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It’s About the Algorithms: Is a Robo-Advisor Right for You?

Like most financial advisors, robo-advisors recommend portfolios based on investors’ long-term financial goals, time horizon, and risk tolerance. Because robo-advisors generally use algorithms to make investment decisions, they avoid emotions and generally charge lower fees.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Friendly robot: Robo-advisors, managed portfolios, long-term investing
5 min read
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Key Takeaways

  • One benefit of using robo-advisors is lower fees
  • Robo-advisors include human involvement from professional managers
  • Investors who want a digital experience as well as a human financial consultant can consider hybrid robo-advisors

Technology generates an abundance of choice in pretty much everything, including investing. Robo-advisors—automated, digital portfolio services that provide managed model portfolios—have grown rapidly over the past decade. Should you use a robo-advisor? First, make sure you understand how robo-advisors work.

There are more than 200 robo-advisors available in the United States, including Essential Portfolios offered by TD Ameritrade Investment Management, LLC. Robo-advisors currently have about $631 billion under management, according to the Backend Benchmarking Robo Report for the second quarter of 2020.

What is a robo-advisor, and what are the potential benefits of robo-advisors? Let’s take a look.

Robo-Advisor Basics: Algorithms, Rules, & Regs

Robo-advisors use sophisticated algorithms to recommend managed model portfolios to investors based on their financial goals. To set up a robo-advisor account, an investor first completes an online questionnaire about their longer-term financial goals, time horizon, risk tolerance, and other factors.

The robo-advisor will then recommend a model portfolio that aligns with those goals. Once the account is set up and the client deposits funds to be invested, the robo-advisor monitors the portfolio over time and, typically, regularly rebalances the portfolio to help investors stay on track with their goals. (Rebalancing means buying or selling positions to ensure certain asset categories, such as stocks, don’t comprise too much or too little of a portfolio. Rebalancing and diversification are important investment principles, regardless of which type of investing service you use.)

Don’t let the word “robo” lead you to believe there’s no human involvement. Investment portfolios are managed by professionals, and there’s human support available too. Robo-advisors, like any investment professional, are required to follow securities industry rules and regulations. A robo service must be a registered investment advisor with the U.S. Securities and Exchange Commission. 

Robo-Advisor Fees: Cheaper by the Dozen

Many robo-advisors charge lower fees than traditional investment advisory services and may also require lower account minimum balances or initial investments.

Weighted average expense ratios, which are one way to gauge fees, ranged from 0.07% to 0.19% for several robo-advisors during the second quarter of 2020, according to Backend Benchmarking. Annual advisory fees ranged from 0.25% to 0.9% of an account’s total balance. (Some robo-advisors assess fees based on the size of an account; the more money in an account, the lower the annual fee.)

For consideration, many traditional financial advisors charge annual fees of 1% to 2% of an account’s balance.

Robo-Advisor Performance: Second-Quarter Snapback

Robo-advisor performance in 2020 has mirrored the overall U.S. equity market, as the coronavirus pandemic sent prices tumbling in the first quarter, followed by a broad, sharp rebound in the second quarter.

During the second quarter, the average robo-advisor portfolio returned nearly 20% on equity holdings and 4.15% on fixed-income holdings, according to Backend Benchmarking. For the first half of 2020, the average robo-advisor equity return was -7.9%, although fixed-income returns fared better at 3.6%.

Over the past four years, robo-advisor equity funds posted an average annual return of 7.7%, while fixed-income returns averaged 3.4%, according to Backend Benchmarking.

Robo-Advisors and Volatility: Emotional Rescue During Turbulent Times

Robo-advisors can offer a steady hand or ally during volatile markets, such as those we experienced in early 2020. As the term indicates, a robo-advisor helps to remove investor emotions from the equation and can help investors maintain a disciplined approach to their investments.

Also, the human market professionals “behind the curtain” of a robo-advisor service can help with rebalancing decisions, which can save investors time.

Although robo-advisors offer potential benefits, especially during whipsawing markets, they aren’t for everyone. A robo-advisor can’t provide the same level of portfolio customization as a human financial advisor, who can get to know you and your financial goals on a personal level and provide more specific guidance that only human intuition and reason can produce. (As with any investment service, past performance is no guarantee of future results.)

For investors who aren’t comfortable engaging purely on digital advice, there’s another category in the robo-advisor spectrum: hybrid robos, which supplement the digital experience with a human financial consultant. TD Ameritrade Investment Management’s Selective Portfolios falls under this hybrid robo category.

“Before making a decision about whether to invest through a robo-advisor, or in deciding which robo-advisor might be best for you … do your own research,” according to the SEC website. “Make sure the robo-advisor and the investment portfolio it puts together for you are a good match for your investment needs and goals, and that you understand the potential costs, risks, and benefits.” 

Robo-Advisors: The Bottom Line

If you’re concerned about market volatility, a robo-advisor may be worth considering. Robo-advisors apply the experience of professional portfolio managers and can help investors avoid some of the emotional pitfalls that can arise in turbulent trading times.

Carefully weigh the pros and cons of robo-advising as you determine the appropriate choice to help you pursue your financial goals, including the fact that human financial advisors might add a more personal touch to financial guidance.

For a combination of online investing and human support, investors might consider a hybrid model, such as Selective Portfolios, which offers a broader range of portfolios than the fully automated Essential Portfolios. Here’s more about Essential Portfolios.

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Key Takeaways

  • One benefit of using robo-advisors is lower fees
  • Robo-advisors include human involvement from professional managers
  • Investors who want a digital experience as well as a human financial consultant can consider hybrid robo-advisors

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