The allure of a set-it-and-forget-it, simple, low-cost way to invest has led to explosive growth for robo-advisor platforms. In 2020, assets managed by robo-advisors topped US$1 trillion and is expected to reach US$2.9 trillion worldwide by 2025.
Before deciding whether robo-advice is right for you, consider some pros and cons.
Robo-advisors use exchange-traded funds (ETFs) that adopt a passive investing strategy. That is, they mimic a set of underlying indices. As such, investment managers overseeing ETFs don’t conduct research to pick assets with the aim of trying to beat an index. They also trade these assets far less than an active investor would, so they charge the investor a much lower management-expense ratio (MER).
This is important for a few reasons:
- The higher the MER, the greater the impact it has on your return and the compounding effect. For example, if you pay 2% in management expenses, and your return shown was 6%, you in fact earned 8%. If you have $100,000 invested, then each year you’re paying $2,000 in fees.
- The more actively traded your funds are, the greater likelihood of the costs and investment taxes being passed on to you. This matters especially if you’re invested outside a tax-shelter such as an RRSP or TFSA.
Note: A robo-advisor may charge a small overall management fee in addition to the MER.
Robo-advisors use computer algorithms, usually based on Modern Portfolio Theory, to create a diversified portfolio that’s best suited for you based on your financial goals. The aim is to maximize the expected earnings for that portfolio based on a pre-defined level of risk tolerance. The portfolio is automatically rebalanced in a timely manner with little or no human interaction.
This method of diversification takes biases and emotions out of the equation. Managers don’t try to time the market, and that has its benefits because it’s very tough to do this on a consistent basis.
Easy to get started
With millions of investment choices to create your portfolio, the whole process can be overwhelming.
Robo-advisors make it easy to get started. When you join a robo-advisor, you will be asked a few screening questions, known as the “Know Your Client (KYC)” process. This is to give the robo-advisor an understanding of your financial circumstances, your investment goals, how much safety and liquidity you require, and your overall risk tolerance. Based on your information, it will choose a portfolio that adequately meets your objectives.
And while some robo-advisors have a minimum investment threshold, the amount is typically low, making investing accessible to almost anyone.
There is no one-size-fits-all approach when it comes to investing. That’s because everyone has different financial circumstances and values. The timeline and goals for what they want to achieve will also vary, which will affect their liquidity needs and capacity to take risk.
So while robo-advisors may capture much of your investment objectives in order to slot it into their categories, they can’t take into account the specifics, especially as they rely more on technology and less on human interaction.
No substitute for a comprehensive financial plan
Robo-advisors lack the ability to do in-depth financial planning, and while investing is an important piece of a financial plan, it is not the only piece. Budgeting, tax management, retirement planning, insurance, and estate planning are crucial financial strategies and will have an impact on how you invest and the type of investments you may need to consider.
Can’t outperform the market
There’s a lot of debate as to whether a passively managed investment strategy will outperform an actively managed investment strategy, and this hasn’t been fully tested in the past decade. That’s because, apart from a few brief blips, we’ve been experiencing a long bull run.
When there’s a market downturn, an active strategy will be able to pivot easier to try to generate better returns than the overall market index. For example, an active manager can seek stocks that are undervalued or oversold in anticipation of them bouncing back. They can move more of their weighting to a specific sector set to benefit from a particular economic cycle. With a passive strategy, you can only hold the underlying indices so the best you can do is what the market does, no more and no less.
Whether to invest with a robo-advisor doesn’t have to be an all-or-nothing choice. It offers new investors an easy way to get started with a low-cost, diversified portfolio. And it can also play a role in a more sophisticated financial plan guided by your financial advisor.
Remember that as your finances evolve, so will your approach to investing.
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