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Understanding robo-advisors

Considerations for robo-investing.

First introduced in 2008, robo-advisors are automated financial planning services with little or no human interaction. Typically, these firms gather client information from online surveys and then use that information to make passive investments (primarily index funds) on behalf of their clients.

Many investors are attracted by the relative simplicity, low fees and low minimum balances. And many robo-advisors also offer educational content and customer service via toll-free numbers. That seems great for the DIY online investor.

But is a robo-advisor right for you? Well, it depends.

The bottom line is you get what you pay for. Robo-advisors tend to be focused on investing rather than advising, especially on more complex issues, and this probably makes them more suitable for novice investors who are just learning about the markets. But even novice investors need to do their homework before deciding if a robo-advisor is suitable even for their basic investment needs.

Here are some questions prospective clients should ask before pursuing robo-investing:

Do you understand how a particular robo-advisor’s algorithms work?

An algorithm is just a set of instructions that is used to solve a mathematical problem. Your problem is – how should I invest my money? So based on the information you provide, a computer will determine the answer. Sounds simple enough, but it can only incorporate a limited number of details about you.

Let’s start with your risk tolerance, for example. Although the online questionnaire you fill out will probably ask you a question of two about risk tolerance, asking someone to rank their risk tolerance on say a scale of 1 to 10 probably won’t result in a very precise measurement of your actual risk tolerance. And it probably won’t consider any changes in how you feel about risk over time. That leads us to another question …

What will your robo-advisor do if the market tanks?

Robo-advisors may react automatically during market downturns. They are not designed to prevent you from making rash decisions, or counsel you on the benefits of long-term investing – they just react the way they were programmed to react. That might be a good thing, or it might not, but it is something you probably want to consider before you hand over your money to be invested.

In general, take a step back and make sure you understand and are aligned with the investment philosophy or methodology that was used to program your robo-advisor.

How many funds does the robo-advisor offer?

Diversification is another important consideration. If the selection is limited to a handful of index funds, your potential diversification will also be limited. And a limited number of investment options will also impact the asset allocation of your portfolio. Make sure there are a variety of funds available that are a good representation of the market.

Also consider your long-term plans for your money. Are you saving for your retirement, children’s or grandchildren’s education, or future health care costs? Your long-term goals and risk tolerance may or may not be taken into consideration by your robo-advisor.

What are you looking for in an advisor?

The real question is – what kind of financial advice are you actually looking for? Critics have remained skeptical about whether robo-advisors can entirely replace human advisors, especially when it comes to more complex financial decisions regarding insurance, tax planning, mortgages, estate planning, wealth management and a host of others.

When you are just starting out, saving money is the most important goal, and a robo-advisor may provide a simple inexpensive vehicle to invest those savings in. But as we progress through life’s journey, we find that our needs change, and seeking comprehensive advice regarding your unique circumstance can be valuable.

Hopefully, by later in life, your existing investments have been able to produce income for some time, and may have been exceeding the amount you originally anticipated. That’s when your financial situation becomes more complex and the one-sized-fits-all solutions that most robo-advisors offer don’t make much sense. It’s then that you need a personalized wealth management plan designed by an experienced financial planner.

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