What Is a Robo-Advisor?
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A robo-advisor uses computer algorithms to create and manage investment portfolios. Designed as a way to bring professional money management to the general population, robo-advisors eliminate two common bars that used to prevent some people from investing: high fees and high investment minimums.
A robo-advisor is an automated tool that uses computer algorithms designed by financial advisors, investment managers and data scientists to build and manage investment portfolios. Designed as a way to bring professional money management to the general population, robo-advisors offer a user-friendly way to invest in the stock market with low fees and investment minimums. They are growing in popularity because they offer high-quality tools that meet many investment needs.
Does a robo-advisor invest in stocks?
For many, playing the stock market seems like a distant dream, restricted to seasoned professionals with an inside track to the complex world of investments. If you want to invest, your choices are limited to hiring a professional financial advisor to build and manage a stock portfolio, or do it yourself. A financial advisor generally requires a significant investment to get started and can be expensive. Now a third choice has emerged: the robo-advisor. Robo-advisors provide computerized tools used by entry-level investors with little investment knowledge and by seasoned investors who seek ways to save time.
Robo-advisors are financial software products designed to help users manage investments without the need to consult a financial advisor. Users typically access the services by downloading an app or setting up an online account. Robo-advisor platforms and related services are provided by financial institutions or companies created with the sole purpose of providing robo-advisor services.
The services, fees, start-up minimums and inner workings of robo-advisors vary depending on the provider you choose. However, users can generally expect the tool to build a portfolio optimized to their financial goals and provide monitoring services to limit risks as the market fluctuates.
While a robo-advisor is considerably less expensive than hiring a financial advisor, you can expect to pay ongoing fees for the services you choose. These can be either a fixed monthly fee or a percentage of assets. Monthly fees can be as low as $1 per month. Percentage fees generally range from 0.25% to 0.50% of your assets, but can be upwards of 0.80%. It's important to note that maintenance fees are not the only cost. The mutual funds and exchange-traded funds (ETFs) within your account come with their own expense ratios, which are taken out of the assets before you get returns.
Because robo-advisors provide convenient access to the stock market at such a low cost, it makes sense to wonder if robo-advisors are safe to use. Fortunately, robo-advisors are held to the same legal obligations as human advisors. They must be registered with the U.S. Securities and Exchange Commission and are subject to the same laws and regulations.
While robo-advisors aren't the perfect solution for every investor, they offer affordable digital financial services that use technology to help automate investing.
The origin of robo-advisors
The first consumer-facing robo-advisors — Wealthfront and Betterment — launched in 2008 during the financial crisis, with different goals.
Wealthfront founders Andy Rachleff and Dan Carroll originally aimed to provide financial advice to the tech community. They soon shifted their focus when they recognized that the software could make investment advice accessible to more people at a lower cost.
Betterment's cofounder, Jon Stein, initially wanted to automate the process of selecting and managing investments to make investing simple for its clients.
These companies were the first to provide the general public with access to digital financial advisors, but the technology was already well established among financial professionals. Since the early 2000s, wealth managers have been using portfolio allocation software to help diversify customer portfolios to align with their financial goals and personal risk tolerance. Before the launch of Betterment, clients had to employ a financial advisor to benefit from this kind of technology.
How does a robo-advisor work?
While robo-advisors come with lower fees and investment minimums, they lack the human touch provided by financial advisors. Automated solutions can't replicate human interactions. Instead, robo-advisors employ strategies based on investment practices and knowledge accumulated over the years by human financial experts.
Robo-advisors work much the same way as human financial advisors. They create individualized portfolios for investors and maintain the investment through rebalancing and tax-loss harvesting. This is accomplished with the use of algorithms that follow a passive investing strategy..
Passive investing is a strategy that reduces risk.
Essentially, an investment manager picks a portfolio and holds the investments for the long term, buying and selling securities only when necessary.
The most popular form of passive investing is the index fund. An ETF or a mutual fund tracks an index by buying all the securities in the benchmark. This cuts costs by reducing the research needed to pick stocks and the commissions for buying and selling.
While there is value in long-term investments, and passive management does little trading, set-it-and-forget-it is not a great financial strategy. For this reason, portfolios must be maintained to limit losses due to market fluctuations. Robo-advisors monitor portfolios to ensure they maintain their value by setting specific limits under which each individual security can fluctuate.
Tax-loss harvesting is a method to rebalance a portfolio to minimize taxes. You sell an investment where you've lost money, a capital loss, to offset the sale of another security where you made money, a capital gain. Robo-advisors take care of these maintenance activities to help investors lower their capital gains taxes.
What does this process look like to investors?
As a new customer, you’ll begin by opening an online account through an app or a website. After establishing an account, you fill out a brief questionnaire asking for personal information. You’ll answer questions about your investment goals, time horizon (the length of time before you'll cash out your investment), and your overall risk tolerance. During the setup, you'll also provide a startup deposit and possibly connect a bank account for continued funding.
The robo-advisor then runs your answers through an algorithm to build a diversified portfolio of mutual funds and ETFs based on your investment goals. This is where personalization comes in. Investment assets for short-term goals, such as a car purchase, will look different than those for long-term goals, like retirement. Some robo-advisors even offer individual retirement accounts (IRAs) for retirement purposes.
Once your capital is invested, the software automatically makes adjustments to rebalance your portfolio in response to market changes and ongoing deposits. These rebalancing efforts ensure your portfolio remains close to the target allocation. Once you set up an automated account with a robo-advisor, you can basically watch your money grow until you’re ready to withdraw it.
Who uses robo-advisors?
While robo-advisors were originally designed to make investing easier for people with minimal investment knowledge and little wealth, many seasoned investors also use them. Since the services are automated, investors can create and maintain diversified portfolios while saving a considerable amount of time and effort. These examples describe how the services provided by a robo-advisor can help different investors reach their goals.
Novice investors: Inexperienced investors can use robo-advisors to successfully invest in the market. Since the service creates a diversified portfolio for the investor, you can start investing even if you have little to no knowledge about investing.
- Seasoned investors seeking a hands-off approach: Automated services provided by a robo-advisor include the creation of a diversified portfolio and daily maintenance. To complete these actions without any assistance, an investor would need to spend considerable time researching investments to create a diversified portfolio. Effective maintenance to avoid losses also requires a significant time commitment. Some investors choose a robo-advisor for this convenience.
- Lower-wealth investors: To work with a financial advisor beyond the advisor’s fee, you may be expected to come up with a minimum investment of $50,000 to $100,000. Many robo-advisors allow investors to begin with a small investment. Some don't even require a minimum amount.
- Retirement investors: There are many reasons why an individual may be responsible for setting up their own retirement fund — and it can be difficult to know where to begin. If you're self-employed, work part-time or have little confidence in your employer's retirement plan, a robo-advisor can help you save for retirement.
- Investors with specific goals: Savings accounts are a common tool used by individuals to reach long- and short-term investment goals. However, they don't offer the same returns as investments. Investors with specific financial goals can use a robo-advisor to put their seed money to work to reach those goals.
- Knowledgeable investors seeking efficiency: For investors seeking a passive investment strategy, robo-advisors can provide a convenient way to manage a portfolio. Beyond the benefits of automatic maintenance, the account is generally accessible 24 hours a day and investors can execute trades with a few clicks of a mouse.
Are robo-advisors for everyone?
Like most products and services, robo-advisors have their limits. They're not suited to the investment needs of some individuals because they lack the freedom and control that many experienced investors seek.
While robo-advisors use questionnaires to provide a level of personalization, the process is determined by computer algorithms. This means that your survey answers are basically used to place you into a category of investors. If your investment needs are particularly complex, the service might not provide the personalization you need. For example, if you need a comprehensive financial plan that can help you do more than save for a specific goal, you aren't likely to get the financial advice you need from a completely automated robo-advisor.
It's important to remember that robo-advisors are designed to make investing easier by automating much of the process. For investors who understand the ins and outs of investing, and are interested in having significant control over the securities they invest in, a robo-advisor would be a poor choice.
Additionally, investors with significant experience might discover they're paying for services they don't need.
Robo-advisors are essentially designed for investors who want help selecting and managing an investment portfolio. They are not financial advisors that can help you make decisions about your financial future. Investors seeking a comprehensive financial plan that assists with spending habits and multiple long-term goals aren't likely to be satisfied with the services provided by a robo-advisor.
Finding the right platform for your goals
There are numerous solutions that can help investors find the balance they need. Since robo-advisors come in many shapes and sizes, success could be as simple as choosing the right tool. When choosing a robo-advisor, it's important to have a clear understanding of your investment goals and your personal risk tolerance. Once you have this information in hand, you can compare solutions to find a robo-advisor that provides the support you need.
Conversely, if you're seeking comprehensive financial advice, you'll want to consider the value a human financial advisor brings to the table. Many financial firms offer access to robo-advisors that combine automated services with added advisory services. These solutions provide access to online tools along with occasional meetings with an advisor to discuss financial planning needs and investment goals. A robo-advisor combined with a traditional solution can be augmented to meet your needs and budget with advisory services that are available online or in person.
Robo-advisor key takeaways
With lower costs and few investment requirements, robo-advisors provide a way for a variety of investors to enter the market and successfully grow wealth. Determining whether a robo-advisor is right for your personal financial investment needs requires research and a firm grasp of your financial situation. If you're unsure of your needs and are seeking a way to create an investment portfolio, a fully featured robo-advisor can be a good place to start.