Investing is as easy as ever.
In the old days, if you wanted to buy and sell stock you had to do so through a financial advisor. In one sense, those were great times. You got to sit down, face-to-face with a professional who had your best interest in mind.
But two things happened over the past decade: the Great Recession and the emergence of apps. The Great Recessions revealed that the financial industry doesn’t always keep the consumer’s best interest in mind. Banks and investors knowingly put their client’s money at risk for the sake of profit.
The backlash on the banking industry was immense. Movements like Occupy Wall Street reflected the general distrust of most Americans.
While this bad blood brewed, mobile-focused developers introduced a world where things like banking and credit card management took place through apps on cell phones.
You can see where this is going – eventually, app developers created a simple way to invest your money without having to deal with financial advisors. In just a few minutes’ time, you can enroll in what are known as robo-advisors, software platforms that use algorithms to automate the investment process.
As trendy as these automated advisors have become, it’s important to know what they do, what types there are and who should be using them.
We’ll talk about each of those areas in the next few minutes.
What do robo-advisors do?
The answer to the “What do they do?” question is pretty simple and really complex at the same time. To give you a sense of what the process is like, we’re going to take you through all the steps for setting up a robo-advisor, then talk about what’s actually happening.
A few months ago we signed up for a robo-advisor called Acorns. Once you download the app, you fill out your personal information, then connect banking accounts and/or credit-card accounts to the app.
You choose your investment strategy (low-risk, high-risk, etc.) and, when your account or accounts are successfully connected, you start investing.
From the Acorns app you can view your investment strategy, how well your investments have performed over the past day, week, month or year, and you get a general overview of your total investment from the app’s home page:
Acorns withdraws the change on every purchase in your connected accounts and then deposits it to your investment account, other sites like Betterment and Wealthfront withdraw pre-determined monthly deposits.
Where exactly do they put your money?
Remember how we said robo-advisors put your money in certain investments based on how much risk you want to take on? Well, that’s about the easiest way we can explain it. And really, if you just want a simple method to put your money away, that might be all you need.
But part of being a wise investor is understanding where your money is at. So, that’s what we’re going to do.
Robo-advisors, for the most part, tuck your money away in in Exchange-Traded Funds (ETF’s). Before we explain what that means, let’s take a step back and look at what types of investment opportunities exist for the average investor:
- Certificates of Deposit (CD) – Savings accounts with a guaranteed interest rate that lasts between one month and five years. Banks typically offer them and they’re a low-risk investment.
- Bonds – What investors issue to companies who need financing. When you purchase a bond as an investment, you’re given a coupon that guarantees you earn a certain percentage each year. This is also a low-risk option, but it involves a few more details than a CD.
- Stocks – Owning a share of a company, whether it be 0.001% or 75%. An individual stock’s prices fluctuate over time. Investing in one company can be dangerous, as you don’t have much of a backup plan if the company flames out.
- Mutual Funds – A mix of stocks and bonds created at various levels of risk. The money you receive as a result of your mutual funds going up is called a “distribution”.
So Where Do ETFs Fit In?
Investopedia gives a really great definition for ETFs: “An ETF trades like a stock on a stock exchange and looks like a mutual fund.”
But there’s another part of it that’s a little more complex. ETFs automatically “track an index”, which means an automated process decides what to buy and sell based on a group of stocks that represent the average growth of the stock market, for example.
There are several different kinds of indexes, which means there are many different kinds of ETFs.
Pretty Much Like an Easter Basket
Basically, an ETF is like an Easter basket and the stuff inside is the mix of stocks, bonds, and there investment types. Candy experts fill the basket based on what candy is selling well for the biggest candy companies on the market (biggest candy companies = an index).
The idea is that, over time, the ETF/gift basket will prove profitable because it’s following what the most successful companies are doing. It’s got a bunch of stuff in it, but if you don’t like it or you want a gift basket with stuff that only kids like (another type of index), you can sell your old basket and get the kid-friendly one.
This makes life easy, right? Instead of having to buy the basket and every piece of candy that goes with it, all you have to do is buy the pre-filled basket. And, you don’t have to do any crazy calculations to make sure your ETF’s are following the indexes you choose.
Your app, as it turns out, will do it for you through the magic of what’s known as algorithms. These mathematical calculations tell the app to follow certain trends for buying and selling based on what the market is doing.
So, when the index your ETF is following goes up or down, the algorithms in your app adjust your investments to follow that trend.
The idea here is that, over time, indexes will go up, which means your ETF will go up as well.
What Types of Robo-Advisors Are Out There?
We’ve reviewed three robo-advisors: Betterment, Wealthfront and Acorns. Each one invests your money in ETF’s made up of big companies, small companies, other stocks, bonds and in some cases, foreign currency.
The main differences between these platforms are fees, portfolios and services offered.
Betterment charges a 0.15% to 0.35% fee based on how much money is in your account. Wealthfront, on the other hand, charges a flat fee of 0.25% for account balances over $10,000. Anything under that is free.
The third site we reviewed, Acorns, charges $1 per month for balances under $5,000 and 0.25% per year for accounts over that. Students and those under 24 years old get free investing.
Based on what we’ve researched, we think that Wealthfront and Betterment offer better services than Acorns. Wealthfront has a pretty extensive retirement program that covers popular areas like IRAs and 401k’s. Betterment does an excellent job of educating their customers through a great support page and live chat option.
All three take your stock earnings (dividends) and reinvest them back into your account. If your ETFs aren’t matching what’s happening in the market, algorithms readjust your portfolio (“rebalancing”).
Both Wealthfront and Betterment’s algorithms ensure that you don’t end up paying tons of money in taxes (“tax loss harvesting”). These services are included in their fees.
Now, we don’t mind getting into the tiny details about each of these sites, but we think it’s important to tell you a little more about why robo-advisors were created and for whom they’re a good fit.
Who Should Use Robo-Advisors
Okay, so remember how we told you that robo-advisors became popular at the end of the financial crisis, right about the time that apps burst onto the scene?
That’s an important fact because, along with the revelation that some financial institutions were taking advantage of their customers, people started to realize that the average bank/advisor were charging a lot of fees for their investment services.
Those fee structures were really confusing, even for experts like Jon Stein (@JonStein), CEO of Betterment (@Betterment). Before Jon started Betterment, he was a financial services consultant and a CFA, which basically means he was a real-deal, full-on financial advisor.
He came to the point where he asked himself, “What do I want to do with my money?” He realized that if he, a well-trained expert, was asking that question then there had to be all kinds of average people asking it, too.
“I think it’s an intentional problem that has effectively been created by many in the financial services industry to make it confusing to manage your money effectively,” he said. “I had a lot of friends in finance and others who were incredibly smart, and there wasn’t a really good answer for what I should do with my money. I wanted things automated and easy.”
“There wasn’t a really good answer for what I should do with my money. I wanted things automated and easy.”
Eventually financial professionals and app developers caught on. Betterment was the first to create an investment app of this kind back in 2010, but soon after robo-advisors started popping up everywhere.
Let’s tie all this together. Fees for financial advising were everywhere. Managing your own money was really complicated. A few people in the industry got tired of it, so now we have a wide variety of low-fee, easy-to-use robo-advisors.
Robo-Advisors Work for People Who Want an Easy Way to Invest
One thing we’ve heard over and over again from experts is that robo-advisors are the perfect fit for someone who wants a simple way to invest and doesn’t care to make hands-on decisions about their stocks and bonds:
- David Ning (@MoneyNing) – “The set-it-and-forget-it nature of the service is one of the best, in my opinion, simply because people who set it and forget it tend to stay the course when markets become volatile – a key to building long-term financial wealth.”
- Han Chang (@InvestZen) – “These robo-advisors will handle asset allocation for you and invest in appropriate, low-cost funds based on your risk profile and investing objectives … There’s no thinking or analysis required.”
- Raghav Sharma (@GuideVine) – “Robo-advisors are well-suited for people who don’t’ have massive amounts of money or they are looking for a fire-and-forget solution. For people who have higher net worth, if they are looking for low cost, easy ways to put money into ETF’s and mutual funds, it can be a great tool.”
We tend to agree with the experts on this issue, mainly because our research shows that sites like Betterment place tremendous emphasis on automation and a fluid user experience.
They, along with Wealthfront and Acorns, are tailored for someone who doesn’t have a lot of time to research markets and just wants a one-touch solution.
The Final Bell: Wrapping Up Robo-Advisors
We’ve come pretty far, haven’t we? We started this article discussing why the financial environment was ripe for a solution like robo-advisors. Then, we talked about how you sign up for one and where your money goes once you start investing – Exchange-Traded Funds.
ETFs are a simple, relatively stable vehicle you can use for long-term investments. You can trade them like stocks but they’re put together sort of like mutual funds.
Sites like Wealthfront, Betterment and Acorns charge small fees to manage your accounts through their system of algorithms. There is variation between the three sites in terms of fees, portfolios and services. However, all three are, according to the experts, suitable for the average consumer who wants an easy, low-fee way to invest their money.
However, letting algorithms run your investments isn’t for everybody. If you’d rather use a financial advisor to manage your funds, take a look at our two-part series on how to choose a financial advisor.
Our first article helps you know which financial situations are best suited for an advisor, how financial advisors are different than financial planners and more. In our second article, we talk about red flags you should watch out for and we give you links to two websites that show you your advisor or planner’s background.