There are many different answers we could give for the question of “Why use a robo advisor?” but it boils down to 2 main points: robo advisors are inexpensive and make investment choices that are free of personal bias.
Of course, most of us don’t like to admit that there’s any personal bias involved in any of our decisions, let alone those that affect our personal investments. But even the smallest thing can affect our moods, and our moods can definitely affect our choices when buying or selling stocks, bonds, etc.
But most people want a bit more information than that, and a few examples too. So let’s take a look.
Key Takeaways
- Robo advisors provide a hands-off approach to investing.
- They're algorithm based and fairly automated, but still have real people involved in the process.
- Investors typically save money using a robo advisor instead of paying an investment manager or even going the DIY route.
- Robo advisors remove the emotional element out of the investment process.
Algorithms, people, and how robo advisors work
A robo advisor can be described as an online investment advisor. It’s a service that helps people invest their money using low-cost, globally diversified funds in a way that matches their long term goals and risk tolerance.
Technology is used to make the process easy for everyone. It keeps costs low and takes out much of the human error that can creep in when making investment decisions.
Sophisticated computer algorithms monitor individual investor accounts for proper asset allocation, invest new money, and determine what trades need to be executed on the markets. These algorithms are created and verified by investment professionals to make sure only sound investing decisions are made.
But computers don’t make all the trading and investing decisions for you.
Before any trades are executed, they are human-verified to make sure nothing unusual is taking place – like a flash drop in the markets, for instance – that could cause a poor trade with an unfair value to take place. Once verified, the trades are executed and individual investor accounts are updated accordingly.
Plus, many robo advisors have a team of real people available to answer your questions about:
- account types,
- risk,
- asset allocation,
- investing goals, and
- to provide general assistance.
Each robo advisor service has its own communication methods, but these investment and financial advisors are usually available via email, phone, and even instant messaging.
Why use a robo advisor? It can save you money
There are 2 main ways that a robo advisor can save you money. The first is that low cost, diversified exchange traded funds (ETFs) and other lower risk investments are used in place of expensive “actively managed” mutual funds. The second reason is that robo advisor fees are surprisingly low.
ETFs vs. mutual funds
Since it costs more, you’d think you’d get better investment performance out of mutual funds, but that isn’t necessarily the case. Many mutual funds are actually “closet index funds,” meaning they really just track the stock market the same as their less expensive ETF counterparts. “Actively managed” is often a big illusion.
Many studies have been done on the difficulty of outperforming the stock markets, especially after paying high MERs. Few fund managers have accomplished this consistently, which means picking a fund manager can be about as difficult as picking individual stocks. And the golden rule still applies: past performance doesn’t predict future performance.
Lower fees with robo advisors
MERs, management fees, fees for selling, fees for buying…they all add up. If you consider a robo advisor with annual fees ranging from 0.35% to 0.5% (depending on portfolio size), the difference in annual price for ETFs vs. mutual funds is significant.
On a $200,000 portfolio, you’d pay a total annual cost of $1,220 with a robo advisor and ETFs, whereas a typical mutual fund would cost about $4,700 – a difference of $3,480. That’s 0.61% in total fees with a robo advisor and 2.35% for a mutual fund.
Over the long term, that difference really adds up. For example, let’s consider the same $200,000 investment over a period of 30 years, assuming a 7% annual return for both. With the aforementioned robo advisor, you’d end up with $1,282,490.81. And with a mutual fund, you’d have $782,000.40. That’s an extra $500,490.81 for your retirement – 64% more.
Choosing robo advisors over DIY investing
When looking at reasons for using a robo advisor, you’ll want to consider the differences between this and DIY investing too. There are plenty of facts and statistics to support both choices, really, but my own story highlights a few key points quite well.
A personal story to consider
After a rough start in the 90s with my first few hundred dollars, I decided to try going it alone instead of treating my dad as a personal investment advisor. I opened up a shiny new Questrade account, cashed out all my personal and work investments, and transferred everything over.
Then, I proceeded to make every stupid investing mistake in the book, some for a second time:
- I tried to time the market during one of the most volatile times in stock market history (2008) for a few weeks.
- I played with leveraged ETFs at the same time. That means gains and losses are doubled in the short term. Long term, I found out if markets go up and down a lot over a period of years, you eventually lose all your money.
- At first, I avoided buying individual stocks and diversified across Canada (good), but I neglected to diversify worldwide (bad).
- After watching several stocks for fun over time, I decided to buy Yellow Pages due to its stable stock price and long track record of paying big dividends.
By cashing out and timing the market, I actually missed one of the biggest single day drops ever, plus a few more big drops. This, combined with only minor losses from the leveraged ETFs, allowed me to come out slightly ahead of the index.
During the period where I lacked global diversification, Canada did fairly well and I managed to avoid some problems going on in Europe. But in the later years, Canada started to underperform and I missed out on some global gains.
Yellow Pages? You guessed it – it almost went to 0 and I lost several thousand dollars.
As for my overall returns, my main RRSP account didn’t achieve the expected 6% to 8% average annual returns, but I was much better off than the typical savings account at about 5%. My TFSA looked better at 14.79%, but I didn’t start it until 2012.
Today I have a globally diversified, low cost investment portfolio of ETFs that are delivering market returns over a long time horizon. It took me a while to get here, but this is exactly what I should have done from day one.
Robo advisors take the personal bias out of investing
As my story above illustrates, our personal opinions and biases can get in the way of successful investment decisions if we’re going it alone. But a robo advisor can help avoid this.
This is how these situations can affect your investment journey and your finances overall:
- You get a hot tip about a dividend stock from a friend, the media, or a colleague and you just can’t resist.
- You get nervous about volatility in the stock market and start trying to time the market. Inevitably, you buy or sell at the wrong time and either experience big losses or miss big gains.
- You unconsciously let your asset allocation drift from your target over the years.
- You start a family or advance your career and wind up too busy forgetting to invest more money and keep up with your portfolio.
Using a robo advisor avoids these types of situations completely, reducing the risk of making poor emotionally-based choices.
FAQ
What are the benefits of a robo advisor?
There are several benefits to using a robo advisor. They’re often cheaper to use than other options, plus they avoid the problems that emotional-based decisions can cause. Robo advisors are easy to access with most computers and mobile devices too.
What’s the difference between DIY investing and using a robo advisor?
The biggest difference between these is that robo advisors make trading decisions for you. With DIY investing, you do the buying and selling yourself, but a robo advisor bases its decisions on your preferences and automatically acts accordingly.
What’s the best robo advisor in Canada?
Our top choice for a robo advisor is Questwealth. It offers a wide range of features, including tax-loss harvesting, Socially Responsible Investing (SRI) options, and automatic rebalancing. Plus, it has some of the lowest fees in Canada.
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Robo advisors offer RRSP as an account type. You should be able to just get them to transfer over your existing RRSP. The only hiccup would be if it is tired to your current employer. You probably wouldn't want to close out your existing RRSP account in that case.
Yes, it can seem like a mountain at first - but keep at it. You'll find yourself in the know much faster than you think and it will all start to seem easy.