March 1, 2018
March 1, 2018
If you’ve been paying any attention to the financial media in recent years you’ve probably heard about robo-advisors. They’re sweeping across the investment landscape, and drawing investment funds from large, small, and new investors alike. But while you may have considered investing with robo-advisors for long-term goals, like retirement, should you use one to save for your down payment?
It’s actually a reasonable consideration, giving the traditional savings accounts and money market funds pay less than 1% per year in interest. Even certificates of deposit typically pay no more than 2%, and only then if you tie up your money for several years. That’s when people who are contemplating buying a home begin thinking about trying equity investments to get a higher return, enabling them to save up the down payment more quickly.
But is that a recommended strategy?
A robo-advisor is an automated investment platform, that operates completely online. That is, they typically don’t have local branches or even human investment managers. Instead, the entire investment process is handled using investment algorithms that are based on popular investing strategies.
When you sign up for a robo-advisor, the first thing they do is ask you a series of questions. Those questions are designed to determine your investment goals, your investment time horizon, and most important, your risk tolerance.
Risk tolerance refers mostly to your attitude toward the possibility that you might lose money on your investments. They generally rank you somewhere between conservative and aggressive.
A conservative investor is one who has a low risk tolerance for loss and will, therefore, be invested in a portfolio that has mostly safe assets, primarily bonds. An aggressive investor is one who has a more casual attitude toward loss and will, therefore, be invested in a portfolio comprised of high reward/high-risk investments, primarily stocks.
Once that has been established, the robo-advisor creates a portfolio for you, that is comprised of exchange traded funds, or ETFs. The ETFs are usually index funds that are tied to popular stock and bond indexes, like the S&P 500.
Your account is typically not invested in individual stocks, since they are seen as being both more risky, and more expensive to trade. The whole purpose of a robo-advisor it to maximize your returns, and minimize losses.
Along the way, the robo-advisor handles all of the management of your portfolio. That includes rebalancing your portfolio, to make sure that the investment allocations within it remain consistent with the target portfolio design.
Robo-advisors charge only a very low annual management fee, that is well below the 1% to 1.50% that is charged by traditional human investment advisors. They typically charge something on the order of 0.25% of your portfolio, which means that you can have $20,000 professionally managed at the cost of just $50 per year.
That gives you the benefit of professional investment management at a very low cost. And since all of the management is handled by the robo-advisor, your only responsibility is to fund your account. You can even do that by making regular payroll deductions into the account.
The whole point of using robo-advisors to save for your down payment is to increase the return that you will get on your savings.
For example, if you save $5,000 per year for five years, with an annual return of 1% in the bank, you will have $25,644 saved. That means that you will have earned just $644 on your savings.
But if you save $5,000 per year for five years, with an annual rate of return of 7% in a portfolio that includes mostly stocks, you will have $29,834. That means that you will earn nearly $5,000 on your savings. And that’s like getting an extra year of savings as a bonus.
Almost as important is the fact that you can get that return without any extra effort on your part. That combination – a higher rate of return on your money, plus no additional effort – is the reason why a lot of people want to invest with robo-advisors.
The biggest risk of using a robo-advisor is the possibility that rather than earning money in your account, you could actually lose some of your investment.
Robo-advisors invest in stocks order to get returns that are higher than the interest that you can earn at a bank account. But in doing so, you are also running the risk that stocks can fall in a general market decline. It’s a fact of investing that higher rewards equal higher risk. You can’t pursue one without incurring the other.
If you are saving money for a down payment on a house, and the market turns against you while you are saving, you could actually have less money for the down payment than you actually saved.
If you’re contemplating using a robo-advisor to save for your down payment, it’s best to do so only if you’re not planning on buying a house for a few years.
Historically, the stock market has stayed down for no more than two or three years. If you plan to purchase a house in say, five years or more, you will have time to recover your investment, should the market fall in the short run.
It might make sense to save through a robo-advisor if buying a house is a long-term goal. Even then, you would probably be better off using a more conservative investment mix, which would reduce the risk of loss in your portfolio. Naturally, it would also reduce the return on your savings.
Fortunately, robo-advisors can adjust your portfolio, and create a more conservative mix. That would give you the ability to participate in gains in the stock market on the upside while limiting your losses on the downside. But even that strategy will only work if you have a few years before you buy a house.
Timing is the major limitation when it comes to using robo-advisors, or any other risk type investment when saving for a down payment.
If you are planning on purchasing a home within a year or two, you shouldn’t even be considering a robo-advisor. In that case, you should be saving your money in a completely safe investment, such as a bank savings account or money market fund. Certificates of deposit are also an option since they guarantee both principal and interest.
Everyone wants to earn more money on their savings. But when you have a specific goal, with a very short-term timeline, you’re best to play it close to the vest. Unless you’re planning on buying a home at least a few years into the future, you should be more concerned with protecting your principal than with earning a higher return on it.