A robo-advisor offers affordable financial services that use computer algorithms to automate investing based on a person’s goals and risk tolerance.
They help level the investing playing field and encourage individuals to invest and plan for their futures. With the start of robo-advisory services, investing became more accessible to the average consumer who didn’t have thousands of dollars to invest with a traditional brokerage firm or time to monitor and rebalance their portfolios.
This type of investing also makes financial planning more accessible. It gives everyone access to a financial adviser, albeit a digital one, not just high net-worth customers of big investment firms.
Understanding how a robo-advisor works can make you feel better about where you’re putting your money and about saving for your future.
What is a robo-advisor?
A robo-advisor is an automated investing service that uses a computer algorithm instead of a person (or sometimes along with a person) to build and manage an investment portfolio. Robo-advisors typically charge lower fees and have lower minimum balances than traditional investment services.
Most services offered by a robo-advisor can be done entirely by a computer, sometimes better than what a human could do. It often includes automatic rebalancing, tax-loss harvesting, retirement planning and picking investments.
Some robo-advisors offer a hybrid option, where the computer does most of the work, but customers still have access to a human financial advisor. This person can answer questions and confirm that you are headed in the right direction. Although these services are usually more expensive than a straight robo-advisor, it’s still often less than meeting with a traditional financial advisor in person.
How do robo-advisors work?
Robo-advisors provide a digital platform that manages your investments automatically. You can access the platform 24/7 from your phone, tablet or computer.
While each robo-advisor is different, they all tend to follow a similar pattern of operations. When you first sign up, the robo-advisor will ask you to complete a questionnaire to learn your general information and financial needs. You’ll likely need to provide:
- Your full name
- Birthday
- Retirement status (working or retired)
- Your current tax filing information
- Retirement accounts you’re already contributing to
- Estimated household spending
- Your financial goals, such as saving for a house, retirement, a car or other large expenses.
Determining risk tolerance and building a portfolio
The robo-advisor will also need to determine your risk tolerance so it can choose the best investments for you. It will likely do this by getting your reaction to different scenarios to determine your risk versus reward preferences.
The algorithm will then build a portfolio based on your answers. Some robo-advisors may offer just one option based on the ETFs or index funds the company has to work with. Others may have a selection of portfolios you can choose from based on risk tolerance, investing preferences or social concerns like ESG (environmental, social and governance) funds.
Robo-advisors use passive investing strategies. That means you don’t get to choose the index funds and ETFs in the portfolio. The computer picks them according to modern portfolio theory (MPT). It’s a way of selecting investments to maximize their overall returns balanced with an acceptable level of risk.
This technique can be a great way to help you keep a diversified portfolio, meaning a mix of investment options, so that you don’t put all your money into one basket. If you’re new to investing, a robo-advisor can help ensure your money is diversified across multiple indexes, which can help protect you if the market goes down.
Remember: All investing carries risk. There are no guarantees you’ll see a return on your money, or even get your original amount back.
Once you’ve selected your portfolio, you’ll work with the robo-advisor company to complete the setup and transfer money to your account.
What about fees?
As with any investment option, asking about fees and minimum balance requirements is vital. Each company is different, so it’s important compare the fee structures and conditions of each option you’re looking at before choosing a robo-advisor.
Most robo-advisors charge an annual management fee, either a flat monthly fee or a percentage of your assets managed by the advisor. You’ll typically see fees between 0.25% and 0.50% of assets under management (AUM). That means that every $10,000 invested through a robo-advisor would cost you $25 to $50 a year.
You’ll also have to pay the fund’s expense ratios. These are fees that the index funds or ETFs you invest in through your robo-advisor portfolio charge. Typically robo-advisors choose low-cost funds, so you likely won’t feel too much of a pinch.
Examples of some robo-advisor fee structures include:
- Betterment charges a flat $4 monthly fee. That switches to an annual management fee once you set up recurring monthly payments of $250 or have an account balance of $20,000 or more.
- SoFi Automated Investing doesn’t charge management fees. However, you will pay fund or brokerage fees on the investments, so research what your money is invested in before committing.
- Vanguard’s Digital Advisor offers no fees for the first 90 days. After that, it charges annual advisory fees. Vanguard does require a minimum balance to enroll with its digital advisor.
Most big investment firms, like Fidelity and Schwab, have a robo-advisor service as part of their services. If you already have a retirement account through your employer, check if that investment company also has a robo-advisor option. Or you can choose to invest with another company, including one that only offers robo-advisor or hybrid robo-advisor services.
Is a robo-advisor right for me?
A robo-advisor can be a good option for individuals who prefer the ‘set it and forget it’ method of investing. It’s also a good option for those who want to check in on their portfolios from time to time without worrying about time-consuming rebalancing or tax-loss harvesting.
A robo-advisor might be the right choice for your situation if:
- You want a low-cost account that a professional investment firm manages.
- You’re willing to pay a fee to have an investment company make investment decisions for you.
- You want 24/7 online access to your account but don’t need to speak with someone over the phone or via video chat often or at all.
- You want someone else to handle rebalancing your portfolio or finding tax advantage solutions.
Bottom line
Robo-advisors offer easy access to investing and creating a diversified portfolio. Investing always carries some risk, and there are no guarantees you’ll get your money back. But still, robo-advisors are a good option for new investors to consider.
Just remember to research different companies and understand the fees, minimum balance requirements and investment options each company offers before investing.
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