What’s easier: buying a basket of groceries or a basket of investments? It’s ludicrous to think that buying the ingredients for spaghetti bolognese could be more difficult than building a diversified portfolio of stocks and bonds. But thanks to modern and technology-based financial advisers that traffic in bits and bytes, investing may be easier. The process is faceless, efficient and cheap.
Meet the robo-adviser, the financial adviser of the future.
Unlike its human counterpart, the traditional financial adviser, the robo-adviser won’t send you a gift basket for the holidays, nor will it preemptively call you when the next financial crisis looms. But if you look under the hood, the robo-advisers are investing your money in similar places, with similar philosophies, to build their client portfolios—all at a fraction of the cost of a human adviser, and as seamlessly as Venmoing a friend.
But is a robo-adviser capable of understanding your needs and adapting to changes in your life? And most importantly, is it safe to hand your hard-earned cash to a faceless robot?
The short answer is yes. But the reasons why are more interesting than you might expect.
What goes into a “basket?”
There are many ways to go about investing. If you require a lot of hand-holding, you could pay a financial adviser a one-time fee for a plan (typically $1,000-$2,000), a fixed annual fee, known as a retainer ($2,000 to $7,500), or a percentage of the assets they manage for you (typically 1% per year.) Human financial advisers typically require minimum balances of $50,000. On the other end of the spectrum, you could use the DIY approach and buy individual stocks, bonds, and investment funds known as exchange-traded funds (ETFs) yourself at negligible cost.
The robo-adviser lies squarely between these two options. And you can “hire” one with as little as $100.
Robo-advisers create investment portfolios for their clients using “baskets” of stocks and bonds called ETFs. You’ve certainly heard of one ETF: the S&P 500, which consists of the 500 largest publicly traded companies in the US. When you buy the S&P 500 ETF, you’re buying the tiniest sliver of these 500 companies. The stocks or bonds that get included in each basket are determined by an independent arbiter and are neatly packaged as a stock itself. But ETFs exist for all permutations of stocks and bonds. The largest bond ETF is the iShares Core US Aggregate Bond. Conversely, there are specialized ones, like the Millennials Thematic ETF.
Now if you want to follow the DIY approach, you can buy these baskets through any online brokerage, such as Robin Hood, E-Trade, or Schwab. One big advantage: the fees are minuscule 0.0945% (i.e. buying $10,000 worth of the ETF would have an annual maintenance cost of $9.50). Even if you hired a human financial adviser, you’d pay these ETF fees on top of the fee you paid the adviser for helping you pick and assemble the right ETFs.
If you assume your portfolio is $10,000, a robo-adviser would charge 0.25%-0.50% ($25-$50 per year) and a financial adviser, on average 1% ($100 per year). Both charge fees based on the invested balance, meaning so these fees get paid regardless of the market’s performance.
Robo-advisers exclusively use ETFs (typically fewer than 20 of the world’s largest ones) to build client portfolios. Even with a small number of ETFs, robo-advisers are able to make a portfolio less risky because they make it diverse. The portfolios contain investments in a range of industries, companies, geographies, and instrument types (both stocks and bonds). All this diversification ensures that no single company’s fate will tank your portfolio.
How can my basket fit my needs?
Once the robo-advisers have selected which ETFs they’ll draw from, they need to determine the optimal mix for each client. Investors refer to the this mix of stocks and bonds that match your preferences and objectives as asset allocation. To determine the right mix, there’s a longstanding approach used by investment professionals and advisers—and now the robots—known as Modern portfolio theory.
Modern portfolio theory (MPT) is the granddaddy of asset allocation. When you create a portfolio, you want to combine assets that “zig” and “zag.” For example, if your portfolio consists of just two stocks, Facebook and Google, what happens to one will often happen to another. When Mark Zuckerberg gets called to testify about election interference, there’s a good chance both stocks lose money—they both zig. But if you owned Facebook and, say, a US government bond, they might move in opposite directions, or might be completely unrelated.
Investors refer to zig-zaginess as correlation. Correlation looks at the historical relationships between stocks and bonds (as well as their ETF baskets) to find the optimal amount of zig-zaginess to match your preferences.
Just like some people prefer chocolate cake to dulce de leche, we have investment tastes, too. Those are shaped by our goals for investing (retiring, buying a home, building a safety net), our investment horizon (will you retire in one year or ten years?), and our risk appetite (can you stomach losses to your portfolio)?
Thankfully, there are investment “recipes” that people can rely upon based on these different goals and preferences. The algorithms that underpin robo-advisers, built from publicly-available research papers, are designed to match your portfolio to your tastes. The robo-adviser will ask you a brief set of questions that helps determine your ideal portfolio.
How much work are robo-advisers?
Though you’re usually thinking long-term when making investments, they occasionally require a little work to keep them stable. One kind of change that might make that input necessary is performance. Say stocks decline in value while bonds increase. To get your portfolio back into a harmonious place, you’d have to sell some of the bonds and buy a bit more stock.
Other factors that can change the asset allocation: the passage of time (as you move closer to retirement, your risk appetite might decline), new inflows (you get a bonus and want to add it to your portfolio), and interest payments (from your bonds) and dividends (from your stocks) that need to be re-invested.
Another perk of the robo-adviser: it can take all those stabilizing actions for you, often without you even having to log into your online account. Using the DIY method you’d have to buy and sell slivers of the ETFs yourself. A financial adviser on retainer will do this rebalancing as part of their annual fee.
Is it right for me?
Everyone’s primary concern with investing is making sure their money is safe. No one wants to invest money and lose it. Fortunately, robo-advisers are protected from some of the ways that people lose money.
One reason people sometimes lose the money they invested? fraud. It’s highly unlikely a robo-adviser would be fraudulent, as all the biggest ones are insured by the Securities Investment Protection Corporation (SIPC), a federally-mandated corporation overseen by the Security and Exchange Commission (SEC). SIPC acts as insurance should your robo-adviser run into issues or go bankrupt; in that event, the SIPC would return the ETFs that you held in your robo-adviser account back to you which you could then transfer into a new account. (The ETFs are regulated by the SEC like any other security, so you don’t really have to worry about them being fraudulent, either.)
For peace of mind, you should always confirm that your robo-adviser is a member of the SIPC. Furthermore, you now know that a robo-adviser is just buying a bunch of ETFs in your name. All are large ETFs managed by known providers (Vanguard, BlackRock’s iShares, and Schwab) and with low fees, and it’s unlikely that any of them would be fraudulent. In case you want to look under the hood, though, each company publicizes the ETFs their robo-advisers use (here are Betterment and Wealthfront‘s lists), so you can verify which ETFs you’ll own.
Another way to lose invested money is when the market goes down. If your asset allocation is appropriately fine-tuned, you should lose money commensurate with the amount of risk in your portfolio. But remember, modern portfolio theory is looking at what happened in the past to guess how the future could play out. If we learned during the global financial crisis, it’s that there’s no such thing as an infallible model.
Despite their many advantages, robo-advisers aren’t for everybody. If you’re skittish about investing and prefer peace of mind by having a specific person to answer your questions and provide updates, then you’ll probably want a human adviser. Interaction with a robo-adviser is going to be almost entirely via digital forms and questionnaires. And if you have a highly complex financial situation—we’re talking lots of trusts, private company options, and international taxation—you may opt for a more customized solution. Conversely, if you want to get into the details and are comfortable determining your own asset allocation, you can save the robo-adviser fees and just purchase the ETFs on your own.
But for most people, robo-advisers suit their investing needs just fine. The robo-adviser lets anyone with a modicum of savings tap into the power of investing. Plus, it levels the playing field with respect to the human financial adviser, at a fraction of the cost and with minuscule minimums. And just like the routine grocery store visit, the robo-adviser is effective, effortless and cheap. The only difference is that you don’t need to leave your house.