-advisors usually rely on index investments that take advantage of broad trends. So even though you’re never completely safe when you invest, robo-advisors aren’t any riskier than investing on your own in index funds or ETFs.
Is robo-investing a good idea?
The main advantages to robo-investing are that you can start with a relatively small amount of money and you don’t have to be hands-on with your portfolio management. The robo-advisor takes care of everything; you just decide how much you can invest each month.
For beginners, robo-investing can be a good way to become familiar with the concepts associated with investing. Plus, it can be an inexpensive and effective way to use dollar-cost averaging to start building wealth.
Using a robo-advisor can also be useful if you’re saving for a long-term goal like retirement. Because the focus is on indexing and long-term asset allocation strategies, robo-investing takes advantage of the tendency of the markets to gain over the long haul.
Plus, because robo-advisors are all about using mathematical formulas to determine your asset allocation and portfolio composition, it takes some of the emotion out of investing. You can’t panic and make drastic changes to your portfolio when an algorithm is in control.
When robo-investing might not be right for you
If you’re interested in a more hands-on experience, using a robo-advisor might not work for you. While some robo-advisors such as Betterment and Wealthfront allow for greater personalization as you increase your account balance, for the most part, you can’t tailor your portfolio. Even when you can tailor your portfolio, your options are often limited.
Not only that, but few robo-advisors allow you to trade frequently or pick individual investments. The point of robo-investing is that it’s hands-off. If you want to make trades and tinker with different assets, it probably makes more sense to sign up with a more traditional online broker.
It’s also possible to combine strategies. For example, I use robo-investing to help me automate my retirement goal, as well as my travel fund. However, I use a more traditional broker for experiments. Combining these types of accounts allows me some freedom in my portfolio while also ensuring that my long-term retirement goals are being met.
Carefully consider your choices and your investing style, then create an investing plan that works best for your goals.
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