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July 24, 2020

What is a robo-advisor, and should I use one?

If the term robo-advisor brings about memories of that robot butler in The Jetsons, you actually wouldn’t be very far off from the truth (side note: if you watched The Jetsons as a child it might be time to look into robo-advisors). A robo-advisor is a tool that uses algorithms to do most of the tasks of traditional wealth managers or investment advisors. It can help you determine an investment strategy for your lifestyle by having you answer a few questions about your income and risk appetite. All in all, the process only takes a few minutes and the real work happens behind the scenes. Based on your answers, your money is invested into investments that are appropriate for your profile. Because most of the work is done by algorithms, robo-advisors can charge low fees and work with smaller deposits as opposed to professional wealth management firms. 

The financial methodologies behind robo-advisors

The robo-advisor industry was built around the concept of passive investing: a set-it-and-forget-it mindset that uses index funds and time in the market to grow financial wealth. 

We’ve already talked about why a passive investing strategy may be better than an active strategy over the long run here. In summary, general wisdom is that it is extremely difficult, if not impossible, to beat the market consistently and over a long period of time. If an active manager does happen to beat the market, the fees that they charge cut into any gains that would’ve trickled down to your account. Contrary to active management fees, passive investing funds and index funds usually charge less than 1% in fees. 

The other methodology that plays a part into the success of robo-advisors is dollar cost averaging. Robo-advisor platforms make it easy to invest small amounts of money on a higher frequency. Only a few years ago, it could cost up to $15 to place a trade in a traditional brokerage, which meant that even investors who had the means to do so usually had to plan and schedule their trades in advance. With robo-advising, there are no minimums on the amount of money you can automatically transfer into your investment account on a recurring basis. This gives investors the benefits of dollar cost averaging—as long as you keep investing a specific amount of money on a regular basis without trying to time the market, you will be better off than if you make larger, less frequent deposits. 

Are there benefits of going with a robo-advisor?

Robo-advisors are the answer to an increased demand for investment options and products for the “average” investor. It is no surprise then that assets under management for robo-advisors are expected to hit $1.6 trillion by 2024. 

The Bottom Line

There are many benefits to going for a robo-advisor over a traditional wealth manager if the circumstances are right for you. Some features that make robo-advisors attractive to beginner and intermediate investors are: 

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