What Is a Robo-Advisor: Here’s How They Work
Saving for your retirement at an early age is an important step toward financial freedom in your golden years, but with an alphabet soup of IRA, SEC and 401(k), many younger investors find themselves stumped.
Turning to a human financial advisor used to be the sole way of getting help with an investment portfolio — until the rise of the robot, er, robo-advisor, that is.
A Guide to Understanding Robo-Advisors
Robo-advisors are gaining in popularity because they are cheap and accessible and often have much lower minimum investment requirements than traditional brokerage services.
In this guide, we cover topics that will help you decide if this portfolio management tactic is right for you.
What Is a Robo-Advisor?
A robo-advisor is an intelligent investment software that utilizes computer algorithms to determine how to invest a client’s money. The software that powers robo-advisors is the same software that financial planners have been using for more than two decades, but in 2008, when Betterment stepped onto the scene as the first robo-advisor, access to this unique software began to transition to anyone with a computer.
“Robo-advisor” is simply a much cooler and catchier term for automated investment services. Among those automated investing services offered are investment selection, retirement planning and tax optimization (also called tax harvesting).
How Do Robo-Advisors Work?
The short version: Robo-advisors use computerized algorithms too complex for us to understand that helps us invest our money wisely and lucratively.
The long version: Robo-advisors manage investments using the same technology that human wealth managers and financial advisors have had access to since the early 2000s. This technology utilizes passive indexing strategies, optimized with modern portfolio theory (MPT).
Each company’s algorithms will vary and are, obviously, proprietary. Some companies even offer specialty investment portfolios, like Hallal investing, hedge fund-esque investing (re: high-risk day trading) and socially responsible investing (if you want to make money but be a good person about it).
No matter the algorithm, you can anticipate that a robo-advisor, much like a real-life dedicated financial advisor, will diversify funds with your investment money to minimize risk. That means you should expect investments like mutual funds, low-cost index funds and exchange-traded funds (ETFs) that invest money in stocks (both in the US and abroad), bonds and even real estate investment trusts (REITs).
How Do I Get Started with a Robo-Advisor?
To get started with a robo-advisor, just research and select the online investment service that makes sense for your needs and sign up for an account all online. Luckily, getting matched with a helpful robo-advisor is much easier than matching your soulmate on Tinder.
Not sure where to start your search? Here are our top robo-advisors for 2022.
Once you’ve signed up for an account, the robo-advisor will typically give you a questionnaire that asks about your financial situation and your preferred investment strategy. Some of the questions might cover:
- Your investment timeline
- Your risk tolerance
- How much money you have in savings
You’ll also need to give the robo-advisor access to your funds, so be ready and willing to share your personal bank information.
With a clearer picture of your financial situation and goals, the robo-advisor can get to work, choosing investments for your initial funds. You’ll want to set up regular money transfers into the investment account so that your robot friend can keep investing more money for you.
Over time, the platform will likely rebalance your funds to ensure your investment strategy is still in line with what you envision.
And if at any time, your personal goals change, you can go in and alter them within the platform so that your strategy reflects said changes in investment goals.
How Much Do Robo-Advisors Cost?
While each company has its own pricing structure for robo-advisors, in general, you can expect to pay anywhere between 0.25% and 0.50% of assets under management annually. We’re talking less than a penny on the dollar.
That’s less than you’d probably pay for an actual human advisor. After all, robots require a lot less food and drink, and they typically aren’t worried about mortgage payments and student loans.
For example, let’s say you’ve got a $50,000 account balance. A 0.25% annual fee is just $125. That’s right: $125 for something (er, someone … robots are people too, yeah?) to manage $50,000 in assets and grow that money for you without you having to lift a finger.
And actually, there are free robo-advisor options, like SoFi Automated Investing. These have much more limited options, however, and are likely not worth the effort when better options are out there for such a low fee.
What Do Robo-Advisors Do?
The full scope of robo-advisors’ portfolio management services and features can be broad and varies from company to company. However, there is a typical set of brokerage services that robo-advisors offer, including basic investing, portfolio rebalancing and tax-loss harvesting. With a robo-advisor, you will also likely receive access to financial planning resources and maybe even a real human financial advisor.
Just like a real-life financial advisor, robo-advisors will typically target specific mutual funds or ETFs, rather than individual stocks, in an effort to grow your money over time. This can be helpful in building a nest egg for your retirement.
An important component of robo-advisors is that they offer portfolio rebalancing. Some do this automatically (in real time) while others do it at set time periods, like once a quarter. Using the algorithm, the robo-advisor will check your investments and make adjustments as needed to better meet your investment goals.
A type of rebalancing, tax-loss harvesting is a method that financial planners and robo-advisors alike use to help investors avoid capital gains taxes. To offset a capital gains tax for an investor, the robo-advisor will sell off similar securities at a loss.
Note: This only applies to if you have a taxable account.
Financial Planning Tools
Most robo-advisors offer a wealth of financial planning tools to help you make decisions about your future. Retirement calculators are a common tool.
Access to Real Financial Advisors
Sometimes, it’s nice to talk to a real person, especially when you’re making major decisions that affect your wealth. Many robo-advisors do have real people whom you talk to. However, this is typically an additional fee.
Note: Online planning services, like Charles Schwab Intelligent Portfolios Premium and Vanguard Personal Advisor Services, are a hybrid of real-world advisors and robo-advisors, with most things automated but giving you access to a team of professionals as needed. As such, they are typically priced in between the two options.
Pros and Cons of Robo-Advisors
Thus far, robo-advisors sound like a pretty sweet deal, right? And rightly so: There are a lot of benefits to robo-advisors. But they also have their pitfalls. Let’s explore both:
Pros of Robo-Advisors
So what are the top advantages of using an automated brokerage account to manage your portfolio?
- It’s so cheap. Human financial advisors typically charge 1% to 3% of your portfolio, but robo-advisors can go as low as 0.25%. That makes traditional brokerage services 4x to 12x as expensive, and oftentimes, they’re using the same software as robo-advisor platforms.
- You can’t beat the accessibility. Investment managers are humans. They have families; they go on vacations; they sleep. But robots? They’re ready to chat 24/7. A lot of people enjoy how accessible robo-advisors are. You can literally make changes to your account at 3 a.m. while binge-watching Stranger Things if you want.
- They typically have a low minimum balance and minimum deposit. To get started with some financial advisors, you may need a lot of dough. Some advisors won’t even start investing for you unless you have $100,000 to play with. But many robo-advisors boast minimum investment requirements as low as $500. Some are even lower. Of course, you’ll eventually want to invest more money to make more money, but the ease of entry is great for people who are just starting their investment journeys.
- It’s easy as pie. No knowledge about investing? No problem! No time for investing? Still, no problem. Robo-advisors do it all. However, it’s important to increase your financial literacy, so take advantage of your platform’s free educational resources when possible.
- It’s safe. All robo-advisors are required to register with the US Securities and Exchange Commision (SEC); this means they are beholden to the same legal regulations as human advisory services. And those that offer banking services, like savings accounts, also carry insurance with the FDIC (Federal Deposit Insurance Corporation).
Cons of Robo-Advisors
But of course, there are downsides to using a robo-advisor. Chief among them:
- Investment options are limited. While their algorithms do yield results specifically for you, robo-advisors often take a more one-size-fits-all approach. You might be able to talk strategies with traditional financial advisors, but unless you speak binary, you won’t get the same financial advice from a robo-advisor.
- Services are limited as well. Robo-advisors are really meant for basic investments. More complex issues, like estate planning, trust fund administration, saving for a child’s college and even complex tax scenarios, should be reserved for real human advisors. More experienced investors will also find the services limiting.
- It can perpetuate financial complacency. If you never take the time to learn more about investing, you may wind up leaving a lot of money on the table, just because an app is willing to do the work for you. While the convenience of automated financial planning services is great, prioritize learning so you can become more involved in your own financial future.
Should I Use a Robo-Advisor?
Robo-advisors are excellent tools for entry-level investors. If you are new to investing and want to save money or don’t have much funds to invest right now, most robo-advisors are a great gateway into building your wealth.
However, if you are a more seasoned investor or have a more complicated set of needs (estate or college planning, complex tax scenarios, etc.), you are better off working with a traditional financial advisor for your portfolio management.
Frequently Asked Questions (FAQs) About Robo-Advisors
We’ve compiled all the answers to the most frequently asked questions here in one place.
A robo-advisor is an automated investment advisor that uses computerized algorithms to determine how to invest funds on behalf of a customer.
Robo-advisors compile information about the customer, including risk tolerance and financial goals, and determine the proper asset allocation for that customer’s funds, rebalancing it as necessary over time.
Robo-advisor service offerings typically include basic investment (IRAs, SEPs, etc.), financial portfolio rebalancing, tax-loss harvesting (reducing capital gains tax liability) and financial planning resources.
Companies typically charge a fixed percentage of assets under management. This fee is much lower than what traditional financial professionals charge. You can expect to pay an annual fee of roughly 0.25% to 0.50% of your managed assets.
In addition to the flat percentage, robo-advisors look to other revenue streams to increase profitability. Some sell their software to human advisors, and some have added financial services like high-yield savings to their suite of products.
Timothy Moore covers bank accounts for The Penny Hoarder from his home base in Cincinnati. He has worked in editing and graphic design for a marketing agency, a global research firm and a major print publication. He covers a variety of other topics, including insurance, taxes, retirement and budgeting and has worked in the field since 2012.