How Do Robo Advisors Work?

Robo advisers, also known as robos, automated investing services, or online advisors, are a relatively new invention in the world of investments. These software products have only been around since 2008 – but in just over a decade, they’ve taken the market by storm.

In fact, by the end of 2020, some models predict that robo advisors will collectively have between $1 trillion and $2.5 trillion under management.

Robos have gained in popularity for several reasons. Some investors like the ability to be mostly hands-off while paying a lower cost than traditional advisors. Others don’t have the capital to dive headfirst into the market, but still want to build a low-risk investment portfolio.

TL;DR

Robos are automated investing software that help investors put their capital to work without the aid (and expense) of a human financial advisor. These low-cost, minimal-effort alternatives assess your financial situation and build a portfolio with the ideal asset allocation for your situation. Whether you want to save for retirement, set up a college fund, or just pad your emergency account, their risk-averse approach can generate returns at a relatively low cost.

Robo Advisor Pros

  • Low cost
  • No prior investment knowledge needed
  • Available 24/7 with an internet connection
  • Straightforward strategies
  • Automatic, no-cost portfolio rebalancing
  • Low to no account minimums
  • Indexing strategies typically generate solid returns over time

Robo Advisor Cons

  • Little to no human interaction
  • Fewer investment options
  • Investors may have to open multiple accounts to access all available options
  • You can’t add specific funds or securities to your account
  • Limited financial services to accompany investments

What is a Robo Advisor?

Robo advisors are proprietary algorithms that help individuals invest in the stock market and other financial investments. Dozens of firms offer these products to investors.

Some of these firms are well-established in the financial community, such as Fidelity and Vanguard. Others, like Acorns and Wealthfront, are standalone products that focus solely on automated investments.

Robo advisors may be web platforms or apps (often both). A few offer investment plans that include access to a live financial professional via phone, email, or digital face-to-face communication. 

How Do Robo Advisors Work?

When you sign up with a robo advisor, just like a human advisor, you start by answering a series of questions. These cover all aspects of your financial life, from your current resources to your future goals. They will also inquire about topics such as your risk tolerance.

After you answer these questions, the robo advisor then calculates the best asset allocation for your situation. Typically, it does this by assigning a target weight and tolerance range to every type of security.

To give a simple example, a robo advisor may crunch your data and recommend that you hold 60% of your capital in stocks, with the other 40% in bonds. The robo may also suggest a buffer of plus or minus 5% for each asset class.

Once you start investing, the software will keep your portfolio balanced according to your target allocation. This occurs both as you see profits, as well as when you contribute additional funds. Many robo advisors recommend that you make small contributions regularly – such as weekly or monthly – to help keep your portfolio balanced.

Furthermore, many robos offer other services to keep you and your account in good standing. These may include features such as tax-loss harvesting, financial planning tools (such as various investment-related calculators), and access to a human representative.

Investment Options

Robo advisors typically gravitate toward ETFs and mutual funds when building investors’ portfolios. These passive investments follow modern portfolio theory, which emphasizes the benefits of a diverse portfolio to minimize risk.

Some robo advisors also let you specify investments by other criteria. These may include socially responsible investments, religious views, or personal preference. Other robos specialize in investments such as by market cap or industry.

One of the downsides of robos, however, is the lack of customization in your accounts. For instance, automated advisors don’t allow you to select individual ETFs or stocks for your portfolio. Furthermore, if your robo advisor in question specializes in a niche or industry, you won’t be able to diversify that account with alternative investments.

IRS

Tax Considerations

As with all investments, your tax situation will change depending on which account(s) you open.

With tax-deferred accounts such as IRAs and Roth accounts, you won’t have to pay taxes until you withdraw money. Some accounts – like Roth IRAs – may not charge taxes even on withdrawal, depending on your circumstances.

For all other accounts, you’ll receive a 1099 form to fill out every year. Here, you’ll report all eligible interest, dividends, and capital gains on which you’ll have to pay taxes.

It’s important to note that some robo advisors allow you to transfer existing investments under their management. However, unless that advisor would have allocated those investments into your portfolio, they will likely be sold off. In these instances, you’re responsible for paying capital gains taxes on any resulting profits.

SEC Regulation

Legally, robos and human advisors are considered “Registered Investment Advisors.” Both are subject to the same securities laws and ordinances, and both must register with the U.S. Securities and Exchange Commission – SEC – before they can offer their services.

How Much Do Robo Advisors Cost?

One of the main benefits of robo advisors compared to traditional management services is that there is often a low – or no – minimum balance required to get started. Thus, instead of saving up your hundreds only to see a handsome chunk removed for “advisor fees,” you can put your money straight to work in the market a few dollars at a time.

Some robo advisors are 100% free for their clients. For instance, Schwab offers a full range of robo advisor services at no cost to their investors. Instead, the company receives compensation for referring accounts to their proprietary ETFs and cash features.

However, most robo advisors do charge fees via one of two payment structures:

  • Fixed fees are charged monthly and range from $1 to $10 per month or more
  • Percentage fees are charged monthly, semi-annually, or annually based on the amount of assets under management (AUM); these can range from 0.15% to 0.50%

When it comes time to pay up, most robos will pull fees directly from your account. This may happen on a monthly or quarterly basis, depending on the service you use.

One important factor to note is that these fees are separate from any fees resulting from your investments. For instance, if you invest in an ETF with an expense ratio of 0.75%, you’ll have to pay that fee on top of your robo advisor fees. Typically, these fees come out of your assets before you see your returns.

However, unlike brokerage accounts, you don’t usually pay transaction fees on your investments. Rather than paying commissions to buy and sell investments when you rebalance your portfolio, robo advisors often waive these fees.

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