Financial Advisors were historically the go-to method for professional investing. But due to shifting demographics and underperformance, individuals have started to shift to Robo advisors.
What Is A Robo Advisor and How Do They Work?
Robo Advisory services can vary from company to company, but generally speaking, it is an online service that selects low– cost exchange-traded funds (ETFs) to invest in based on a survey you complete.
Most robo-advisors do not select individual stocks but a portfolio of low-cost ETFs.
A relatively unknown service 10 years ago, there are now nearly 100 companies that offer Robo-advisory services.
According to Charles Schwab, assets managed by Robo-advisors are expected to rise to $460 billion, up from $47 billion in 2015, with the average assets under management hovering around $100,000.
Robo-advisory services weigh your personal preferences against unpredictable market forces to create your customized portfolio.
Personal Preferences
- Time Horizon
- Financial Goals
- Risk Tolerance
Market Forces
- Asset Class Performance
- Market Conditions
- Market Volatility
How Do They Work?
Robo advisors vary from company to company but generally operate in a similar format.
Step 1. Complete a questionnaire that assesses your risk tolerance and investing goals.
Step 2. Based on the responses in your questionnaire, the Robo-advisor builds a portfolio of low-cost funds.
Step 3. Experts regularly monitor market activity and underlying investments to ensure your portfolio is rebalanced appropriately by a sophisticated algorithm—all so you don’t have to.
What are Financial Advisors, and What Do They Do?
A financial advisor is a licensed investment professional providing investment, tax, and estate planning advice.
Before the proliferation of the internet and trading data readily available to everyday investors, individuals relied on financial advisors to manage their investment portfolios.
Note: Do you think you could execute a trade on the phone or find up-to-date market research quickly and easily in 2005?
Most financial advisors work as part of a larger company, like the advisors at Personal Capital, but may also work independently. Traditional advisors usually charge clients a flat fee based on assets under management (AUM).
There are approximately 330,000 financial advisors in the United States.
Robo-Advisors vs. Financial Advisors: Head-to-Head Comparison
Below we look at some of the key features between Robo advisors and Financial advisors and see how they stack up against each other…
Fees
Winner: Robo Advisor
Robo advisors charge very low fees, between 0.05% and 0.25% of AUM, which is one of the main reasons individuals turn to them to provide investment advice.
Meanwhile, financial advisors usually charge 1% – 2% of assets under management (AUM), making them considerably more expensive than robo-advisors.
Some financial advisors are commission-based; they charge clients when they purchase an investment product recommended by a financial advisor.
Robo-advisors are cheaper than financial advisors because robo-advisors are an algorithm, while financial advisors are licensed investment professionals seeking to earn a livable income.
If your investment advisor manages $100,000 and charges you a 1% investment management fee, they would charge you $1,000 yearly.
The low cost of robo advisors is one of the main reasons investors choose them as their primary investing service.
Technology
Winner: Robo Advisors
Another reason robo advisors are so popular is their technology and automated services. Most robo advisors operate with a “digital first” mantra.
Robo advisors can flawlessly execute purchases and sales of stocks without error. Plus, the algorithm can seamlessly perform portfolio rebalancing and tax loss harvesting.
In addition to portfolio management, robo advisors can make administrative work such as opening accounts, account transfers and rollover, paperwork, and withdrawals much less burdensome.
A human financial advisor is undoubtedly an “old school” way to receive investment advice, requiring manual intervention during the entire investment process, entirely subject to human error.
Holistic Financial Advice
Winner: Financial Advisors
Financial advisors offer a full spectrum of financial services, from investment and tax advice to estate planning. Meanwhile, robo advisors only give you advice based on a questionnaire you completed.
Robo advisors cannot consider nuanced and evolving financial considerations, making a dedicated financial advisor better for holistic financial advice.
Robo Advisor vs. Financial Advisor: PROs and CONs
PROs of Robo-Advisors
Automation
Low costs aside, robo-advisors offer many valuable benefits. The stress of finding and meeting with a financial advisor is one reason many people avoid seeking professional financial advice.
You tell yourself that you will do it this weekend, but in reality, you push it off for months at a time.
Robo Advisors simplify the financial planning process by turning the process into an easy-to-manage experience that takes less than an hour to set up.
For example, many robo advisors automated tax-loss harvesting. Tax loss harvesting is a technique that lets you immediately buy or re-purchase a stock or asset to maintain the structure of a portfolio as long as the value decreases.
Robots Don’t Cry
As mentioned above, robots aren’t afraid of mistakes and do not have feelings. Emotional realism is often the most significant reason we don’t make the best investment decisions.
The people who trust their guts are not interested in facts and are more likely to make risky investing decisions.
Investors who followed the crowd regret it. According to BlackRock, periods that followed investors cashing out of the market have provided above-average returns. In contrast, periods that followed investors adding to the market have provided above-average returns.
Low-Fee Funds Only, Please
Robo-advisors have low fees, which is very appealing. Fees for robo advisors are usually less than 0.50%, compared to fees between 1 – 2% of AUM for traditional advisors.
Flawless Execution
Robots are capable of optimizing thousands of portfolios, flawlessly. They don’t feel a mental crash at 1:00 pm and won’t even dream about catching the next episode of Billions.
They do what they need to do.
Algorithms rebalance portfolios in response to market changes.
Robo advisors will Always have your best interests in mind
Because algorithms are not sentient(yet), they will continuously operate with your best interests in mind.
Through a robo-advisor, you don’t have to worry about an algorithm pushing you towards a particular product to earn a higher commission or investing in a fund based on speculation.
And while there are laws like Regulation BI to prevent traditional advisors from behaving unscrupulously, it’s not guaranteed.
A few years ago, TIAA-Cref agreed to pay $97 million to settle claims from 20,000 customers that they used misleading sales tactics.
This isn’t to say that all traditional investment advisory services have nefarious intentions, but to serve as a cautionary investing tale.
PROS of Financial Advisors
Holistic Financial Planning
Algorithmic systems can’t provide holistic financial advice as humans can. A Robo advisor assesses your needs by analyzing a short survey you completed.
Many people have nuanced and complex investment needs.
Robo advisors can’t discuss your estate plans or show you your budget mistakes like a human financial advisor can.
Also, robo advisors can’t talk to you in-depth about how to prioritize a long-term investing goal.
Human Interaction and Emotional Management
Sometimes humans need a little reassurance or, more importantly, need a personal relationship with a financial adviser.
You can always call your advisor if you are unsure about an investing strategy or stock. You can feel assured a qualified financial expert can answer your questions.
When stocks fall and send their portfolios plunging, panic can quickly ensue. If you call your broker and tell them you want to get our of a certain investment, they will give you the advice you need to calm down.
Complete Personalization and Flexibility
When you hire a human advisor, they advise you but ultimately do what you want. Your financial advisor can assist if you want to invest $25,000 in a Zimbabwe-based diamond-producing company.
Plus, they will examine your property, assets, or any other assets you make available to them.
CONS of Financial Advisors
Human Fallibility
Like a human, financial advisors are subject to emotions. If you threaten to move your money or are unhappy with your returns, your advisor may execute transactions in hopes of beating the market and making you a happy client.
However…
Recent research found that only 23% of the actively managed funds had better performance than passive managed.
It’s tough to pick winning stocks. Other intelligent people often try to beat the market to make themselves appear bright.
High Costs
Financial advisors are often more expensive than robo-advisors.
Human financial advisors generally charge a flat fee between 1% – 2% of assets under management, while robo advisors usually charge less than 0.50% in annual fees.
So if a traditional financial advisor manages $100,000 of your assets, you can expect to pay between $1,000 and $2,000 in management fees.
Availability for the Average Person
It requires time and effort to manage an individual investment portfolio.
Because human advisors usually charge a percentage of assets under management, their time and effort are limited to managing the most important high-net-worth clients.
Many traditional financial advisors require a minimum portfolio of $50,000, and some advisors require a portfolio of at least $1,000,000 before taking on a new client.
Meanwhile, a robo advisor like M1 Finance has a minimum investment of just $500.
Unless you have a decent nest egg already set aside, most traditional financial advisors may not even be an option.
Who Should Use Robo Advisors?
- Novice investors who do not have in-depth market knowledge
- Individuals who do not have a large amount of cash to invest
- Experienced investors who want to automate complex activities like portfolio rebalancing and tax loss harvesting
- Investors who do not have complicated personal finances
Who Should Use Financial Advisors?
- Investors who want a personalized investment experience
- Investors who want the comfort of talking to a human instead of an algorithm
- Investors who have nuanced personal circumstances that a computer cannot address.
The Bottom Line
Both robo advisors and financial advisors have their place in the investing world.
As Millennials and Gen Z become the majority of the workforce, their preferences are shifting towards a more mobile and digital-friendly investing service with lower costs.
However, as you become older and your finances are more complicated, there is still a need for financial advice that cannot be handled by a computer.
That said, Robo advisors are a better option for younger investors who do not have complicated finances and could benefit from lower fees and the power of compounding.
Meanwhile, using a financial advisor is better suited for individuals who have families or generally are more advanced in their investing experience.
