For many people, the idea of investing may feel unattainable because they lack important knowledge about the world of finance. Others might feel unable to take their finances to the next level because they do not have a financial advisor, or they want to be in charge of their money directly. Fortunately, these issues may be solved with the introduction of new finance management and investment technology, known as robo-advisors.
Robo-advisor programs can build your portfolio for you, investing and trading according to your preferences without the need of an actual middleman. Many investors now recommend them as simple, easy, and affordable investment strategies. However, there are some drawbacks to this type of investing as well. While using software like this can add convenience, it does not allow for the insight and personal advice provided by a real financial advisor. With this in mind, it is best to consider the advantages and disadvantages of this type of investing before deciding whether it might be right for you.
What is a robo-advisor?
A robo-advisor is a software generally based on a website or app that invests your money using modern portfolio management theory. Modern portfolio theory is intended to optimize your returns according to the risk of the investments made, while controlling the risk as much as possible. As such, with this software users can create a profile and adjust all of the preferences for their investments. These preferences can include the following:
- Investment sectors
- Investment themes or motifs
- Account types
- Fee limits
- Time frames for investments
- End goals
The robo-advisor uses these preferences when choosing where to invest, when to make trades, and other management decisions. The algorithms in the program, while automated, are based on Nobel Prize-winning investment theories developed by human researchers. These theories have been turned into codes, ideally lessening the chance of human error. However, it is important to remember that the codes themselves were written by humans, and may still experience issues.
Costs
Robo-advisors are often one of the most affordable ways to invest. They generally have low fees, as well as low minimum amounts for your initial investment and balance. If you only have a few hundred dollars to invest, you may find a robo-advisor is the best way to start.
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Fees for robo-advisor services are around .25 percent of your investment. Additional investment fees, such as those required to invest in mutual funds are paid for out of your returns. Real financial advisors typically charge at least one percent, and often more, for their services.
However, these fees are not universal. Some robo-advisors are more expensive than others. You may also be able to find a personal financial advisor with lower fees than you may expect. It is important to consider the returns that will be made on your investments as well. If you find more success through a financial advisor, the additional fees could be worth it.
Taxes
Transferring existing investments to a robo-advisor can result in an inflated tax bill if you have experienced a gain on your account. However, retirement accounts with deferred taxes, when invested through a robo-advisor, do not experience this same issue. There only require taxes to be paid on withdrawal, just like they would with other investment strategies.
Tax-loss harvesting, a strategy frequently advertised by personal financial advisors, is one of the services many robo-advisors now offer at a lower price. The choices used to make the trades are automated, relying on the algorithm to recognize which stocks should be sold and when for tax optimization.
Limitations
When using a robo-advisor, one of the greatest disadvantages is a lack of flexibility. The software performs its various tasks based on the numbers in your fund and on the market, so the impact of your preference settings may be limited. For some, the personal understanding that a real financial advisor can bring may be needed.
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You might experience a change in circumstances, for example, that requires you to alter the way in which you spend your money. Other personal needs, such as investing one type of account in a different way to another, are also best handled by a financial advisor.
Robo-advisors use the goals you set as a way to plan the investments they make. The decisions they make are based on broad categorizations, rather than small, personal choices. If your goals or preferences change, the robo-advisor may not be able to adapt.
Uncertainty
Robo-advisors are a new service that has only been in use for a few years. Despite the success some have seen, robo-advisors have not been tried and tested over generations in the same way financial advisors have. The software used to run the robo-advisors shows success in the current economic climate. However, it is difficult to predict whether the programs would show as much success should the economy change dramatically.
Personal Touch
For many users, the lack of human involvement in their investments is a bonus when it comes to considering the benefits of robo-advisors. Many investment losses are the result of emotional reactions, and these risks are mostly eliminated when using a computer program.
The fact that you do not need to attend meetings or log into your account to make trades is also an advantage to those who do not have the time to manage their portfolios personally. If you become anxious when dealing directly with your finances, you may find having a robo-advisor to be a better experience.
Many investors, however, may feel more trust for a personal financial advisor. Meetings, while time consuming and potentially stressful, can also be reassuring for those who want to know where their money is and exactly what it is doing. If you experience financial loss through your investments, it might also be more comforting to have the immediate advice and support of an experienced professional.
Some platforms are now combining the use of automated and personal advisors for the best possible user experience. If you are tempted by the easy access and low fees of a robo-advisor, but want the reassurance of a person to whom you can speak when you need advice, you might be able to find both by seeking out a combination service.
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