Ever since robo-advisors first appeared on the scene in 2008, they have been hugely popular. However, you may be wondering if they are as good as the hype.
Perhaps more importantly: do robo-advisors beat the market?
The best way to answer this question is to look at real returns from real robo-advisors. However, it’s also important to understand what robo-advisors are and how they work.
What is a Robo-Advisor?
A robo-advisor is an algorithm-driven set of tools that offer financial planning and investment management. These tools often require little human input and may require no human interaction whatsoever.
The lack of human interaction allows management fees for robo-advisors to be much lower. Whereas human advisors tend to charge 1%-2%, robo-advisors can charge 0.5% or lower.
In addition, many robo-advisors have a low minimum investment or no minimum at all. Costlier human advisors can require a minimum as high as $100,000 before they will take you on as a client.
The first robo-advisor, Betterment, initially launched in 2008 and opened to investors in 2010. At that point, the investing landscape changed for good.
These platforms have made investing cheaper for many investors and have reduced barriers to entry. However, this is not to say they are perfect or without their shortcomings.
The main downside to robo-advisors is that they can’t give you the guidance that a human advisor can when you are navigating complex financial decisions.
They may not quite be sufficient to help with tax strategy, retirement planning, and other complicated scenarios.
That said, some robo-advisors, like Betterment, do offer financial advisors. In the case of Betterment, you pay a separate fee for that option.
How Do Robo-Advisors Work?
Robo-advisors work by first asking the user a set of questions, typically about their income, goals, and risk tolerance.
Then, the system may suggest different portfolios based on the user’s answers, or it may construct a portfolio around the way the user answered. Each robo-advisor handles this part of the process a little bit differently.
Once it knows the ideal portfolio, the algorithm will maintain it according to the user’s input. This usually includes dynamic rebalancing.
Dynamic rebalancing involves buying and selling assets in order to keep the portfolio in line with the user’s preferred allocations.
Some robo-adviors, namely, Betterment, also include tax-loss harvesting. As its name implies, this feature reduces tax liability by selling assets at a loss to offset capital gains.
For wealthier investors, tax-loss harvesting can make quite a significant impact. For smaller portfolios, though, the difference is slight.
Do Robo-Advisors Beat the Market?
It’s worth noting that beating the market can be both unrealistic and unnecessary. That’s because the market itself has quite strong returns in the long run, and even matching market performance can lead to huge wealth accumulation.
And as we will see in the section ahead, robo-advisors don’t often beat the market. But what these portfolios do give you is a more well-rounded portfolio that is less volatile during uncertain economic times.
Plus, according to data Betterment cites from ARC group, its portfolios beat human-advised portfolios by around 2%. That may not sound like much, but it can result in tens of thousands more in wealth over the course of your career.
The point here is that while robo-advisors won’t always beat that market, that is not the goal. Essentially, whether or not they “beat the market” is too simplistic a question and doesn’t account for the nuance and complexity of investing.
To give you an idea of what to actually expect from a robo-advisor, here is some data from actual robo-advisors compared to the S&P 500:
6.2% - 9.8%
To be clear, these numbers are not absolute; they are average annual returns from 2011-2020.
The one exception is Ellevest; the number above is not a real-world number but is instead the expected return Ellevest provides in its white paper.
If you simply look at the above numbers, you might think you should just skip the robo-advisors and put all of your money into an S&P 500 index fund.
However, that instinct doesn’t take the whole picture into account. Most robo-advised accounts are diversified in some way, meaning they don’t simply invest in the S&P 500.
Betterment, for example, invests in a variety of ETFs, including value stocks, emerging markets, bonds, and more.
And the average for Betterment assumes a 70% stock allocation. That means they are 30% bonds, which leads to lower volatility.
During the tumultuous times of 2008, the S&P 500 took a nose dive to the tune of negative 38.49%.
Meanwhile, a Betterment portfolio of 70% stock would have seen a return of negative 27.1% during that same time period. That represents a difference of more than 11%.
What this illustrates is that while the S&P 500 may look attractive in the long run, there will be years where things are less rosy if you don’t diversify.
How Much Do Robo-Advisors Charge?
Because robo-advisors require little to no human interaction, they are able to charge fees much lower than traditional advisors. Most charge a fee as a percentage of assets known as an expense ratio, but a few charge a monthly fee.
Here is a list of fees from popular robo-advisors:
0.25% (Digital) or 0.40% (Premium)
$1, $3, or $5 per month
Ally Invest Managed Portfolio
0.30%, or 0% with 30% cash position
$1, $5, or $9 per month
While different financial firms have tried different fee structures and deals to attract users, aloof them are affordable. Even the highest monthly fee on this list at $9 per month is cheaper than a Netflix subscription.
Can Robo-Advisors Make You Money?
Robo-advisors can generate pretty solid returns. Granted, there are many different robo-advisors out there and they don't all work the same way.
But if you look at a popular robo-advisor like Betterment, it's clear that you can indeed make money. For example, a portfolio of 70% stock on Betterment would have generated ~170% returns from 2004-2020:
Sure, that's quite a bit lower than the returns the guys at The Motley Fool are getting. Still, Betterment's portfolios are entirely automated, and it uses a broad set of ETFs.
That means less stability and more dependable returns.
So, yes, robo-advisors can certainly make you money in the long run.
Should I Use a Robo-Advisor?
The answer to whether you should use a robo-advisor is not a simple yes or no. The answer depends on your investing knowledge and how much time you are willing to spend managing your portfolio.
After all, you could just as easily open an IRA or brokerage account and invest in index funds. However, you will have to know which set of funds to select, and you’ll have to rebalance your portfolio regularly.
Additionally, robo-advisor fees don’t eat away at your returns the way 1%-2% fees charged by human advisors would. This is not to say the fees are completely irrelevant, but their impact is much smaller.
Some investors avoid robo-advisors because they feel comfortable with DIY investing and feel managing their own portfolio is worth their time.
And, as mentioned earlier, robo-advisors may not be sufficient to help navigate complex financial planning. However, robo-advisors such as Betterment do offer access to human financial advisors for a flat fee.
So, do you feel comfortable managing your own portfolio? Do you feel doing so is worth saving on fees? That is not to mention the tax-loss harvesting you may be forgoing compared to a Betterment portfolio.
However, these are the questions you must ask yourself. Once you determine what is most important to you, you will know whether a robo-advisor is right for you.
Want to learn more? See our list of the best robo-advisors.