If you don’t like the hands-on approach of investing, a robo-advisor can set up an investment plan for you and manage it, letting you focus on other things that you love instead. But the idea of letting a software algorithm select your investments may seem somewhat strange to many new investors.
Keep reading to learn more about what robo-advisors are, how they work and whether investing in one is right for you.
What Is a Robo-Advisor?
There are many definitions of what exactly a robo-advisor is. To put it simply, a robo-advisor is a digital platform that automates the investing process with little to no human supervision. A typical robo-advisor gathers data about your current financial situation and future goals, then automatically invests based on the information provided.
Though some robo-advisors are entirely automated, others give you access to human financial advisors, but only for services that require human assistance, like estate planning, retirement and taxes.
Unlike conventional financial advisors, most robo-advisors charge low fees. For that reason, many investors find robo-advisors fairly reliable, often producing favorable outcomes even during market upswings. Plus, it lets you get started with investing quickly, usually in a matter of minutes.
How Does a Robo-Advisor Work?
Behind closed doors, investment professionals who work like traditional financial advisors manage robo-advisors. But, instead of serving one customer at a time, both robo-advisors and human advisors work to serve thousands of customers at once.
Working with a Robo-Advisor
- As soon as you sign up, the automation process begins with a questionnaire designed to help the software that runs the robo-advisor understand your current financial situation, financial goals and risk tolerance.
- Based on the answers you provide, a robo-advisor assigns you a portfolio that aligns with your investment goals.
- Some robo-advisors may, however, give you control over your investments, letting you tweak your portfolio to meet your current financial goals. Others also offer advanced features, like automatic rebalancing and automatic tax-loss harvesting.
Robo-advisors essentially build their investment portfolios out of low-cost exchange-traded funds, such as index funds and mutual funds. Today, most robo-advisors use modern portfolio theory to set up their portfolios — the primary goal of MPT is to diversify portfolios by maximizing returns while reducing risk.
How Much Does a Robo-Advisor Cost?
In terms of cost, robo-advisors are relatively cheap compared to traditional financial advisors. Robo-advisors often charge in two ways: management fees and fund fees.
Generally, most robo-advisors charge annual management fees of 0.25% to 0.50% of your assets. However, others charge a fixed monthly fee instead. Let’s say you have an investment balance of $10,000, a 0.25% robo-advisor fee would cost you $25 a year.
Typical Robo-Advisor Features
Many robo-advisors offer similar features, including:
All robo-advisors automatically invest for you based on the data you provide in the initial questionnaire. For example, if you indicated you want to save for retirement, a robo-advisor would likely suggest an investment retirement account.
Another feature that’s common among many robo-advisors is automatic rebalancing. Portfolios often drift away from their target allocations due to market performance. Rebalancing aligns your portfolio to meet your goals.
Some robo-advisors offer tax-loss harvesting, where they sell losing securities to offset capital gains taxes. Usually, this doesn’t incur an extra fee, though some robo-advisors do.
Pros and Cons of Using a Robo-Advisor
As with any other investment, a robo-advisor has its own set of advantages and disadvantages.
- Low cost and fees: Unlike human advisors, who charge 1% to 2% of your portfolio balance per year, robo-advisors often charge only 0.25% to 0.50% of your portfolio’s value every year.
- Little knowledge required: You can use a robo-advisor even if you are new to investing. All you need to do is sign up for a robo-advisor of your choice and answer a basic questionnaire. From there, the software that runs the robo-advisor automatically chooses and invests assets for you.
- Accessible: Robo-advisors are available 24/7, as long as you have an internet connection. Plus, they take less capital to get started, as $5,000 is the standard minimum portfolio amount. However, other popular robo-advisors like Betterment have no account minimum requirement.
- Doesn’t guarantee returns: Like any other investment, robo-advisors expose you to some risk. Sometimes you’ll get great returns, and other times you may lose money.
- Limited human interaction: One of the biggest drawbacks of robo-advisors is the fact that they are not human. A software algorithm makes recommendations based on the data provided.
- Human assistance services may require an extra fee: Some robo-advisors offer access to human advisors for services that need human assistance like taxes, estate planning and retirement. You may have to pay an additional fee to get these services.
Is a Robo-Advisor Right for You?
The question of whether robo-investing is right for you will largely depend on your specific needs. Robo-advisors aren’t for everyone.
But if you have been putting off investing simply because you only have basic knowledge about the stock market, a robo-advisor may be a perfect fit. Also, if you have little money and want to contribute to an investment portfolio, you might need to turn to a robo-advisor.
Robo-advisors offer several automated features, like choosing investments, investing, rebalancing and tax-loss harvesting. A robo advisor can be a perfect choice if you’re starting with investing and just looking for a simple way to build your wealth.
You may, however, want to consider working with a human financial advisor to help you navigate your financial future as your net worth increases and your situation becomes complex.