How Technology Is Changing Investing | ModMoney

How Technology Is Changing Investing (And Why It Matters)

This post may contain affiliate links. We've all come to terms with the fact that technology is changing our world. Toddlers now have iPads, respectable adults play Pokemon Go, and robots can perform human jobs. Well, the investing landscape is no different. Technology is fundamentally changing the way we invest.

It matters because it's important to have a long-term investing strategy. Especially at a young age! Your 20s is generally the time when you can afford to take on some risk and allow your nest egg to grow exponentially (thank you, compound interest). While investing without any knowledge of the subject can seem daunting, technology is making it easier for new investors to get started.

Financial Advisors vs. Robo-Advisors

Traditionally, people rely on financial advisors to invest their wealth. Few of us have the time, desire, or insight to choose our own investments and maintain a balanced portfolio. So we outsource it. Financial advisors charge us a 2-3% fee and manage our money based on our risk tolerance and goals. That all sounds great. But what if you could replace your financial advisor with a software platform? Over the last few years, robo-advisors, or automated online investment platforms, have gained popularity. These online platforms use software algorithms to determine and maintain the right portfolio strategy for each person.

Besides the novelty, why are robo-advisors so popular? Put simply, they are inexpensive. They can charge a low fee because they are cheap to run. Think about it. A financial advisor can only assist so many clients before reaching capacity. A robo-advisor can achieve much greater scale. Once the software algorithm is created, it doesn't take much to keep it running for millions of people. Most robo-advisors charge 0.25%-0.5% of assets managed, while a financial advisor may charge eight times that! A few percentage points may seem low, but you pay these fees every year, and they increase as your wealth grows. Fees can have a material impact on your long-term returns.

Another reason robo-advisors are so popular is that their minimum account size is low and often nonexistent. This makes them perfect for new investors. On the other hand, financial advisors often require a minimum balance of $200,000 or more. Remember, you pay financial advisors a percentage of the assets they manage for you. The more money you give them, the more money they make. Managing a small account just isn't worth their while. However, a robo-advisor can give a new investor access to investment management at pretty much any size.

Some people are still not fully on board with the whole robot thing. They want a personal relationship with their financial advisor and a flesh-and-blood contact who understands their goals. And it's a fair point! However, there's no denying that robo-advisors offer a compelling value proposition, especially to new and young investors.

Who are these Robo-Advisors?

There are a number of online investment platforms in the market today. Some target a niche population, such as Ellevest for women. Most take a broader approach (Wealthfront, Betterment, Personal Capital, and Future Advisor, to name a few). I personally use Wealthfront and plan to write a separate post reviewing this software platform.

Sidenote: If you're interested in funding a Wealthfront account, you can sign up here. Wealthfront already manages your first $10,000 free, but if you sign up through my link, you'll get an additional $5,000 managed free!

These robo-advisors operate in similar ways. They start by assessing your risk tolerance through a series of questions. Then, they calculate the best asset allocation for you based on your age, expected retirement date, income level, wealth goals, etc. An asset allocation is another term for your investment mix, or how you spread your dollars across different asset classes to manage your risk to a particular level (think bonds, international stocks, domestic stocks, natural resources, etc.). As an example, I included a screenshot of a sample Wealthfront investment mix for a high risk tolerance. The robo-advisor then invests your money in passive index funds that line up with your strategy. Now we're getting more technical. Let me break it down for you in the next section.

Wealthfront Asset Allocation
Wealthfront
Betterment
Future Advisor
Personal Capital

Passive vs. Active Investing

We've talked about who we hire to advise and manage our wealth. But how is technology changing what we actually invest in? The answer lies in active vs. passive management. An actively managed fund means someone researches and chooses stocks in an effort to beat the broader market. As you might expect, this requires a lot of human capital and research hours. Which means these funds are more expensive. On the other hand, passive index funds are baskets of stocks created to track the market, not to beat it. For example, the Vanguard 500 is a passive index fund that tracks the S&P 500. If Apple makes up 3% of the S&P 500, then for every $100 invested in the Vanguard 500, Vanguard allocates $3 to Apple stock. Index funds invest according to a formula. Like robo-advisors, they are much cheaper than their human counterparts.

For a long time, people believed that active managers could consistently outperform the market. The problem is that humans are inherently flawed and can make costly mistakes based on whim or emotion. On the other hand, a passive index fund is objective and runs on autopilot according to a formula. More and more individuals and institutions have transitioned from an active strategy to a passive strategy largely due to under-performance from active funds. While you give up the ability to beat the market with a passive fund, you can at least be sure that the market won't outperform you.

Now, don't get me wrong. There are active funds out there that perform quite well. My point is that passive index funds are popular among investors for their simplicity, low cost, and solid performance. Robo-advisors invest your money in low-cost passive index funds, while financial advisors assume a more active strategy.

Why Does This Matter?

Many people don't have a long-term investing strategy, especially outside of their retirement fund. And it's a shame! I get this question a lot: "What should I do with my excess cash after I make my retirement fund contributions?" First, I recommend that you keep 3 to 6 months of living expenses in a safe savings account. You should also pay off any high interest rate debt. After meeting your near-term financial obligations, I think you should invest your incremental savings. Let your money work for you! If you let your excess cash sit in your back pocket, inflation will erode its value over time. But investing in the right portfolio strategy will help you reach your long-term goals much faster. Remember, compound interest is a powerful tool.

The Bottom Line

I firmly believe that everyone should have a long-term investing strategy. But I also know that it can be intimidating. If you are a new investor looking for a place to start, check out a robo-advisor. At the very least, fill out the initial questionnaire and get a sense for a portfolio strategy that makes sense for you. Many of these platforms also have blogs with helpful information for beginner investors. Investing does not have to be complicated or time-consuming, and technology is finally making it easier for investors of all levels to get started. I'd love to know if any of you use robo-advisors. Which ones? What do you think? Comment below!

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