Robo Advisors vs. Index Funds

While most people understand that investing for retirement is a good idea, the way to get started can be unclear. Two investment tools investors may start out with include robo-advisors and index funds. Investors can utilize either of these without committing to hours of market research or constant manual oversight. The following information will help you understand which might be a better fit depending on your financial plan. You can also enlist the help of a financial advisor who can help you create that financial plan or help you choose the right investment options.

What Is a Robo Advisor?

A robo-advisor is an electronic investment service, typically through the website or app of a firm, bank or other financial institution, that helps you invest based on your financial circumstances and preferences. Once you provide information about your financial goals, comfort with risk and how long you plan to hold your investments, a robo-advisor’s algorithms send your money into motion and create a portfolio.

Robo-advisors automatically adjust your portfolio based on your selected investment strategy. Because a program manages your money, robo-advisors charge lower fees than human financial advisors. You pay for digital investment services instead of hands-on assistance from a person working in the financial industry.

What Is an Index Fund?

Index funds come in two types: exchange-traded funds (ETF) or mutual funds. ETFs trade throughout the day, while investors can buy or sell mutual funds only once per day. Index funds correlate with a specific market index consisting of a comprehensive selection of stocks. Many index funds follow the Standard and Poor’s 500 Index (S&P 500), but diverse stock indices available to investors number in the thousands.

Since the S&P 500 invests in companies with the highest market capitalization, it tends to lean heavily into tech. Clients looking to broaden their investments may want to look into index funds that match other sectors of the stock market.

Because index funds’ performances automatically mirror the stocks of various market indexes, they don’t require active management. Therefore, index funds have low fees compared to financial managers who seek out investment opportunities with higher potential returns and more risk than the average index fund.

Robo Advisors vs. Index Funds: Key Differences

Robo-advisors and index funds both offer clients passive management-style investing. However, crucial differences might make one more suitable depending on your financial circumstances.

Manual Input: Robo-advisors operate automatically once the client enters their financial goals and risk tolerance. Therefore, robo-advisors buy and sell stocks and bonds without manual input or oversight from a human manager or the client. Of course, clients can change their preferences and redirect a robo-advisor’s actions at any time. On the other hand, investors decide which index they want to buy or sell and can shift their money into a different index fund at will.
Additional Services: Robo-advisors provide clients with services that help them define their financial goals and investment methods. Additionally, most robo-advisors can utilize tax-loss harvesting to minimize taxes owed on profitable investments. Index funds offer no additional services, only serving as investment vehicles that match specific portions of the stock market.

Robo Advisors Strengths and Limitations

Working with a robo-advisor can be advantageous to investors for the following reasons:

Robo-advisors usually have minimal to no balance requirements, meaning you can start investing with a robo-advisor with any amount of money.
Robo-advisors use client input and information to create a personalized investment strategy.
Clients can access various financial tools for free, and for an additional fee they can communicate with a human manager for more help.
Robo-advisors can implement a personalized, sophisticated investment approach with fees lower than a human investment professional.

Just as human financial advisors have their limitations, robo-advisors can carry these drawbacks:

Robo-advisor total costs are usually higher than those for investing in a mutual fund or ETF. Accessing human assistance through a robo-advisor will cost additional fees.
Robo-advisors typically have access to a narrow range of funds and indexes, curtailing your ability to invest in particular stocks or market sectors.
Once the robo-advisor receives your data, it makes automatized decisions unless you intervene. Therefore, you will need to give additional input if you want to pursue a new investment strategy.

Index Fund Strengths and Limitations

Index funds can offer investors the following benefits:

Maintaining your index fund investment account is cheaper than a robo-advisor. Some index funds do not charge investors any fees.
Index funds are myriad and diverse, giving investors hundreds of choices.
The investor decides which funds to put money into.
Index funds can serve as a solid foundation for an IRA or 401(k) that you plan on contributing to for years or decades.

While index funds are flexible and inexpensive, they may carry the following drawbacks:

Unlike robo-advisors, index funds do not come with financial tools or investment advice.
Investors may need to occasionally adjust their investments or risk drifting away from their financial targets.
Because index funds usually require a certain amount of cash to create an account, a new investor with a small initial investment may find it difficult or impossible to start investing in them.
Generally, index funds require time to provide stable, healthy returns. Investors looking to retire soon may prefer the predictability of bonds or other securities instead of an index that mirrors stock market volatility.

The Bottom Line

Robo-advisors and index funds are ways for people to start investing without spending excessive amounts of time, research and money. Investors looking for a mix of investment advice, assistance with strategy and automatized management may want to create an account with a robo-advisor. On the other hand, index funds may be better for those looking to minimize fees and implement a long-term investment strategy that follows swaths of the stock market. Typically, your overall financial plan will decide which one is right for you.

Tips on Investing

Before committing to a specific investment strategy or service, you can likely benefit from the insights of a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you invest, get started now.
Success in investing is partly about your portfolio’s asset allocation. SmartAsset has an asset allocation calculator that will assist you in picking the right asset allocation for you.
How much in taxes will you pay in retirement? Let SmartAsset’s retirement calculator help you determine your potential tax liability.

Next Steps

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