What Is a Robo Advisor? - A Detailed Guide

ByG. Dautovic
September 30, 2021

Everyone needs a little advice and guidance. When it comes to our health, we’ve got doctors. For legal issues, we turn to lawyers. If you’re searching for a house, contacting a real estate agent can be helpful.

But what do you do when you need help managing your investments? Well, you can try a traditional financial advisor or the more affordable and automated robo-managed option. So, what is a robo advisor? In short, this is a sophisticated digital financial service that uses advanced algorithms to manage your portfolio. Keep reading to find out more about how the software works and if it’s the right solution for you.

Understanding Robo Advisors

Most of us wish we had a robot to take care of everyday chores. And while a robo advisor isn't exactly a robot, it will provide you with financial planning services that require little to no human supervision. These digital platforms collect data from clients on financial situations and financial goals. They then offer the most suitable advice and/or automatically invest on behalf of the clients. So what is an automated investment advisor capable of doing exactly?

While there is a large pool of advisors to choose from, the best robo advisor will offer the following features:

  • Portfolio management, especially for beginner investing
  • Advanced security
  • Account services
  • Responsive customer support
  • Financial planning
  • Low fees
  • Comprehensive education

Now that that’s out of the way, let’s take a look at what robo advisors actually do and how they do it.

How Do Robo Advisors Work?

Robo advisors build and manage portfolios using advanced software and computer algorithms. These automated investing services cover everything from tax optimization to retirement planning. The robo part of the name stems from the fact that there isn’t much in the way of human guidance. However, it isn’t uncommon for some of these services to have human advisors answering questions from clients.

Another key advantage is that robo advisors have low opening balance requirements, which isn’t the case with more traditional portfolio management services. Moreover, robo advisors are inexpensive, making the service more accessible.

History of Robo Advisors

The very first robo advisor, Betterment, was launched in 2010. It was initially designed to help rebalance assets within target-date funds (funds that are structured to grow assets within a particular time frame). This gave investors an online interface to manage passive investments.

This technology was being used exclusively by human wealth managers before Betterment was launched. Back then, you had to hire a financial advisor for automated portfolio allocation. Today, robo advisors use rebalancing strategies optimized with modern portfolio theory. Some robo advisors offer a variety of portfolio types in addition to serving as an automated investment service. These include options for socially responsible investing or portfolios with tactical strategies mimicking hedge funds.

The Cost of Robo Advisors

Robo advisors cost way less than their human counterparts. Most companies offering robo advisors charge annual fees, which are between 0.15% and 0.50% of your total assets. With accounts that have a value of $50,000, you could end up paying as little as $125 a year. With some companies, you may have a fixed monthly fee, which can be as low as $1. More importantly, perhaps robo investing doesn’t involve any transaction costs. And there are also robo advisors such as SoFi that don’t charge any annual management fees.

Should You Use a Robo Advisor?

Deciding if you should use a robo adviser can be tricky. Ideally, you should take the following into account:

Account type

Robo advisors typically manage taxable and individual retirement accounts. Some even manage trusts and 401(k) accounts.

Minimum investment requirements

Depending on the robo advisor, the minimum investment requirements vary. But most will manage accounts with as little as $500, and some companies don’t even have an account minimum.

Portfolio recommendation

One of the very first things you should do with a new robo-advisor is answer a few basic questions. After all, what good is a robo advisor if it doesn’t take your investment preferences into account? The questions are designed to evaluate a number of factors, such as your tolerance for risk, your investment goals, and overall preferences. Most robo advisors will offer about five to ten portfolio choices ranging from conservative to aggressive risk tolerance.

Using an algorithm, the robo advisor will recommend a portfolio based on your answers. However, you are free to ignore the recommendation and go with your own preferred option.

Investment selection

Most portfolios built by robo advisors are made up of ETFs (exchange-traded funds) that are generally low-cost. These are investment baskets designed to mirror index behaviors and generally come with their own expense ratios, which are fees charged by the ETFs.

What Is a Robo Advisor Account?

Your robo advisor account is essentially a diversified investment managed by an advanced computer algorithm. It holds your investments and the portfolio that your investments are based on. Setting up an account is a straightforward process.

Fill in the short questionnaire

Make sure you include your financial details like your bank account info, total asset value, and debt information. The more accurate your information, the better your robo-advisor can serve you.

Put in the minimum deposit

If there is no minimum, enter the amount that you’re comfortable with.

Choose your approach

If you’re new to the world of investment, the robo advisor algorithm is a great asset when trying to make informed decisions.

Review the fees policy

After reviewing your fixed monthly or percentage fees, remember to check if there are any additional costs. For instance, sometimes ETFs within your account can come with their own expense ratios.

Robo Advisor Services

Most robo-advisors operate the same way. Typical robo advisory services include the following:

Portfolio rebalancing

Using the aforementioned complex algorithms, robo advisors will evaluate and then buy or sell assets within a portfolio to meet the investor’s desired goals.

Financial planning tools

In order to maximize your robo advisor returns, you’ll get access to a range of useful financial planning tools. For example, you can calculate how much you’ll be spending during retirement each year by using the retirement savings calculator.

Tax-loss harvesting

This is a common strategy employed by robo advisors to help clients reduce their tax bills. It involves selling securities at a loss to offset capital gains.

But many still don’t trust computerized operations. They fear they’re going to lose money if they don’t monitor the process properly and prefer a human touch when it comes to advisory services. If you fall into this category, online planning services such as a hybrid robo advisor might be the ideal option.

What Is a Hybrid Robo Advisor?

A hybrid robo advisor combines a digitally managed account with a human investment advisor. In other words, you’ll get all the automation advantages with the added benefit of having someone to speak to about your investments. Compared with traditional financial advisory services, hybrid robo advisors cost much less.

Can a Robo Advisor Help Manage Risk?

All investments are risky primarily due to market fluctuations. Through automated financial planning, robo advisors can help manage some of that risk by building diversified portfolios, monitoring the market, and of course, through investment rebalancing. The technology manages your account and makes adjustments that help keep portfolios on the right track to achieving your investment goals.

However, not all robo advisors are built the same. Some are right for a certain type of investor and not for others. When choosing one, it’s imperative that you compare the features offered by different services with your investment preferences and goals in mind. More importantly, you need to ask if giving a digital investment advisor control over your account is something you want.

Robo Advisor Pros and Cons

Pros

  • Inexpensive
  • Create portfolios with great returns
  • Low minimum balances
  • Robo advisors for all types of clients
  • Access to financial advisors

Cons

  • Not fully personalized
  • No face-to-face contact with advisors
  • More affordable alternatives for newcomers and those trying to figure out how to invest in the stock market

 

Frequently Asked Questions
What is a robo advisor, and how does a robo advisor work? +

A robo advisor is a financial planning service that helps manage investment accounts through automated processes. They gather client information through questionnaires and then use that data to invest automatically for the client.

Can you lose money with Robo advisors? +

Yes, you can. This is more likely with fees, tax-loss harvesting, and the costs for rebalancing.

How should you choose a robo-advisor? +

Choosing the right robo advisor depends on your preferences and goals, and also if you agree with the terms of service, such as fees.

How much does a robo advisor cost? +

Most robo advisors charge between 0.15% and 0.50% of your total assets, while some charge a fixed monthly fee.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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