This is a guest post from Tom Drake at MapleMoney.
In recent years, robo-advisors have taken the financial world by storm. Can an algorithm really manage your money as effectively as any other financial professional?
While the jury might still be out on that subject, the reality is that many people benefit from robo-advisors. I’ve been hesitant to turn to robo-advisors because it’s seemed like I do fine on my own. I’m investing in Canadian dividend stocks as part of the Smith Manoeuvre. Everything else I’ve got is in ETFs and index funds.
But, of course, ETF investors are exactly what robo-advisors are aimed at helping. Besides, using a robo-advisor can be less expensive than investing in “traditional” mutual funds. If you’re trying to decide what to do with your money, here’s what you need to know about robo-advisors:
How Do Robo-Advisors Work?
First, you need to understand how robo-advisors work. These companies follow the principles of modern portfolio theory (MPT) to create an asset allocation for you. When you sign up, you will be asked to fill out a questionnaire. This questionnaire looks at your current situation, as well as when you hope to retire. The advisor uses the information to put together an asset allocation that is likely to work for you.
Many robo-advisors (and there are many) meet your asset allocation requirements with the help of exchange-traded funds (ETFs). These are collections of investments that look a lot like mutual funds. However, they trade like stocks on the exchanges, so they can be a little easier (and less expensive) to buy and sell. A robo-advisor will build your portfolio with a mix of stock and bond ETFs that add diversity and are likely to help you reach your goals in the long run. Using the principles of MPT, the robo-advisor will assign you a set percentage of stocks vs. bonds, and then adjust the ratio as you get closer to your goal.
With many robo-advisors, all you need to do is invest a set amount of money each month, and it will be invested according to your asset allocation. If one asset class becomes too strong in your portfolio, the robo-advisor will automatically sell it, and then use the gains to buy more shares of an asset class that you could use more of in your portfolio. It all happens without you needing to do more than keep investing.
Another nice touch to robo-advisors is that you can actually access dividend growth. You can’t invest in individual stocks, but there are dividend funds. Wealthsimple’s Growth portfolio offers a respectable 2.32% dividend yield, with a cost of 0.1% annually. That’s not bad at all, and it offers you a way to add a little more growth to your portfolio without the need to manage your own dividend stocks.
Simplicity and Low Cost
While a human investment advisor can tailor your portfolio more specifically to your needs, the reality is that you might not have the assets to qualify to work with a wealth manager. This is especially true for beginning investors. You probably want some guidance, but you don’t have the assets to get personalized help from a dedicated investment advisor. This is where robo-advisors can help.
Your portfolio is going to be very similar to others’ in a similar place, but it will have small tweaks based on some of your risk tolerances differences. The reason this works is due to the broad-based ETFs. Because the ETFs used have exposure to a wide swath of the market, you have the chance to keep pace with market performance. No, you won’t beat the market. But if you are looking for a way to steadily build your nest egg over time, you don’t need to beat the market. Instead, keeping pace is usually sufficient over time.
It’s a simple way to grow your portfolio without the need for complicated formulas or the need to try to evaluate stocks on an individual basis in an effort to pick a “winner.” Plus, your risk is a little lower than with stock picking because you have a whole basket of investments. If something loses ground, you have plenty of other items to make up for it.
On top of all that, robo-advisors come with low costs. Investing in three to five well-chosen mutual funds can accomplish much the same thing as a portfolio put together by a robo-advisor. However, it will cost you much, much more. It’s common to find mutual funds in Canada with annual management fees of between 1% and 2.5%. Many ETFs, on the other hand, have much lower fees — more on the order of 0.1% annually. Once you figure in compounding, you could end up with hundreds of thousands of dollars more in your nest egg after a period of 30 years, just by choosing investments with lower fees.
Many of those who manage dividend portfolios find that robo-advising wouldn’t be that great for them. remember though, that dividends are part of a robo-advisor’s portfolio, and that can benefit you in the long run. You get access to a solid collection of dividend-paying investments at a low cost and without the need to try to identify the best choices.
Robo-Advisors Aren’t for Everyone
Robo-advisors are great for those who are just starting to invest and might have fewer assets. They offer a way to invest a bit each month and build a portfolio using time-tested strategies of asset allocation. Additionally, a robo-advisor can be great for a more seasoned investor who wants a relatively stable core for a long-term portfolio.
Robo-advisors help beginners with analysis paralysis get over their hangups and start investing in low-cost ETFs that can help them take that first step. Once you are investing using a robo-advisor, you can start learning more about investing and your options, and perhaps branch out into different assets in different accounts.
Tom Drake is the founder of MapleMoney, a personal finance blog that helps Canadians learn how to make money, save money, invest money, and spend money in a way that helps you create lasting financial freedom.