In today's fast-paced world, many investors lack the time, knowledge, or skills necessary to research and manage an investment portfolio. In other cases, investors may simply lack the interest or desire to manage their own savings and investments.
In the past, investors generally had two options. They could pay a professional financial advisor to manage a portfolio of stocks, bonds, and/or mutual funds. Or, they could do their best to manage their own portfolio. Today, however, there is a third option: hire a "digital advisor."
Within the financial services industry, new technology is changing the way some people manage their investments. Rather than relying on a human financial advisor, investors who are digitally savvy and comfortable with a web-based relationship can manage their asset allocation and investment portfolios online, without ever speaking to an advisor.
A new category of online service providers —sometimes referred to as "digital advisors" or "digital advice providers"—has emerged in the financial services industry alongside traditional human advisors. Some of these firms are startups backed by venture capital firms, while others are new offerings from large and established players within the financial services industry.
How digital advisors work
Rather than discussing your needs and goals with a human advisor, most digital advisor interactions are conducted online through a website. These websites will guide you through an online questionnaire to assess your current financial situation, risk tolerance, and financial goals. Digital advisor firms then use this information and their own proprietary profiling algorithms to develop and suggest an asset allocation, build a diversified portfolio, and manage it over time.
Some digital advisor firms will invest your money in a mix of exchange-traded funds (ETFs) and mutual funds. It's important to note that these firms generally invest in passively-managed ETFs or funds, rather than funds that are actively managed. Some firms invest in a mix of individual stocks in separate accounts, although this option is less common. Once your portfolio has been constructed, your digital advisor will periodically rebalance it to maintain your target asset allocation.
Most digital advisors manage assets held within taxable accounts as well as IRA accounts. Within taxable accounts, some firms offer tax loss harvesting. This service generally involves selling a security that has experienced a loss to offset taxes on both gains and income in other positions. The sold security is then replaced by a similar one. The goal is to achieve a higher after-tax return for the customer.
Many traditional advisory firms have investment minimums of $250,000 or more, while minimums at digital advisors range from as low as $10 to $100,000. For this reason, these firms have thus far tended to attract younger investors who have not accumulated enough savings to hire a traditional advisor, or who may not need more sophisticated or personalized financial planning at this point in their lives.
Portfolio management fees at digital advisor firms may be significantly lower than what investors might pay a traditional broker or financial advisor. For investors with a long-term investment horizon of 30+ years, these lower fees could add up to thousands of dollars over time.
In addition to pure digital advisors, there is another type of offering that combines elements of the digital advisor model with access to a human advisor. Rather than simply relying on your responses to an automated questionnaire, these firms conduct a phone-based or video-based consultation to discuss your finances, goals, and risk tolerance, as well other details of your financial situation. If you become a client, these firms may also provide ongoing access to an advisor, usually via phone or video conferencing.
All digital advisor firms use their own proprietary algorithms to determine what they deem to be a suitable asset allocation for someone in your situation. Just as with human advisors, some firms may be more aggressive or less aggressive in their suggestions. Keep in mind that the suggestions will be based on the information you provide. So if you indicate that you have a high risk tolerance, the firm's suggestions will reflect that.
Is a digital advisor right for you?
Many investors struggle to maintain a disciplined approach to investing. In fact, independent research firms estimate that the average stock investor's returns trail the stock market significantly. The primary reason is bad timing.
Individual investors often let emotions influence their investment decisions. This sometimes results in buying at market highs and selling at market lows. Therefore, investors of all ages who are seeking a disciplined approach to investing may want to explore whether a digital advisor or other type of managed account would be a good fit for their needs.
Keep in mind, however, that if you have a complex financial life that includes stock options, sophisticated tax planning, or estate planning issues, or if you value the ability to interact with a human advisor, a digital advisor may not be able to provide the personalized financial planning help you need.
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