Robo advisors have grown in popularity over the last few years as more people continue to warm up to the idea of having algorithms make financial decisions for them. Many of the robo advisor companies have done their bit to make investing more accessible to less-savvy individuals. But, what financial instruments do the robo advisors invest in?
Robo advisors typically invest in a mixture of ETFs and index funds that hold stocks and bonds as the underlying assets. The exact options they pick are determined by the specific user’s calculated risk profile. Most robo advisors employ a passive management approach with occasional rebalancing.
The rest of the article will look closely at how robo advisors invest your money. I’ll also cover the case for and against these algorithms.
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What Securities and Assets Do Robo Advisors Invest In?
Robo advisors invest in low-cost index funds and ETFs, and help you manage a balanced portfolio. They choose the holding in your portfolio using the modern portfolio theory (MPT). The approach targets maximizing the expected return for a specific risk profile.
Robo advisors are automated investment management services that provide financial advice to users with the help of mathematical algorithms. They rely on these algorithms to recommend investments to all categories of users.
Robo advisors are very useful for investors who don’t want to get too involved in the wealth management process. They first burst onto the scene after the 2008 financial crisis, and in the years that followed, they’ve grown in popularity a great deal.
The investments made by a robo advisor are typically highly diversified. Before an advisor chooses the funds to invest in, you have to answer a short questionnaire. The goal is to evaluate your risk profile. Some of the questions you’ll be expected to answer include your age, overall investment goals, investment time target, and your general risk tolerance.
Once you’ve provided the answers, the robo advisors will use complex algorithms to allocate your money in funds that are the best fit for you. Therefore, a portfolio designed to save money for the short term will look different compared to one with a longer-term goal. Some robo advisors may also offer individual retirement accounts (IRAs) to retirees.
Robo advisor investments aren’t 100% automated. You can choose where you want them to invest your money if you want to be a bit more involved in the process. You may prefer investing in a socially responsible portfolio or ETFs in specific industries. You may also decide to allocate a portion of your investments to riskier vehicles like cryptocurrency.
A robo advisor doesn’t go to sleep after the initial investment. They’re designed to automatically adjust your portfolio when necessary to ensure you’re still in line with your goals. The process is known as rebalancing.
5 Advantages of Robo Advisors
You may want to consider using robo advisors for the following reasons:
Robo Advisors Are Less Costly
Robo advisors offer traditional management services at fees lower than the charges from traditional human advisors. Although financial advisors now charge management fees around 1%, some still charge extra commission on generated returns.
On the other hand, Robo advisors charge fees as low as 0.20% per year, with a few charging zero fees. The reduced cost means that investors keep more of the generated returns and don’t have to shoulder expensive fees in losing years.
Robo Advisors Are Easy To Use
Robo advisors exist to simplify the investment process. The platforms and apps are designed to be very simple to use, with many of them taking the gamification approach to make investing more attractive to all categories of investors.
So, whether you’re a rookie or a seasoned investor, you can find your way around robo advisor platforms in minutes. You’ll get access to several portfolio management tools, and the platforms are highly secure. The investment minimums are often $0, removing all minimum account barriers common in this niche.
You Can Get Competitive Returns From Robo Advisors
The returns generated by robo advisors are comparable to what you’d get from human advisors, or better. The lower investment costs certainly help improve returns, but these advisors tend to go with highly diversified investments that track well-known indexes like the Nasdaq or S&P 500.
Robo Advisors Work Round the Clock
With a human advisor, your interactions are limited to the standard working hours. On the other hand, robo advisors are capable of working round the clock. If you’d like to effect changes to your portfolio, you only need to log into your app or web portal. You can also move money in and out when necessary. They’re also constantly rebalancing your portfolio when necessary, limiting tracking errors to the barest minimum.
Robo Advisors Limit the Impact of Human Behavior
Investors tend to make knee-jerk reactions regardless of their experience level. If you choose your investments on your own, there’s the probability that you’ll stick with securities that don’t match your risk profile because they have enticing historical performance.
Similarly, you may give in to fear in periods of drawdown and exit your investments prematurely, missing out on the possible recovery. A portfolio completely managed by a robo advisor would never have these problems. All decisions are guided by sound logic.
The Case Against Robo Advisors
Although robo-advisors are highly regarded in the finance world, they still have arguments against them. Some of these arguments are covered below:
The Personalization Is Still Lacking
Although robo advisors do well to analyze risk profiles, they’re still lacking in true personalization. Most of them allow you to set and edit goals using tools available on the platform, but there are times when you’ll benefit more from talking with a human advisor.
During a significant drawdown, a live advisor can calmly explain the situation to allay any fears you may have. With a robo advisor, you just have to hope that it knows what it’s doing. A robo advisor also can’t take a holistic approach when analyzing your finances. On the other hand, a human advisor can look at your finances, taxes, and more.
You also can’t explore certain investment strategies without setting up a separate investment plan outside the robo advisor. For instance, you can’t buy individual stocks or sell call options with a robo advisor.
As seen above, the asset classes available with a standard robo-advisor are severely limited.
There’s No Human Connection
If you’re someone who can benefit from maintaining a physical relationship with your advisor, robo-advisors won’t work for you. There’s no office to walk in and chat with your advisor. Some brands now offer human advisors to go with the robo-recommendations, but that usually comes at an extra fee that counteracts the low-cost advantage.
Robo Advisor Returns Are Rarely Spectacular
As seen above, robo advisors mostly invest in index funds to maintain diversification. Therefore, you’re probably going to generate similar returns by just going with a mutual fund that tracks a popular index.
You’d end up saving some money on fees while safe in the knowledge that you’re fully in control of your investments. If you’re looking for real market-beating returns, you may have to look beyond robo advisors.
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Conclusion
Robo advisors are great tools for anyone looking for an automated investment strategy. They invest in some highly liquid securities that are capable of tracking the wider stock market. Users aren’t limited by minimum investment requirements, and the entire setup process is fairly straightforward.
Robo advisors are also trustworthy because the legitimate companies are all regulated by the U.S. Securities and Exchange Commission (SEC), just like conventional human brokers. However, they also have downsides you shouldn’t ignore.
Go over the pros and cons covered above before you decide to start your investment journey with one.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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