An introduction to robo-advisors

2 January 2024
Understanding robo-advisors

Sensible robos

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Robo-advisors are online services that make investment decisions on your behalf – hopefully sensible ones. Unlike traditional (human) money managers, robo-advisors use computers to automate some or all of the decision-making process. Which means they can keep fees lower.

How is this new? Human investment managers spend their time allocating clients’ money to different investments – things like stocks, bonds or commodities – with the aim of growing the pot of money without taking crazy risks. A robo does the same. Just without needing a fat paycheck.

Investors in a robo-advisor must define their risk appetite – because investments that might gain the most are also those most liable to fall. Robos often do this by making customers answer a series of questions about their lifestyle and goals. Then an algorithm (that’s a fancy word for software) crunches the numbers to create suitable investment portfolios for you.

If a traditional fund manager is British Airways, think of robo-advisors as JetBlue or Ryanair – robos offer the same end product (growing your money) but with a lower price and fewer frills (like being able to talk to humans).

What else do robos offer? In addition to lower fees, robos also tend to do away with minimum investment amounts. This makes it possible for people with relatively modest sums to access services previously available only to wealthier clients.

How do robos work?

Once you’ve deposited money with a robo-advisor – either a single lump sum or a regular payment – it’ll create a portfolio spread across different assets. If you’ve said you’re more tolerant of risk, the algorithm will put more money in things like stocks. And if you’re more cautious, it’ll lean more towards assets like government bonds. (We’ll talk more about how to decide how risk tolerant you are in a later session.)

Sounds simple. What else do they do? Well, the robo will periodically assess the performance of your investments and rebalance funds to maintain the original allocation. For example, imagine your portfolio was originally 50% stocks and 50% bonds. But say a few months later stocks have done well and bonds have fallen. The pot now consists of 55% stocks and 45% bonds. Your robo will therefore sell some stocks and buy bonds to bring it back to 50-50.

Why? This means you’re always selling the assets that have performed best (locking in those profits) and putting money into those that have performed badly (but may do better in the future). Over time this rebalancing automatically helps you achieve the old investing cliche of “buy low, sell high” and should boost returns.

Robos don’t generally buy and sell actual stocks and bonds – instead, they put clients’ money in exchange-traded funds (ETFs). ETFs are an easy, low-fee way to own a broad selection of assets – like the top 100 stocks in the UK or US-based tech stocks.

Who are robos good for?

Robo-advisors are best for people who want the potential to generate higher returns than those offered by bank accounts, yet don’t want to be actively involved in making investment decisions.

Anyone else? They’re also great for people just starting out investing, who may only have fairly small amounts to put away at first and might not require the more complex services offered by traditional advisors (such as inheritance tax planning). Despite the name, robo-advisors don’t really give out financial advice. They just allocate investments on your behalf.

Robos aren’t for you if you want to make your own choices about where to invest your money, like picking individual stocks. For that you’ll want a brokerage account.

What if I don’t want to hand over my money to an algorithm? If you’re the kind of person who wants to talk through options with an experienced professional, you might want to think again too. Though many robos have humans you can call, they’re closer to customer services operatives than financial advisors.

Next, we’ll talk more about robos’ returns (nice) and fees (boo).

Returns and fees

Putting money in a robo-advisor – like most long-term investing – is about generating a modest return each year and hoping it grows nicely over time. It’s not about getting rich overnight.

Talking about returns is tricky because, of course, past performance is no guarantee of what will happen in the future. But to give you an idea, stocks in rich countries have tended to gain about 6-8% a year (with a wide divergence around this average – US equities fell 38% in 2008 then gained 23% in 2009, for example) while bonds have returned about 4-5%.

But I’ll get more than that, right? Almost certainly not, no. Robos aim to match the market, not beat it. While this may sound unambitious, lots of research shows that most actively managed funds actually underperform the market once you factor in the fees paid for the service. The more successful a fund is, the more investment it’s likely to attract. And the bigger the fund grows, the more it tends to track the overall returns of the market.

Don’t try to beat the market – thousands of people are paid to do this full-time and the majority still fail.”

And how much will I have to pay these robos? Fees are a little easier to quantify than returns: you should expect to pay a robo about 0.25-0.5% of the funds invested as an annual fee. This compares with fees of at least 1% levied by traditional money managers. Some robos also offer more active services in return for a higher fee. It’s important to make sure you know what fees you’ll be charged before signing up for any service.

Next, we’ll tell you what else to look for when choosing a robo-advisor.

How to choose a robo

In the US, the largest (independent) robo providers by amount of money under management are Betterment, Wealthfront, and Wealthsimple. In the UK, the biggest are Nutmeg, Scalable Capital, and Moneyfarm. Some huge providers of exchange-traded funds – like Vanguard – also offer robo-like investment services if you go to them directly.

What’s the difference? The fees charged are obviously a key consideration. As well as an annual fee for managing your money, robos may well charge fees for adding or withdrawing cash – so be sure to check!

You’ll also need to make sure you’re investing enough to meet the robo’s minimum threshold (if applicable), as well as considering how easy it is to talk to a human if you need to. Many robos also offer automated “tax-loss harvesting,” where losses are booked on assets that have fallen in price and used to reduce your overall tax bill – always handy.

But why are there are so many options? Robo-advisors have exploded in recent years and there are now more than 100 different firms offering the service.

Lastly, it’s worth noting that investing some of your money with a robo-advisor doesn’t stop you putting the rest of it elsewhere.

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