6 Questions to Ask Before Hiring a Robo-Advisor
For many, digital investment advice is a fine low-cost alternative to traditional advisors. Here’s how to tell if it’s a good choice for you.
Robo-advisors offer investors a low-cost, automated way to build and maintain diversified portfolios. In this video, Morningstar’s Amy Arnott shares several questions investors should ask themselves to determine if a robo-advisor is the right choice for them.
• What a robo-advisor is
• When to consider a robo-advisor
• How much money you need to use a robo-advisor
• What financial situations may be too complex for a robo-advisor
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. So-called robo-advisors have gained traction with investors seeking low-cost financial advice. But is a robo-advisor the right fit for you? Here to discuss that question in depth is Amy Arnott. Amy is a portfolio strategist with Morningstar and the co-author of Morningstar's 2022 Robo-Advisor Landscape report.
Hi, Amy. Good to see you today.
Amy Arnott: Hi. Great to be here.
Dziubinski: Let's start out with a very basic definition of what a robo-advisor is and how it works.
Arnott: Sure. A robo-advisor is basically a computer program that manages your money for you, and usually what you get is a diversified portfolio made up of low-cost ETFs from different asset classes. And the way you start out is usually by answering a series of questions about your goals, your time horizon, your risk tolerance, and then the robo-advisor will match you up with a portfolio that's an appropriate fit based on those things. And another helpful thing about robo-advisors is that they automatically rebalance over time. So, you don't have to worry about your asset mix getting out of balance.
Dziubinski: Now, you say in your latest report that a robo-advisor isn't necessarily the best fit for everyone and that there are some questions you can ask yourself before you forge down that path of seeking digital advice this way. The first question you say an investor should ask him or herself is, Have I covered the financial basics? So, what do you mean by financial basics?
Arnott: There's really two things that I would make sure to check off your list before you sign up with a robo-advisor. Number one is making sure you have an emergency fund in place. Usually, we recommend having at least three to six months' worth of living expenses in cash or some other type of very short-term liquid bond funds that you could use in case your car needs a repair or you have a home repair or you suddenly lose your job so that you're not scrambling around for cash to meet those expenses. And then, number two would be starting to contribute to your workplace retirement plan like a 401(k). In a lot of cases, your employer will match at least part of those contributions, which is basically free money, so definitely a good thing, and then you're also getting tax benefits because your contributions are deducted from your gross income, plus those contributions are growing and compounding over time and you're not paying taxes on that growth until many years later when you start drawing down assets in retirement.
Dziubinski: So, cover those two things before you go down that path of a robo-advisor?
Arnott: Exactly, and that will give you a strong foundation and then you can use the robo-advisor for other goals.
Dziubinski: Speaking of other goals, you also say in your report that you need to think about if there are other types of investment accounts that you would want to be setting up for specific goals that, say, maybe is outside of retirement. Why is this an important question that an investor be thinking about before going down that robo path, and what effect does it really have on the decision of which robo you would choose?
Arnott: Typically, robo-advisors are available for different types of accounts, so an IRA, a Roth IRA, taxable accounts, sometimes a custodial account for children. And it's also helpful because you can match up the type of account and the type of portfolio with a specific goal. So, if you are, say, saving for a down payment on a house, the robo program will match you up with a portfolio that has an appropriate asset mix for that specific goal. And another helpful thing is that the robo-advisor services will usually keep you updated on your progress toward a specific goal and also help you figure out how much you should be saving monthly or quarterly to meet that goal.
Dziubinski: The next question is a straightforward, simple one: How much money do you have to invest? Are there different investment minimums associated with the various robo-advisors that are out there?
Arnott: Yeah. So, the nice thing about these programs is they're very accessible to beginning investors. We looked at about 20 different robo-advisors in the U.S., and about five of them have no minimum investment at all. And almost every other provider has a minimum of $5,000 or less. So, they're very accessible to a smaller investor who might not have a lot of other options for financial advice. One interesting statistic we found is that only 7% of financial advisors focus on clients who have less than $100,000 in investable assets. So, if you're in that category and you're just getting started, these could be really a good option.
Dziubinski: And you also say that a robo-advisor may make sense for investors who maybe do even have a little bit more money than that to invest given the cost of traditional financial advice. Let's talk a little bit about that.
Arnott: Yeah. Another interesting statistic we found is that 85% of U.S. households have less than $500,000 in investable assets. If you're in that category, you might be saving for retirement, like I said before, maybe you're saving for a down payment, or you have a few other goals, but chances are your overall financial situation isn't that complicated. If you go to a traditional advisor, you may be paying 1% of assets versus a robo-advisor, you're typically paying about a third of that, so about 30 basis points on average. It can definitely be a more economical way to get financial advice, especially for people who don't have an overly complicated financial situation.
Dziubinski: Amy, speaking of complexity, let's delve into that: How complex is your financial situation? First, what do you mean by "complex"? And then, how can someone figure out, "OK, this is the line where complexity moves into, yes, maybe I need to work with a one-on-one financial advisor rather than go the robo route?"
Arnott: I would define "complexity" as basically the number of things that you need help with. If you are someone who is mainly saving for retirement and maybe a few other financial goals, your situation might not be that complex. As you get older and accumulate more wealth, you might need help with other things like tax planning, charitable contributions, stock-based compensation, things like that. Another situation I would consider more complicated would be if you have a family member with special needs, you might have additional medical costs or planning for guardianship, things like that. And most robo-advisors really aren't equipped to help people with that.
Dziubinski: Another question that you suggest investors ask themselves is how confident they feel about managing their own investments and doing their own financial planning. Why is this an important question to be thinking about when it comes to whether you choose the robo-advisor route or the in-person financial planning route?
Arnott: Right. A lot of people actually do enjoy managing their own money and putting together their own portfolios. And as you know, a lot of those people use Morningstar.com to help them do research. If you're someone like that, you may not need a robo-advisor or a traditional advisor. But there are a lot of people who find the whole process of managing their assets intimidating and really would like to have someone there to give them more guidance and education. You can get some of that through a robo-advisor, but if you really are the type of person who likes to sit down and talk with someone and develop a relationship over time, you might be better off with the traditional financial advisor.
Dziubinski: Now, investors—you talk about having that experience of actually talking to a person. And you say that investors really should consider how important they think that would be—interacting with a human being as a part of this process. Do robo-advisors offer, or do some robo-advisors offer that experience where you can talk with someone?
Arnott: Yeah. When these programs first started coming out about 10 or 15 years ago, the original idea was that they would really leverage technology and primarily not offer a lot of human interaction. But over time, I think the lines have blurred, and the robo-advisors have realized that people do really want to be able to call someone and ask a question or get texts periodically to find out how they're doing. But in most cases, you're still going to get the most human interaction with a traditional advisor.
Dziubinski: And then, given that, who might be better off taking the traditional route of working with a financial advisor? How do you gauge how much of that human interaction that you need?
Arnott: I think it really depends on how you like to process information. Do you like to talk through your financial decisions with someone, or are you comfortable getting a recommendation on your computer screen or through a printout? And I think part of it also depends on whether you really like to build a relationship with time where you get to know an advisor and have the option of meeting with someone in person. And in that case, you might prefer to go with a traditional advisor.
Dziubinski: Amy, thank you so much for your time today, for walking us through some of these key questions we should be thinking about if we want to take the robo-advisor route. These will really help us make more thoughtful decisions. We appreciate your time.
Arnott: Sure. Great to be here.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.