What Is a Robo Advisor and How Do They Work?

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    (Last Updated – March 23, 2023)

    What Is a Robo Advisor?

    Despite the name, a robo advisor is neither a robot nor an actual financial advisor, but a sophisticated computer algorithm that picks investments for you and helps you manage them over time.

    Typically, a robo advisor provides you with a questionnaire so you can set some parameters, like your financial goals, risk preferences, and time horizon. The algorithm then recommends an automated portfolio that aligns with your responses. You can use a robo investing as you would any account — for retirement, as a taxable investment account, or even for your emergency fund — and you typically invest using automatic deposits or contributions.

    Based on your goals, the robo advisor automatically rebalances the portfolio to stay within your chosen allocation. And some robo advisors may offer services like tax-loss harvesting. It can be a surprisingly easy yet sophisticated way to set up a portfolio, but it helps to know some of the details of robo investing in order to decide how a robo advisor might fit into your plan.

    Understanding Robo Advisors

    The history of robo investing or automated investing is an interesting one. While traditional (human) advisors have long worked with investors to help them create financial plans and manage their portfolios and other financial accounts, that system hasn’t worked for everyone.

    First of all, paying a live financial advisor to manage your money can be expensive, and sometimes the account minimums required to work with a professional advisor can be high as well. Also, in the last few decades, it has become evident that technological advances in financial services might benefit investors, but couldn’t afford (or didn’t want) to work with a live advisor.

    A Brief History of Automated Investing

    Lifecycle funds and target-date funds (TDFs) were among the first types of accounts to harness the power of technology to create automated portfolios for investors. These were, and still are, designed primarily for retirement savings.

    While there’s some variation in how target date and similar funds work, the basic idea is that an investor can pick a fund that’s geared toward a target date for their retirement (e.g. 2030, 2040, 2050, etc.). The fund’s portfolio is pre-designed. It provides a mix of investments that starts out more aggressive and gradually becomes more conservative as the target date approaches.

    To accomplish this gradual shift, most funds use an automated portfolio management function called a glide path. (Some college savings plans use a similar automated glide path function.) And some funds might have some input from a live portfolio manager.

    The Evolution of Robo Investing

    How do robo advisors work, and how are they different? Robo investing evolved partly as a way to improve on target and lifecycle funds, and offer investors an automated portfolio that they could adjust themselves, without the predetermined glide path. Target funds, sometimes called “set it and forget it” funds, generally don’t give investors the option of adjusting the underlying assets in the fund.

    Robo advisors — which build an investor’s portfolio with low-cost index and exchange-traded funds or ETFs — can also be used more easily for a range of shorter- and longer-term investing goals, not only retirement.

    In addition, robo advisor portfolios are designed to align with a range of investor goals, not only a target retirement date. For example, an investor with a very aggressive — or very conservative — outlook could select an automated portfolio that reflects their risk tolerance.

    Benefits of Using Robo-Advisors

    Why consider robo investing? It turns out there are quite a few benefits, including cost efficiency, potential performance, time, and helping control for human error.

    Cost

    When you remove the human part of the investment equation, the cost to invest with a robo advisor is often lower. That opens new possibilities for those who might have been turned off by the price, or higher account minimums, that come when you work with a professional investment advisor.

    Encouraging long-term financial plans and investment is important because many people may be financially unprepared for the future. The median retirement account value in the U.S. for people ages 35 to 44 is about $65,000. For those under 35, the median retirement savings amount is just $13,000, according to 2020 Federal Reserve data.

    💡 Check out our retirement planning guide to help you prepare for the future.

    Performance

    What’s more, many robo advisors offer low or no investment minimums, which can help some investors get started sooner — another potential upside, given the time value of money in the investing process.

    Performance is also worth considering, as the portfolio returns of an automated investment account can be comparable to what you’d get with a live investment advisor. This is due to the lower cost of robo investing, in many cases, since lower investment costs help improve overall returns.

    Another benefit is that you aren’t limited to a human advisor’s work schedule. Robo advisors are working for you 24/7, and you may have the flexibility to make changes to your investments.

    Correcting for Human Error

    Another key benefit of robo advisors is that they can help control human behavior. People — whether brand-new investors or seasoned professionals — are prone to make investment decisions based on emotions.

    The awareness of these cognitive and behavioral biases, as they’re called, has fueled the thriving field of behavioral research, which examines how fear (or excitement) can inspire poor investment choices.

    The understanding of these human impulses has also helped shape robo advisor technology. Because the portfolio is managed by the underlying technology, that can help people stick to their plan, and make logical financial choices rather than emotional ones.

    Automated Tax-Loss Harvesting

    Automated tax-loss harvesting is often considered a valuable tool for tax-efficient investing because it involves using an algorithm — rather than a human advisor — to sell securities at a loss so as to offset capital gains and potentially lower an investor’s tax bill. Some robo advisors offer this service as part of their automated portfolio structure (SoFi’s automated platform does not).

    Ordinary tax-loss harvesting uses the same principle, but the process is complicated and an advisor might only harvest losses once or twice a year versus automated tax-loss harvesting which can be done more frequently.

    💡 Recommended: Capital Gains Tax Rates (2023)

    Limitations of Robo Advisors

    While it’s true that automated portfolios offer a seemingly streamlined and often lower-cost approach to investing, there is more to the story.

    Fewer Choices

    Choosing a robo platform does give you some control over your investments, but your choices are quite limited compared with a portfolio you set up yourself or with a professional.

    The investments in an automated portfolio are typically low cost ETFs available through that robo platform. When you build your own portfolio through a brokerage, for example, you typically have a greater universe of choices, including index mutual funds, actively managed funds, individual stocks, and more.

    Less Control

    Automated portfolios are managed, essentially, by complex technological calculations that occur automatically behind the scenes. For that reason, it’s difficult for an individual investor to step in if they have a sudden life event or change of plan.

    In that sense, if you want to have more flexibility or control over your investments, a robo platform may not be a good fit.

    How Robo Advisors Make Money

    Part of answering the question, “how do robo advisors work,” requires looking at their cost structure. Given the number of different robo advisors on the market today, those costs can vary.

    Some robo advisors charge fees on a per-trade basis, while some charge a percentage of the value of your portfolio. Others may charge a flat monthly fee, particularly if an investor’s balance is under a certain threshold.

    Many robo advisors state their cost structure clearly up front, but not all do. In either case, it’s wise to double check what you’re paying. Most robo advisors still allow you to ask basic questions of a live professional, if you need to.

    How Much Do Robo Advisors Cost?

    All investments come with their respective costs, and it’s important for investors to look beneath the hood, so to say, and know what the fees are.

    While traditional advisors typically charge a fee of about 1% of assets under management, robo advisors’ management fees generally range from 0.25% to 0.50% of your assets. So if you have a $10,000 account balance, the annual fee to use the robo advisor would be about $25. That said, fees vary and there are frequently more than one type of cost associated with any portfolio.

    For example: Although robo advisors do use low-cost index funds and exchange-traded funds, the cost of those funds is passed onto the investor as well, in addition to the robo advisor’s basic management fee. Generally, all investment costs are deducted automatically from your account, which is why you may have to look carefully to gauge what you’re really paying.

    The fees charged by robo-advisors are important to pay attention to even if they seem low. Consider that a 0.25% fee would reduce an annual return of 7% to 6.75%. This reduction may not seem like much, but over the course of time, these costs can add up.

    So it bears repeating: Always weigh the fee options of different robo-advisors to make sure that what you’re paying is worth it to you. For example, a slightly higher fee might also give you access to a human financial advisor, who could offer you investment advice. If that kind of service is important to you, it might be worth paying a little bit extra.

    Choosing the Right Robo Advisor

    In addition to the fees you’ll pay, there are a number of other factors worth considering when you’re deciding whether a robo-advisor is right for you, including:

    Types of Investments

    Most robo advisors use a mix of ETFs and low-cost index funds. ETFs hold a basket of stocks or bonds and the vast majority of these funds are passively managed, i.e. they are built to mirror an index, such as the S&P 500. ETFs differ from index mutual funds in that they are traded throughout the day on an exchange, similar to stocks.

    ETFs come with certain risk factors. Because ETF shares are traded throughout the day, they’re bought and sold at the market price, which may or may not reflect the fund’s net asset value or NAV. Thus, an ETF’s performance is subject to market volatility. In addition there can be tax consequences, owing to the trading of shares.

    Mutual funds also include dozens or even hundreds of securities, but they only trade once per day. Mutual funds can be passively or actively managed. For example, index funds are mutual funds that hold a mix of investments and track an index.

    Just as you would examine an ETF or mutual fund to see what investments it holds, when choosing a robo advisor, make sure that it offers the types of investments that you want to include in your portfolio.

    The main difference, of course, is that a mutual fund or index fund generally invests in only one asset class — like stocks or bonds or commodities. A robo advisor can include a variety of asset types, to create a portfolio that’s allocated or aligned with your goals.

    Account Type

    You’ll typically be offered two broad types of accounts when you consider a robo advisor: a retirement account or a regular taxable investment account. A standard investment account has no limits on the amount of money you can invest.

    Retirement accounts, such as traditional IRA and Roth IRAs, offer specific tax advantages, but these come with contribution limits. The 2023 annual contribution limit for a traditional or Roth IRA is $6,500, with a $1,000 “catch-up” provision for those 50 and older.

    Be clear about your goals when you choose your account type. If you’re saving for retirement, the tax advantages of retirement accounts are important to consider.

    But if you’ll need access to the money sooner because you’re saving for another goal, consider a regular taxable account. You don’t want to face the early withdrawal penalties and tax implications that can come with dipping into retirement accounts too early.

    Portfolio Offerings

    Robo advisors usually offer a fixed number of investment options or pre-set portfolio allocations — sort of like a prix-fixe menu at a restaurant. The robo advisor will typically have you fill out a questionnaire, and then recommend one of these portfolios based on your goals, comfort with risk, and time horizon.

    In some cases the questionnaire doesn’t lock you into a portfolio, so you might be able to override the default selection to create a portfolio of your choice. If you don’t see an option you want, it’s important to ask.

    Additional Perks of Automated Investing

    Once you’ve signed up for an account with a robo advisor, you will typically be offered a range of automated services.

    Rebalancing

    Based on the process described above, let’s assume you were placed in an allocation that consists of a mix of 60% stocks and 40% bonds. Over time this allocation will likely shift a bit as investments fluctuate based on the movement of the market.

    For example, the stock market may grow faster during a particular period of time than the rest of your portfolio. Rebalancing your portfolio helps you buy and sell assets to realign the investments inside your portfolio to the desired allocation.

    Recurring Contributions

    Many robo-advisors make it easy to establish sound financial habits such as ongoing saving by establishing recurring contributions. A common example of recurring contributions is in an employer sponsored plan such as a 401(k).

    The value of recurring contributions is that they automate the tough decision of saving for the future. This strategy is not just limited to your 401(k), and might help you be more disciplined with your other accounts.

    Access to Humans

    Some robo-advisors combine the cost-effectiveness of technology with the expertise of humans by offering access to financial professionals. This hybrid approach can enable investors to ask questions, discuss goals, and plan for the future. Robo-advisors might charge for this service, but it tends to be optional if it is offered.

    Robo Advisor Growth & Growing Pains

    Since their inception in 2008-2009, robo advisors have gained in popularity, with roughly $800 billion under management today. Still, the number of people who choose automated platforms is a small fraction of the overall investor population — about 1%.

    Generally, investors who choose robo advisors tend to tilt younger, with some robo companies reporting that their average investor is under 40.

    Despite the steady growth of this market, robo advisors have seen some growing pains. In a couple of cases, the use of cash deposits by the investment company warranted SEC intervention, and companies have also been charged with misleading investors as to the exact nature of the investments offered by the robo platform.

    The Takeaway

    There’s no denying that the convenience and cost efficiency of robo advisors has generated a lot of interest from investors. Robo advisors can offer investors a streamlined experience, and they can also be a low-cost way to set up an investment portfolio to help investors reach their goals.

    As noted above, however, there are potential drawbacks to the one-size-fits-all approach of robo-advisors. These automated plans may not be useful for investors with more complicated situations (e.g., if you’re going through a divorce, navigating multi-generational wealth, or seeking answers to nuanced questions like the timing of your retirement versus saving for college).

    Cases like these, and others, may require a more hands-on approach or a strategy tailored to an individual’s unique circumstances or life events, which is not what a robo-advisor is designed to do.

    That said, robo advisors can be an effective financial tool, especially for those who are just starting to invest, and who don’t yet have complicated investment needs. For example, younger investors who are still accumulating assets may find that robo-advisors are a good fit. The low cost of robo-advising has lowered the barrier to entry for many investors, giving them access to tools once reserved for higher-net-worth individuals.

    Additional Resources on Robo Advisors


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