With more and more financial technology (fintech) companies appearing all the time, in addition to traditional brokerages expanding their offerings, consumers have more choices than ever. Robo-advisors are no exception to this phenomenon. And while having more options is generally good for consumers, it can also lead to paralysis of choice.
In other words, you have so many options that you find yourself unable to choose between all of the alternatives.
Hence, the purpose of this article will be to help you better understand the types of robo-advisors and which type best suits your goals.
Why Invest with a Robo-Advisor?
Most of us have busy lives and don't necessarily have time to manage a complex portfolio of stocks and bonds. That's what has led to people paying financial advisors to manage their portfolios for them.
But another thing most of us don't like is paying exorbitant fees to have our portfolios managed, as that can really eat into your returns.
That's where robo-advisors come in. Robo-advisors are algorithm-driven systems that do some or all of the work for you. And since you aren't relying on a human to manage it for you, costs are usually much lower.
However, not every robo-advisor is exactly the same. There is sort of a spectrum in terms of how much they do for you.
As you will learn in this article, robo-advisors can vary quite a bit. Those that are more automated will roughly match the stock market.
For example, from February 2010 to June 2020, a Betterment portfolio of 100% stocks had a 124.7% return. And from December 2009 to September 2020, the S&P 500 had a 147.57% return.
Betterment's portfolio was a bit lower during that time period, but it uses several different ETFs to fill out its stock lineup, so it could have a higher return at times. This Betterment review provides more detail on this platform.
On the other hand, things can be a lot more varied when you look at hybrid robo-advisors. This goes without saying as these portfolios can be made as diverse as the entire stock market (plus international stocks), and have bonds thrown in, too.
On the other hand, hybrid robo-advisors can manage a single stock if for some reason you wanted to do that. That isn't normally something you would want to do from a risk perspective, but the point is that there can be a huge amount of variation with this type of portfolio.
As such, it isn't possible to give any real numbers as to what type of return you can expect. In theory, with smart picks, it might be possible to beat the market (more on that later).
Passive robo-advisors entirely manage your investments for you. There will probably be some setup needed when you first sign up, but beyond that, the algorithm does all of the work for you.
You will typically have to fill out a questionnaire when setting up your account, answering questions about things such as your risk tolerance and how long you have until retirement.
You may still have some control over your portfolio after the initial setup, such as what percentage of stocks it should contain vs. what percentage of bonds. However, you wouldn't have control of which particular stocks, bonds, ETFs, or mutual funds should be included.
Typically, there will be a management for these portfolios, although the fee is usually reasonable.
This type of robo-advisor is ideal for beginner investors who know investing is important but don't have the knowledge or confidence to choose their own investments.
You will likely see a better long-term return on this type of portfolio than you would leaving your money in cash, which is why using a passive robo-advisor can be great for those just getting started.
Hybrid robo-advisors automate some of the process for you, but they also offer you some control. One of the best things about them is that you can create a custom portfolio and automate the whole process once everything is in place.
One example of this is pie-based investing with M1 Finance (check out this M1 Finance review for more information). With it, you have an investment "pie" with different slices. Each slice is a stock, bond, or ETF in which you invest.
When you add slices to your investment pie, you set the allocation each one should receive. Then, you can set up automatic investments, and the algorithm will automatically distribute the money in a way that approximately equalizes each slice.
As you can see, this is a perfect example of a hybrid robo-advisor because the system does much of the work for you without completely taking the wheel.
There are also no management fees, at least for M1, allowing you to maximize your performance without a huge amount of effort.
This kind of investing does require a bit more investing knowledge than the totally passive robo-advisor. Still, it can be great for intermediate to more advanced users who don't have a ton of time to manage their portfolios.
Active Investment Robo-Advisors
In a way, active investment robo-advisors are hybrids as well. The key difference is who is handling the "manual" management.
As you may have guessed, it will be a financial advisor handling the human component rather than the customer.
There are a number of reasons you may opt for active investment rather than one of the other two alternatives. One reason could be market fears, particularly when the market is volatile.
When the market is particularly volatile, some investors look to a financial advisor who may be able to help them stave off losses caused by the tumultuous market. They can help find recession proof stocks to protect your portfolio.
Some of these advisors may attempt to beat the market, too. That task is easier said than done, however, and most fail to do so.
In some cases, you may be able to work directly with one of those financial advisors in order to address any concerns about your portfolio, be it taxes, returns, or any other questions.
Fees on this type of account is the highest of those mentioned here - but likely still lower than what you would see with an advisor manually managing your portfolio.
Which One is Best?
As you may have guessed by now, there isn't one "best" type of robo-advisor. Each type has its own pros and cons, and each is better suited to different types of investors with different sets of goals.
Passive robo-advisors are typically best for beginner investors. Those who are fresh out of college or trade school may decide to start this way to get a head start on investing.
Passive advisors also work best for those who don't have a very complex set of assets that might require the help of a human financial advisor.
In such a case, an actively-managed investment profile might be worth a look.
And for investors who have a bit more investing knowledge, want to create a custom portfolio, but don't need the help of a human, a hybrid robo-advisor could be ideal.
Regardless of where you fall on the spectrum, investing with a robo-advisor is a great way to start growing your net worth. Not having your money invested at all results in an opportunity cost if your money is sitting in cash.
Types of Robo-Advisors: Conclusion
As we've seen in this article, there are many types of robo-advisors these days. However, choosing one isn't all that difficult if you know what things you should take into consideration.
It comes down to your level of experience, whether you're okay with "average" market performance, and whether you're okay with paying some fees. Most types can be almost entirely automated, so time is ultimately not a huge factor.
But, again, the most important thing to remember is to get started. Don't let paralysis of choice hold you back. Hopefully, this article has given you the confidence you need to get started.
Bob Haegele is a personal finance writer, blogger, and dog walker. He enjoys growing his wealth through investing and helping others do the same.