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How Do Robo Advisors Work?

By Susan Guillory · September 22, 2021 · 8 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

How Do Robo Advisors Work?

What is a robo advisor, exactly? Despite the name, it’s 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 builds an automated portfolio that reflects your choices. 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.

What Is a Robo Advisor?

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 50 or 60 years, it has become evident that a large portion of investors (or would-be investors) didn’t actually need a complex financial plan — but they did need something to help them achieve greater financial security.

Recommended: Robo Advisor vs. Financial Advisor: Which Should You Choose?

A Brief History of Automated Investing

Lifecycle funds and target date funds 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 funds.

While there’s some variation in how these 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 includes a mix of investments that starts out more aggressive and becomes more conservative as the target date approaches — using an automated portfolio management function called a glide path. (Some college savings plans use a similar automated glide path function.)

The Evolution of Robo Investing

How do robo advisors work, and how is it 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 — can also be used more easily for a range of shorter- and longer-term investing goals, not only retirement.

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 goes down considerably. 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.

Performance

What’s more, many robo advisors offer low or no investment minimums, which means you can start investing any time — 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 (and in some cases greater than) what you’d get with a live investment advisor. This is also due to the lower cost of robo investing, in many cases, since lower investment costs help improve overall returns.

Recommended: How to Track Robo-Advisor 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 can make changes to your investments at any time.

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.

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?

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.

Although robo advisors typically use low-cost index funds and exchange traded funds (ETFs), 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.

Recommended: What Are the Different Types of Investment Fees?

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:

Investment Type

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.

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 and Roth IRAs, offer specific tax advantages, but these come with contribution limits. The 2021 annual contribution limit for a traditional or Roth IRA is $6,000, 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 hard to beat.

But if you’ll need access to the money sooner than that because you’re saving for another goal, consider a regular taxable account. You don’t want to face the early withdrawal penalties and tax implication 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, investment preferences, comfort with risk, and time horizon.

This 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-Advisors and the SEC

In 2020, robo advisors in the U.S. reported about $323 billion in AUM, with some projections suggesting that number could reach $1.2 trillion by 2024 (estimates vary). But as robo advisors become more popular, the Securities and Exchange Commission (SEC) seems to be stepping up its oversight of these companies in order to protect investors from fraud.

In 2018, the SEC brought its first actions against two robo advisors for misleading customers, leading to settlements of over $300,000 combined.

There has been little SEC activity in the years since then, but given the rapid asset growth among robo-advisors, there could be greater SEC scrutiny of the industry overall.

The Takeaway

There’s no denying that the convenience and cost efficiency of robo advisors has generated a lot of interest from investors. This year, some 3.5 million people will use a robo-advisor to handle their portfolio — an increase of about 23% over 2020. Robo advisors are easy to use, yet they can also be a sophisticated, low-cost way to set up an investment portfolio to help you reach your goals.

There are some 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 one’s retirement versus saving for college). Cases like these may require a more hands-on approach or a strategy tailored to an individual’s unique circumstances, 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, millennials 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.

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Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected] Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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