The last few decades have been very good for individual investors.
Vanguard introduced the first publicly available index fund in 1976, and since then index mutual funds and ETFs have exploded in availability. Given what we know about investing – namely that minimizing fees and using index funds both increase your odds of success – these developments have made it easier than ever for regular people to access high-quality investments.
Of course, there’s still the issue of choosing which mutual funds and ETFs you want to use, constructing a portfolio, and managing it across multiple investment accounts. If you’re not an investment professional, or at least someone who enjoys reading and learning about investing, all of those decisions can feel overwhelming, especially now that there are so many index funds and ETFs to choose from.
That’s the problem that robo advisors like Betterment and Wealthfront are trying to solve. Their mission is to take the hard work off your plate by creating and managing the investment portfolio themselves, allowing you to focus solely on contributing money and getting on with your life.
And in many cases they do a great job. But they have some weaknesses as well, and many of them promise more than they can actually deliver.
In this post you’ll learn what robo advisors provide, how they work, when they can benefit you, and what the downsides are.
What Are Robo Advisors?
Robo advisors are automated investment platforms that handle the construction and maintenance of an investment portfolio for you. You open an investment account, answer some questions about your goals and risk tolerance, and the platform invests your money in a pre-constructed portfolio (typically a collection of low-cost ETFs).
The concept is similar to the idea behind target-date retirement funds and other all-in-one funds. In both cases, the goal is to provide you one-stop-shopping for your entire investment portfolio.
The biggest difference is that robo advisors typically offer a little more guidance and a slicker user interface. Rather than requiring you to evaluate all of the target date retirement funds available to you and pick the one that meets your needs, you can sign up with a robo advisor, answer some questions, and have your choice made for you.
Of course, this service also means that they cost a little more, at least when comparing them to low-cost target date funds like the ones offered by Vanguard. We’ll get into that more below.
It’s also important to understand that the “robo” part of robo advisor simply means that they’re taking advantage of technology to provide the ongoing portfolio maintenance. There are still humans in charge of choosing the underlying funds, constructing the portfolios, and programming all the decisions made during that ongoing maintenance. You’re not actually hiring a cyborg advisor (though that would be cool!).
So with that context, let’s dive into some of the pros and cons of using a robo advisor.
The Benefits of Using Robo Advisors
1. High-Quality, Low-Cost Portfolios
At this point the research on investing is clear: A portfolio made up of low-cost index funds gives you an 80% to 90% chance of outperforming anything else.
And the great thing about robo advisors – at least for now, before Wall Street mucks them up – is that they take this to heart. Just about every robo advisor I’ve seen constructs their portfolios using low-cost, index-based ETFs.
So when you use one of these platforms, you’re getting an investment portfolio that adheres to the best research we have on how to invest well. That doesn’t guarantee anything, but it’s certainly a good start.
2. Ease of Use
The other big benefit of robo advisors is that they make things easy. It’s usually very simple to open an account, set up ongoing contributions, answer some questions about your goals and risk tolerance, and be placed in a portfolio that matches your personal investment profile.
All of which means you can focus on the things that really matter, like making contributions and living your life. I’m all for anything that makes investing easier.
3. Tax Efficiency
If you’re investing within a taxable account, many robo advisors offer services that can increase your after-tax returns.
For example, most of them offer some form of automated tax-loss harvesting, which essentially takes advantage of temporary market losses to offset gains that would otherwise be taxed. The benefits of this strategy are often overstated, but there is still usually a benefit.
Betterment has also started to offer automated asset location, which, when done correctly, can absolutely enhance your after-tax returns.
These features won’t help if your investments are held within 401(k)s, IRAs, and other retirement accounts, but they may be helpful when using a taxable account. And they aren’t something that target-date funds or other all-in-one funds can offer.
The Downsides of Using Robo Advisors
1. They’re Not Financial Planners
One of the things that bugs me about certain robo advisors is that they market themselves as a replacement for financial planners.
It is true that in terms of portfolio construction, most of these robo advisors are just as good as the best financial planners, and honestly better than most simply because of their lower cost. Portfolio construction alone is a commodity, and there’s really no need to pay big bucks for it.
But a good financial planner does much more than that. A good financial planner gets to know you personally and helps you create and implement a plan that uses all of the financial tools and opportunities available to you to reach your specific personal goals.
Robo advisors are not financial planners. Maybe the technology will get there someday, but for now they are simply a tool that helps you implement and manage your investment portfolio.
2. They Cost More Than Other All-In-One Funds
Robo advisors are typically pretty cheap, but they do still cost more than the lowest-cost all-in-one funds available.
For example, Vanguard’s target-date retirement funds currently cost between 0.13% and 0.16% per year, and their LifeStrategy funds cost 0.12% to 0.15% per year.
Betterment, on the other hand, charges 0.25% for its baseline management fee, the cost of the underlying investments, which for most portfolios will be around 0.10%. That’s a total cost of around 0.35% per year.
There’s not a huge difference between the two, and even with the management fee Betterment is still much less expensive than most other investment options out there. Still, it’s worth knowing that there are cheaper ways to get an all-in-one portfolio.
3. They Don’t Guarantee Performance
This is true of any investment, so it’s not specifically a knock on robo advisors. But some of the marketing may make it feel like they’re guaranteeing a certain return, and that’s just not the case.
Robo advisors expose you to just as much risk as any investment. Sometimes your returns will be great. Sometimes you’ll lose money. That’s just the way it is.
Should You Use a Robo Advisor?
On the whole, I think that robo advisors are a fantastic option. They offer high-quality, evidence-based investment portfolios at a low cost, making it easy for you to invest well no matter where you’re starting from.
Compared to other low-cost all-in-one funds like the ones offered by Vanguard, they come at a slightly higher cost. If you’re able to find an all-in-one fund that matches your personal asset allocation, you may be able to save yourself some money going that route.
And it’s important to recognize that they are simply investment management tools, not comprehensive financial planners. They don’t ensure your success and they don’t help you navigate the complexity of your entire financial situation.
But if you’re purely looking for a simple way to implement a high-quality investment portfolio, robo advisors are a good choice.
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Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.