Investing is one of those concepts that can sometimes sound like it’s a foreign language. Whether it’s “passive v. active”, “stocks v. bonds”, “mutual funds v. ETFs”, it can get very easy to get caught up in the minutiae of it all.
The truth of the matter is that investing can be as simple or as complex as you want it to be. For example, saving for retirement can be as simple as choosing a Target Date Fund (a diversified portfolio that gradually becomes more and more conservative as retirement approaches) or as complex as hand picking stocks and bonds for your portfolio. The first approach is completely fine if you have one goal in mind and know exactly when that goal is going to occur. If you’re in your 20’s and know exactly when you’re going to retire and how much you’ll need in retirement, the first approach will suit you just fine. However, for the rest of us, it might be helpful to get a second opinion.
There’s always professional wealth managers we can hire who can customize a portfolio for you, but those can sometimes require minimums of at least $200,000, $500,000 or even $1,000,000+, not exactly pocket change for those of us in the early stages of our careers. Or you can schedule a meeting with a financial planner and get a one time second opinion on how your portfolio is organized/structured. Often times, these traditional wealth managers can charge a fee of 1% to 3% to manage your money, not exactly chump change in the long run. However, for those of us who are comfortable with an impersonal relationship with the person/team managing our money, a robo-advisor could be the answer.
What is Robo Advising?
Robo-Advisors are a growing class of financial advisors that provide financial advice and/or portfolio management online with very minimal human intervention. To understand how they work, it’s important to quickly understand a few simple investing terminologies:
Passive Investing: Passive Investing assumes that it is practically impossible to beat the market in the long run. Rather than trying to earn a relatively impressive additional return (“Alpha”) over the market, the passive investor merely accepts the market return and seeks to minimize costs/fees that can be a drag on performance. Passive investors typically invest in a portfolio of market index funds such as the S&P 500, Russell 2000, NASDAQ, etc. that have fees between 0.03%-0.25%.
Active Investing: Active investing is the belief that by analyzing either the economy, market or even individual companies, there are securities that are undervalued and can be purchased and perform better than the market on a whole. This is no easy task and is certainly not cheap. Typical active management funds charge anywhere between 1% to 2% or even more, which can sometimes offset the additional return that active managers provide over the overall market.
Robo-Advisors typically create a diversified portfolio of passive funds to minimize cost. They use complicated algorithms that takes into account your risk profile, goals, and individual preferences to design a portfolio of passive funds that suits your unique needs. The goal is to have as little human intervention as possible to minimize fees. The result is a customized portfolio that automatically adjusts based on changes to your specific needs and the overall market with a minimum of a little as $500.
Why was Robo-Advising introduced?
For many Millennials who grew up during the Global Financial Crisis of 2008, investing is simply not something that many are eager to jump into, for very understandable reasons. Many Millennials watched as many of their friends family members lost significant money in the market and have acquired a distrust for the financial markets. In addition, frauds such as the Bernie Madoff scandal have instilled a sense of disbelief for the finance profession, so trusting a financial advisor with your life saving is simply that much more difficult.
On the flip side, Millennials have also developed a sense of “do it yourself” with the rise of the internet. Why should I have to pay to have someone invest my money when there is literally thousands and thousands of different articles out there for free with all the information I could possible want. They are increasingly comfortable relying solely on the internet for banking, so why not investing as well?
Who are the major players when it comes to Robo-Advising?
It appears that Vanguard, Charles Schwab, Wealthfront, and Betterment have been leading the way when it comes to robo-advisors and have the largest assets under management for robo-advising (as of 2/28/17). Vanguard and Charles Schwab make sense as these are both traditional and well established low cost financial firms. Wealthfront and Betterment are both relatively new robo-advisors founded in 2008.
Time will tell whether Robo-Advising truly takes off as a major test of an investment product is how well it performs in a down market. As many of the robo-advisors were formed during the near-bottom of the financial crisis in 2008, it will be interesting to see how these portfolios perform during the next market correction.