Robo-advisors can make investment planning quite intriguing. By using algorithmic calculations to determine the optimum asset allocation for your portfolio, robo-advisors offer you computerized investment advice.
Sound complicated? Well, it isn’t, at least not for a robo-advisor, who can help you set your investment goals and can provide you with the best investment advice to meet these goals. The best part in using a robo-advisor is that you don’t have to spend a lot of money.
Robo-advisors offer online investment planning services at a lower cost than traditional advisors (as there is no active management involved), and guide you every step in the process.
So, What Is So Special About Robo-Advisors?
Robo-advisors are using automation in the form of algorithms to optimize your portfolio and advise you on how to allocate your investment assets in a way that fits your investment profile, i.e. the risk that you are willing to accept.
Furthermore, with the use of technology, they offer optimization of investment returns based on quantifiable data, thereby providing you with a tax-efficient diversified portfolio that can meet your investment goals. Are they so much smarter than traditional advisors? Maybe or maybe not.
In fact, they are using the same technology that traditional advisors use for so many years now. However, there are no middlemen in the process, and you can beat the behavioral biases of active management, without being on your own. The best part is that most of them invest in index funds. Here is a brief comparison of online investment planning services to help you determine which one suits you best:
The Hidden Risk of Mutual Funds
Mutual funds offer you access to beautifully constructed portfolios of equities, bonds, and other securities, and they often serve as a good alternative to diversify investment risk.
For example, a mutual fund portfolio may simultaneously invest in large growth US stocks, moderate growth international stocks, and aggressive growth mid-caps. Or, if it is a retirement portfolio, it may simultaneously invest in long-term growth US large-caps, and long-term growth mid-caps.
It all boils down to the investment profile, and the best thing is that as the investment vehicles trade simultaneously. The losses in one can be alleviated by the gains in another.
However, everything comes with a price and in the case of mutual funds this price is the expense ratio. Put simply the expense ratio is all the fees associated with owning a mutual fund, i.e. management fees, advisory fees, administrative costs, 12b-1 fees (distribution costs), redemption fees, reinvestment fees and exchange fees.
You invest $20,000 a year for 20 years. Management fees are 1.25%, administrative fees are 0.50%, 12b-1 fees are 0.75% and every time you sell and buy a mutual fund, there are transaction fees of 6%. Assuming that you are charged with transaction fees 3 times during the investment period, and a realistic annual return of 10%, here is how all these fees can lower your return:
So, you are paying a total of almost $15,000 in fees for 20 years, but even worse you realize a net gain of $28,890, whereas, without fees, you would realize $43,800. So, you are actually losing 34% of your money in fees.
On the other hand, passive management is associated with the efficient market hypothesis (EMH), which holds that all newly available information is reflected in the current stock prices. So, if a company releases strong quarterly results, its stock price will rise. If the economy enters a recession phase, the stock prices will decline.
However, in passive management, there are no fees involved, and you are not relying your portfolio returns on potential biases stemming out of the fund managers’ beliefs that some stocks may be undervalued while they are not.
Index Funds and Robo-Advisors Go Hand in Hand with Great Returns
Although no investor can beat the market, you can enjoy significantly higher returns with an index ETF fund. First, index ETF funds are tracking benchmark indices like the S&P 500 or the Dow Jones Industrial, so, based on how good the stocks on the benchmark index perform, this is your return.
Second, ETFs do not incur all these fees that mutual funds so you are free of the biases of the fund managers. Sometimes, people are losing money because their fund manager miscalculated the risks or misjudged the broader conditions of the market.
Robo-advisors invest in ETFs because there is no active management involved and because ETFs are great investment vehicles for diversification. Now, considering that a robo-advisor is technology and that it uses algorithms, it is highly unlikely to have an algorithm misjudge the market.
Dividend Growth Investing and ETFs?
If you are a value investor seeking for a steady stream of income every month, ETFs may not be the answer for you. Dividend stocks deliver a dividend every quarter, and in many cases, they raise their dividends, thereby increasing shareholder value.
So, you know that if you invest in a growth startup that consistently delivers a dividend or in a large cap with an established brand name that tends to increase its dividends for many consecutive years, you will have dividend money in your account, no matter what.
ETFs do not deliver or increase dividends consistently. Because they own a wide aggregate of stocks, their dividend payments can vary wildly. You can get dividend compounding, but it is likely less optimal than with a steady dividend increaser.