Over the last decade, robo-advisors have exploded onto the investing scene and disrupted how individuals invest. Old-school investment management companies employ lots of people with finance and math degrees to figure out what’s going to happen to specific stocks and the stock market as a whole.
To cover the cost of running the company, they charge a management fee, usually around 2 to 2.5% of your total portfolio annually. This may seem like a small amount until you remember that you should actually be comparing the (annual!) fee percentage to the annual return percentage. Assuming an average return of 5 to 8%/year, a 2.5% fee would eat up one-third to half of your annual returns. Ouch! This hurts your portfolio in two ways: first, by making it smaller than it could be right now. Second, by slowing down the compounding growth of your money in the future.
You’ll eventually wise up to the effect fees have on your portfolio’s growth, do a bit of research, and learn about robo-advisors.
So what is a robo-advisor?
Essentially, instead of having lots of workers read company reports all day and create technical charts and shake an 8-ball, a robo-advisor uses computers and algorithms to manage investments with minimal human intervention. This translates into big savings for the company since computers are cheaper than workers, which means that robo-advisors typically charge much less than traditional investment firms. Most robo-advisors charge around 0.5% fee on top of the fees charged by the funds in the portfolio they create for you.
Robo-advisors generally have several different portfolio types. When you set up an account with a robo-advisor them, they get you to fill out a quiz to figure out things like your investment horizon (how long you plan on keeping that money invested) and risk tolerance (essentially, how much of a drop in your portfolio you can handle before it starts affecting your emotions or behavior), and whether you have any additional considerations (for example, a preference for halal or socially responsible investing). Once they have an understanding of your investing mindset, they’ll recommend a portfolio for you. Their portfolios are generally made up of the exact same low-fee exchange-traded funds (ETFs) that you could buy yourself as an individual investor. As you add cash to your investment account, the robo-advisor will use that cash to purchase assets that will keep your portfolio balanced and on track, so there’s no need for you to do any calculations yourself or stay up late inputting numbers into spreadsheets.
A robo-advisor is a great choice for certain investors, such as those who have graduated from high-fee mutual funds but who aren’t jazzed about spending their spare time managing their investments themselves
One thing to keep in mind is that, when you’re starting out with investing, paying that extra 0.5% each year to a robo-advisor may not break the bank, and the value you get out of it may be worth it for you. But past a certain portfolio size, you may balk at the amount you’re paying for such a simple service.
As a quick example, if your portfolio is $25,000, and you pay 0.5% to your robo-advisor (we’ll ignore the fees associated with the funds themselves for now), you’ll be paying the robo-advisor $125 each year. That may seem like a reasonable price to pay, but once your portfolio grows to $100,000, that fee increases to $500. At a portfolio size of $250,000, you’re paying the robo-advisor $1,250 every single year. This scaling fee has a large effect on your portfolio over time, as shown in the graph below.
In the graph above, you can see the outsized effect that “small” fees have on your portfolio over your investing lifetime. If a 25 year old invested $5,000 in ETFs (~0.14% fee) every year until they retired at 65, their portfolio could be over $1 million. However, if they had invested the same amount in mutual funds (~2.5% fee) or robo-advisors (~0.64% fee), they would have significantly less — about $481,000 and $139,000 less, respectively. You can see that mutual fund fees create an enormous drag on portfolio growth, while the drag of robo-advisor fees is less but still significant. Imagine how many trips you can take or how much sooner you could retire with an extra $139,000.
You can see that, as your portfolio size increases, the cost of using a robo-advisor scales up higher and higher, and this cost becomes a larger drag on your portfolio as the years go by. Rather than using a robo-advisor and paying this fee, many investors have taken control of their own investment portfolios. This is called do-it-yourself (DIY) investing.
DIY investing to save on fees
If you’re interested in investing for yourself to save more, here’s how you can start your DIY investing journey.
Open an account at an online brokerage
When choosing an online brokerage, make sure to compare trading fees, account fees, account minimums, and the quality of their customer service. Once you made your choice, opening an account is fairly straightforward and will only require you to fill their online forms and make an initial deposit. The cool thing about brokerages is that most, if not all, offer free ETF purchases which are basically the same funds robo-advisors invest your money into.
Generally, it is wise to max out contributions into tax-sheltered accounts like TFSAs or RRSPs before you invest in other types of accounts where you’d have to keep track of your returns and pay taxes on profits and dividends.
Set up your portfolio
The first step is to choose the assets in your portfolio, which can be quite intimidating. A little bit of research is required here but you can start by looking into replicating a robo-advisor portfolio, or another popular option is to use the Canadian Couch Potato portfolios.
The choice of ETFs and allocation are dependent on your investment objectives (how much returns you want), your investment horizon (the longer time, the more you can handle market swings), and risk tolerance.
Set up recurring contributions
The next step is to build a consistent habit of contributing to your investment account(s). There's no reason to have your cash sitting idle in your chequing account. Set up a pre-authorized deposit to your brokerage account to make sure you pay yourself first.
Invest and rebalance
When new cash hits your account, or there are market swings, you will want to rebalance your portfolio.
Rebalancing is simply the act of bringing your portfolio back to what its intended allocation is. Let’s say for example that you want your portfolio to be 50-50 in ETF a and ETF b. With market fluctuations, ETF a goes up and now your portfolio is 60-40. Rebalancing would mean selling some of ETF a to buy more ETF b to get back to 50-50. This can also be achieved by allocating new cash to ETF b.
There are a lots of spreadsheet templates to help you allocate new cash to your account or rebalance if your allocation gets too far from your targets. You can also use automated tools like Passiv to help you with managing your portfolio. If you’ve got a brokerage account with Questrade, you’ll get access to this tool for free. So, it’s a great perk of being with them!