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How to find the best robo-advisor

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The robot age is here.

From drones to self-driving cars, machines that perform functions previously handled by humans are marching off the pages of science fiction and into reality. So if they can make a self-driving car, how about a self-driving investment program?

That idea has been reality for a few years now. Automated wealth managers, more popularly known as "robo-advisors" are here and they are growing fast, stepping into roles that have traditionally been filled by financial planners and investment advisors.

So is a robo-advisor right for you? This guide will give you some background on how they work, some pros and cons, and 10 things to look for when choosing a robo-advisor.

How robo-advisors work

Robo-advisors use algorithms to translate your investment risk tolerance into a diversified investment portfolio. This includes both determining asset allocation and choosing individual mutual funds to populate that allocation.

Some robo-advisors also offer tools that will help you with retirement planning. For example, if you specify a retirement income target and retirement date, the program will tell you how much you need to contribute to your IRA or 401(k) each year to meet that target.

As you may have noticed, asset allocation, security selection and retirement planning are all functions that human financial professionals perform. Can robo-advisors do it better? The results have been mixed, but conceptually there are both pros and cons to the robo-advisor approach.

Pros and cons of robo-advisors

Robo-advisors address two problems that have traditionally plagued the financial industry: cost and human error.

Pros

  • Lower charges. Robo-advisors offer investment management for a fraction of what human investment advisors charge. Since some investors will perform above average and some will perform below average, overall it is the fees that play a large role in determining how well individuals keep up with the market and make progress toward their goals.
  • Lower risk of being affected by market extremes. As for human error, besides the fact that some investors are more competent than others, the fact is that time and time again professional and amateur investors alike have gotten caught of in the emotion of market ups and downs. They get more aggressive during bull markets and more tentative during bear markets. A robo-advisor can smooth out those extremes, keeping your portfolio on an even keel.

Cons

  • Limited by past data. The other side of the coin is that a robo-advisor cannot see into the future any better than a human investment professional. In fact, robo-advisors work by looking into the past rather than into the future, and that can have its limitations.
  • Market models may not be accurate. The formulas used by robo-advisors to make decisions are based on the historical behavior of different assets. The problem is that history does not always repeat itself in a predictable manner. In particular at a time like now when bond yields are unusually low and stock valuations are unusually high, the historical risk/reward characteristics of these asset classes may not be especially relevant. That would make the type of models used by robo-advisors less effective.

10 things to look for when choosing a robo-advisor

If you decide to use a robo-advisor, what is the best firm to go with? That largely depends on your needs. If you work through this shopping list of 10 things to look for when choosing a robo-advisor, you should have a better sense of which is the best firm for your needs.

1. The base fee. Robo-advisors typically charge a fee based on a percentage of the assets you place under their management. A base fee of 0.25 percent seems common among industry leaders. Since the premise of robo-advisors is to lower investment expense through automation, checking the base fee is a good place to start. Note that in addition to this fee, you will also have to pay the expense ratios of the funds that are used to build your portfolio.

2. Trading fees. Are there fees for each trade within the program? This could quickly get very expensive, so look for robo-advisors that do not charge such fees. Also, if you plan to make some self-directed trades through the same firm, check that their commissions are competitive with those of leading discount brokers.

3. Fee reductions for higher balances. In theory, management should get more cost-effective with bigger account sizes. Typical robo-advisor accounts are less than $100,000, but if you have more than that to invest, you should see if you can get a reduced fee.

4. Captive vs. outside products. Some robo-advisors are affiliated with fund families and use their own products to build investment portfolios. You may get a broader range of choices from a robo-advisor that uses independent investment products. Also check to see if the robo-advisor's asset allocation model can account for assets you have outside their account, such as an employer's 401(k) retirement plan.

5. Tax treatment. If you are planning to place a taxable portfolio under a robo-advisor's management, understand what tax-efficiency strategies they use, and whether you are able to employ techniques such as tax-loss harvesting when needed.

6. Minimum account size. Make sure you have enough to qualify for a firm's services, and are not so close to the minimum that you might fall below it after a market downturn or a withdrawal.

7. User interface. Play around with the user interface. It should be simple to use, and work effectively on the device of your choice.

8. Socially-responsible investing capabilities. If your investment guidelines include prohibitions against certain types of investments for ethical reasons or particular sectors you want to positively target, make sure the robo-advisor's system can accommodate these priorities.

9. Retirement goal targeting. Besides managing your money, some robo-advisors offer tools that can help you see what level of saving will be necessary to meet your retirement goals. Integrating these targets with your investment program can help make sure saving for retirement is properly coordinated with investing for retirement.

10. Rebalancing methodology. Automated investment allocations need to be reset periodically to make sure they stay in balance. Look into each robo-advisor's methodology for rebalancing. Overly frequent rebalancing can be inefficient, while doing so too infrequently can lead to portfolios getting out of alignment as asset values change at different paces.

Choosing the best robo-advisor for 2018 is just a first step. Once your program is in place, monitor it to make sure the fees are staying competitive and the robo-advisor is delivering as expected.

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