Since 2008, digital money management has grown from strength to strength. In the era before robo-advisors, you would meet with your financial advisor, discuss retirement options, and invest in a diversified portfolio for the long-term. But there was a catch: high fees.
For most investors discussing costs with their financial advisor, management fees were the focus during conversations. But only the savviest of investors would have spotted that total fees included expense ratios and commission charges.
When all the costs are added up, the average Joe or Jane investor ends up losing out on a huge portion of their nest egg over time because of the compounding effect of fees, including management fees, expense ratios and commission charges.
Some studies show that if you were to invest $100,000 over a 30 year period and pay 2% fees compared to your neighbor who pays no fees but simply tracks a general stock market index, like the S&P 500, you would end up with nearly $500,000 less in your retirement account.
So, even if you have an optimally diversified portfolio of stocks, bonds, and cash for your age, you may still end up losing out big time when factoring in the effect of fees.
Lots of investors may have felt the pinch of fees in the pre-robo-advisor era but couldn’t quite put a finger on why their portfolios weren’t growing as much as they might have expected. And the reason lurks behind the surface of the fee structure when you invest with a financial advisor. While management fees are disclosed and reported on your monthly statements, expense ratios – the fees charged for managing and operating mutual funds – are withdrawn at the fund level, meaning you don’t see them unless you really go looking for them.
To get a good handle on how much fees actually cost, you need to dig a little deeper than the regular report you receive. And the reality is few investors actually go to those greater lengths to find out how much they pay each year in total fees.
So, what’s the answer? Until 2008, there wasn’t a whole lot of choice but to suck up the high costs. When you combined financial advisory management fees with expense ratios, you might well have paid as much as 2% of your invested capital in costs each year.
But then along came robo-advisors, who leveraged technology to perform many of the same portfolio allocation duties as human advisors, but at a fraction of the cost. You can think of a robo-advisor as a digital money manager that oversees your money and constantly scans how you are positioned each day to ensure your portfolio aligns with your risk profile and financial goals.
Instead of calling up a human advisor, a robo-advisor takes care of virtually everything for you. Once you answer a few questions about your time horizon, capacity for risk and retirement objectives, a robo-advisor gets to work buying positions that are suitable.
But that’s just the beginning. Thereafter, good robo-advisors will scan your portfolio daily to look for opportunities to lower your tax liability using a method called tax-loss harvesting – check out this Betterment review to learn more. And if your portfolio drifts because one holding gets too large, the robo-advisor will automatically rebalance it.
Some robo-advisors will offer a host of additional services too. For example, Betterment caters to socially responsible investing portfolios, so you can align your ethics with your investment dollars.
Do you care about gender equality or environmentally friendly companies? Do you want to avoid companies that have ethically questionable practices? Selecting companies that have a positive social impact would be difficult with a traditional financial advisor, who will typically diversify your portfolio based on Modern Portfolio Theory but won’t generally research which funds have the greatest social impact. However, robo-advisors rely on heavy computing power and smart algorithms to find appropriate funds and buy them for your portfolio.
Another nice feature of robo-advisors is how they specialize in different areas that would be difficult for any human advisor to masterfully. For example, blooom specializes in analyzing and monitoring 401(k) portfolios while Personal Capital has a world-class mobile app that lets you easily track your net worth, expenses, loans, and income.
Some robo-advisors, such as Betterment, even go so far as to overlay human advice with digital money management, so you get the best of both worlds. And where robo-advisors really shine is the cost. Management fees charged by many robo-advisors are in the ballpark of 0.25% annually. And most of the top robo-advisors will screen for low expense ratio funds, so you are not getting nickeled and dimed as you might if you invested with a human advisor.
The problem human advisors face is they serve as many as 150 clients at a time. So when you think about it, a human advisor has no more than 1-2 working days per year to focus on any single person’s portfolio. However, a robo-advisor enjoys scale benefits where a single computer algorithm can adapt to serve thousands or even tens of thousands of clients. Obviously, these algorithms have to be thoroughly vetted but the numbers speak for themselves. Top robo-advisors, such as Betterment, Schwab Intelligent Portfolios, Personal Capital and Wealthfront have amassed client assets in the billions of dollars and some in the tens of billions.
So, if you want lower fees and lower expense ratios, and a virtual advisor to monitor your portfolio daily, the future is clear. Robo-advisors have already taken a big chunk of market share from traditional advisors, and if the trend keeps going they will take a whole lot more as time goes by.