Everything You Need to Know About Using and Choosing a Robo-Advisor

Jan 18, 2017

Never heard of a "robo-advisor"? You're not alone. Fewer than half of investors recognize the term, according to a recent poll by Gallup and Wells Fargo. And only 5% of investors say they've used one. But robo-advisors—computer algorithms that invest your money for you—have evolved in a way that could make them a key player in your financial future. First-generation robos, which started to arrive a half-dozen years ago, are adding new features. Well-known names in financial services are launching new automated investment managers. And that gives you a wider selection of robo-advisors to choose from.

A big part of the promise of these digital systems is that they can manage your investments better than you could by yourself. They're the equivalent of a GPS navigation device for your finances: an electronic aid that can map out a better route than you could by fussing with a map and going it alone. And they're cheap: Traditional financial advisors generally charge in the range of 1% to 2% of clients' assets annually in exchange for managing their money, and typically require a minimum of $250,000 to invest. In contrast, the 14 largest robo-advisors charge an average fee of just 0.4% of assets, according to a recent survey by personal finance research site ValuePenguin. And a minimum investment of just one dollar is enough to open your account with some of them.

But robo-advisors also come with drawbacks and caveats. They're limited in the types of accounts they can manage for you, focusing mostly on IRAs and taxable accounts. They have a relatively brief track record, making it unknown how they will behave in a bear market. Your access to human help may be limited, and the advice you do get won't be as comprehensive as what you could get from a good financial advisor.

With major financial firms Fidelity, Merrill Lynch, and TD Ameritrade among the latest companies to either launch or announce a robo, these services are solidifying their presence in the investment landscape. Not sure whether a robo-advisor is right for you, or what type of robo might serve you best?

Here are five essential things to know about robos that will help you guide your decisions.

1. Robots Have Limited Powers

Before you have a robo-advisor manage your money, you need to understand what types of money these services can manage. If you're saving for retirement in a traditional IRA or a Roth IRA, or if you want to roll over money from a 401(k) or other defined-contribution retirement plan into an IRA, robo-advisors can handle that. And if you want to save in a taxable account for retirement or another goal—say, a down payment on a house—most robo-advisors can take care of that too.

But beyond IRAs and taxable accounts, your choices are more limited. Although Americans have a significant portion of their retirement savings in 401(k) and 403(b) accounts ($7 trillion, compared with $7.5 trillion for IRAs), none of the major robos currently manage money in those retirement accounts. A few, however, offer limited guidance. Personal Capital and Vanguard Personal Advisor Services, for example, will give you advice about how to manage investments in your 401(k)—suggesting an appropriate allocation, say—though neither will actually do the trading for you.

And should you want a robo to manage your children's college savings, your only choice currently is Wealthfront's 529 college savings account.

2. You Can Get Human Help ... at a Price

One advantage working with a robo-advisor has over working with a flesh-and-blood one is that, on average, you'll pay less. On an investment of $50,000 earning 7% annually, for example, that difference between the 0.4% average fee for a robo and a 1% fee paid to a human advisor amounts to a difference of $5,000 in your account over 10 years. That's a full 10% of your original investment—not exactly chump change.

But while you pay less for a robo, you also miss out on a key benefit you can get from a human: hand-holding. "Many human financial advisors will tell you that their main role is not a financial advisor, but a psychotherapist," says Christine Benz, Morningstar's director of personal finance. This can be important if you tend to panic when the market drops suddenly. But the human touch can also help at noncrisis times too. An experienced advisor, for example, can suss out your financial goals and challenges in a way that a robot cannot, and tailor a financial plan to match. A traditional advisor can also advise you in areas such as life insurance, estate planning, and budgeting. A robo-advisor might have plenty of good financial advice on its website, but its primary job is to help you with your investments.

That said, robo-advisors are increasingly trying to be the equivalent of a supportive Facebook friend. They'll message you to let you know that your deposits have cleared or that your portfolio is being rebalanced. They'll also keep you posted about market news, such as when Betterment messaged its customers the morning after the presidential election, advising them to stay the course.

And robos are increasingly offering a measure of actual human contact. The more money you have in your account, the more personal and personalized the connection. Robos with low costs and low minimum investments, including Wealthfront, WiseBanyan, and E*Trade Adaptive Portfolio, will route your questions to one of their financial professionals, who most likely have a securities license and perhaps a certified financial planner designation. Available for free as part of your basic service, they can answer questions on subjects like investment risk and asset allocation. They can give you general advice on subjects such as saving for retirement or starting a college fund. And they can try to calm you down if the market goes nuts.

If you want a higher level of service or a more personal touch, you'll have to put more money on the table. Got $25,000? Schwab plans to introduce this year its Intelligent Advisory service, designed to give you access to a team of certified financial planners, available for regular check-ins, who can provide a personalized financial plan. Already, a balance of $100,000 at Betterment or at Rebalance IRA will get you a single, dedicated financial advisor, while the same amount at Personal Capital will get you a two-advisor team. Vanguard's robo-advisor (which has a $50,000 minimum) brings you aboard with a one-on-one talk with a financial advisor who assesses your situation and helps craft a financial plan. Afterward, however, you're served by a 100-advisor tag team, unless your balance hits $500,000. Then a single professional handles your account.

3. Each Robot Has a Personal Style

While different robo-advisors have similar processes for getting you started, the choices they make for you are more distinctive.

With most robos, you begin by filling out a brief online questionnaire designed to assess your personal situation and your risk tolerance—a streamlined version of the experience you would have with a human advisor. Based on your answers, a robo will recommend a portfolio, usually a basket of low-cost exchange-traded funds.

Once you deposit money in the account, the robo-advisor goes from advice to actual management. It will buy securities corresponding to its recommended portfolio. On a regular basis, it will rebalance your portfolio, buying or selling ETFs (or other components of your portfolio) so that as certain holdings rise or fall in value, your investments track your ideal mix of assets. Any new money you add will be allocated in the same way.

The number of available portfolio options varies widely. TD Ameritrade, for example, has five portfolios, while WiseBanyan says it has more than 90 variations. And the blend that different robos might advise for the same person won't always match up. The situation is similar to that of target-date retirement funds designed by different mutual fund companies; a fund intended for people retiring in a particular year may have different allocations to stocks and bonds depending on whether your account is with, say, Vanguard or T. Rowe Price.

Consider the allocations devised by 11 different robo-advisors for a hypothetical 40-year-old man with a moderate tolerance for risk, intending to retire at age 67 and rolling over a $100,000 401(k) into an IRA. Suggested portfolios range from a conservative 60% stock allocation from E*Trade Adaptive Portfolio to aggressive 90% stock portfolios from Betterment and Vanguard.

And while most investment portfolios are composed of ETFs, there are some outliers. Vanguard, for example, may employ actively managed funds in client portfolios, and Personal Capital uses individual stocks in the place of just stock ETFs or mutual funds. (For more information about portfolio design, cost, and other features of different robo-advisors, see the following table.)

Note: Annual cost includes advisory fees and average investment expenses. Sample portfolio is for 40-year-old male rolling over a $100,000 401(k), with moderate risk tolerance and expected retirement age of 67. Sources: Individual companies, MONEY reporting

What does this mean for the investment returns you might get from different robos? Unfortunately, performance data is scarce, in part because so many of the robos are relatively new, and because assessing their differences would require studying multiple portfolios from each robo. One attempt to compare robos' performance comes from financial advisory firm Condor Capital, which opened taxable accounts in late 2015 with nine different robo-advisors, adjusting user profiles so it would be assigned portfolios with a 60% stock allocation. Condor reports that the advisors delivered average returns, after fees, of almost 8% through September 2016. (Top performer Schwab Intelligent Portfolios earned 10.2%, thanks largely to holdings in gold, which happened to surge in the first half of the year; last-place Vanguard, earning 5.7%, had less holdings in emerging-market securities, another outperformer in that limited period.) By comparison, the Vanguard Balanced Index Fund (VBINX), which itself has roughly a 60%/40% split, delivered 7.4%, and the S&P 500 index delivered a total return of 7.8%. Although you can't conclude anything about long-term performance from only nine months of data, you can take heart that the results weren't alarming.

But the very customized nature of a robo-advisor limits the value of the 60%/40% comparison. "Your performance is, in many cases, going to be unique to you," says Tom O'Shea, associate director of financial research firm Cerulli Associates.

So how do you know which investment approach is best for you? Take a look at the asset allocations in the chart above to get a sense of how relatively aggressive or conservative the different robos are. At many of the robos, you don't have to send in money to see what portfolio you would be placed in; you just fill out the forms and get instant feedback via a suggested mix. So you can sign up with different ones, test-drive the initial experience, and get a feeling as to which robo "understands" your situation best from the questions you answer.

4. Robots Haven't Yet Been Stress-Tested

It's easy to be satisfied with an investment advisor, whether human or robotic, in a bull market such as the one that has tripled the S&P 500's value since March 2009. So it's no surprise that three-quarters of current robo-advisor customers polled by the investing website Investopedia said they were either satisfied or very satisfied with the performance of their automated investments.

But none of these robos have been tested in a major market downturn such as the financial crisis of a decade ago. The oldest of the robos, Betterment, didn't launch until 2010.

How will they behave in a similar crisis, or even just a garden-variety bear market? Possibly more calmly than you. "The machine is a purely rational investor. It's the Spock of investing," O'Shea says. When stocks plummeted following the surprising outcome of the U.K.'s Brexit vote last June, Betterment's computers suspended all trading for its portfolios for 2½ hours as the results became apparent. Some individual investors and financial advisors who use Betterment questioned the decision at the time, as well as the company's lack of communication. In hindsight, though, hitting the pause button was a good call, says O'Shea.

You can also take comfort in knowing that robos most likely wouldn't do worse than human financial advisors. "At the end of the day, the algorithms in the robo-advisors do what finance theory tells you to do," says Gauthier Vincent, head of Deloitte's U.S. wealth management consulting practice. "The human advisors are trained the same way. Whether they do it for you or the machine does it for you, it's all based on the same theory. But the machine can apply the theory faster and more consistently."

5. A Robo Might Not Be Your Only Good Choice

At each stage of your life, you have a range of options for managing your money. You could work with a robo-advisor. Or it might make sense to invest your money by other means.

Here are some suggestions for how to proceed based on your situation.

If You're Just Starting Out ...

Are you a young adult with sparse savings? In that case, if you go robo, choosing one with a low investment minimum is essential. And because your financial situation most likely isn't too complex, you don't need to pay up for services you don't need, like a holistic financial plan. "In general millennials and new investors don't have a lot of money, so they're fine with a basic robo," says Barbara Friedberg, owner of financial technology review site Robo-Advisor Pros. One good choice, for example, might be WiseBanyan, which has a $1 investment minimum and an average cost of 0.12% annually, making it the lowest-cost robo among the two dozen surveyed by MONEY. One reason the price is so low is that WiseBanyan doesn't charge an advisory fee. You pay for just the underlying expense ratios—the annual fees that all mutual funds and ETFs charge to cover costs like management and operations. Instead, WiseBanyan charges for opt-in services like a tax-minimization strategy that probably isn't needed by a young worker in a low tax bracket. What you don't get is a wide selection of accounts; for example, you can't open a joint taxable account.

Another good option is Betterment. It has numerous tools and financial education resources, such as a calculator that shows you how to divvy up your savings between Roth and traditional IRAs. Yes, you can find similar tools on other websites, but Betterment makes them easy to use by housing them in one place and drawing in financial information from non-Betterment accounts so you don't have to input data manually. The robo also makes it easy to save for multiple goals simultaneously—everything from having a safety net to short-term savings accounts for things like next year's beach vacation.

One inexpensive alternative, if you're just saving for retirement, is a target-date fund, which holds stocks and bonds and shifts to become more conservative as you approach retirement. Target-date funds make investing simple, and they'll probably cost you less than a robo. Vanguard's funds, for example, have an average expense ratio of 0.13%. But target-date funds aren't designed for shorter-term goals like funding a down payment for a house or saving money for college.

If You're More Established ...

Staring down a major life decision like starting a family or opening your own business? Look for a robo-advisor, such as Personal Capital, that can make personalized recommendations based on your life situation and all your assets, ranging from your 401(k) to your house.

Or maybe just create your own. If you don't want to (or can't) jump into a robo with an investment on the scale of Personal Capital's $25,000 minimum, you can create your own hybrid advisor. For example, if you just need advice on one-off questions—like how to set up an ABLE savings account for a child who's disabled—you can invest in a more automated robo like Betterment, Wealthfront, or bigger players like Schwab. Then, once you have set up your account, seek out a financial planner who works by the hour to get your toughest questions answered in person. "That solves a lot of robo-related problems," Friedberg says. It's relatively easy to find these planners through directories operated by the Garrett Planning Network or the XY Planning Network.

Another approach is to search the Financial Planning Association's directory, filtering results by choosing "Fee only" from the "Compensation" drop-down menu.

If you're worried about entrusting all your money to a relatively untried automated advisor, invest a small amount of your portfolio and see if you're happy with the experience before going further. "We're seeing a large portion of the American investing population take a portion of their portfolio—not their entire portfolio," says Kendra Thompson, global managing director of Accenture's wealth management unit.

If You're Approaching Retirement ...

Are you less than 10 years away from retirement? It's more than likely you'll have complex questions that require in-depth conversations and planning strategies. At this age, if something goes wrong with your investments or another part of your financial plan, you have precious little time to recover. "The stakes at this point are so high—if you screw up your retirement, you could be devastated in your elder years," O'Shea says.

You need a higher level of personalized service—one requiring an investment minimum that you most likely can meet after decades in the workforce. In these cases, the upper tiers of service from Vanguard, Personal Capital, and Rebalance IRA, which provide more one-on-one contact, make the most sense. But you might instead seek out a traditional financial advisor.

If You're Already Retired ...

Despite all their advancements, robo-advisors aren't quite ready to handle your retirement, say experts. That's because retirement finances entail not only sound investment management but also the development of a smart strategy to draw down money from a portfolio in a way that will provide a lifetime of financial support. "Retirement brings the consumer to the edge of where the machines, at least presently, aren't able to help them," says O'Shea.

That might very well change within a few years, given the parade of new robos and other financial technology tools hitting the market. Says Thompson, "You're seeing the beginning, not the end, of these services."

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