What is a Robo-Advisor? How Do They Work?

Investing
Updated: 1st Jan 2021
Written by Kim Pinnelli
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Investing
January 1, 2021
Written by Kim Pinnelli

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Do you ever wish you could snap your fingers, and someone would create the perfect investment portfolio for you?

Your wish may come true or close to it. Robo-advisors are as close as you’ll get.

The automated investment services create a portfolio, manage your investments, and allow you to start investing safely and responsibly. All you have to do is answer a few questions and fund your account.

Sounds great, right? Here’s what you must know.

What is a Robo-Advisor?

If the thought of paying a human advisor thousands of dollars for investment advice scares you, consider a robo-advisor.

Robo-advisors are digital investment platforms that help you manage your investments. While you don’t get the personalization of dealing with a human, robo-advisors use technology, algorithms, and data derived from its users to create and manage portfolios.

Honestly, most online platforms are the equivalent of working with a human advisor, but without the financial cost or stress of making decisions yourself.

Almost the entire process is digital and automated, but each platform has features that make them unique. Some are a hybrid of automated and hands-on investing, while others are completely hands-off.

What Does a Robo-Advisor Do?

Each robo-advisor works differently, but in general, they assess your risk tolerance, goals, and timeline to create a portfolio for you. Once you fund the account, the advisor invests the funds for you. Some even automatically rebalance your portfolio to get it back on track.

No matter the platform you choose, they all provide some form of guidance and support as you choose the right portfolios and individual investments.

How Robo Advisors Work

Most robo-advisors start with the same tasks – you provide your personal information so they can verify you are who you say you are. They then ask specific questions (usually just a handful) to assess your risk tolerance (how well you can stomach the market’s ups and downs), goals (what you are saving for), and the amount of money you can and will invest.

Robo-advisors take this information and either choose one of their prebuilt portfolios or guide you to a portfolio that you can customize.

Some robo-advisors take the wheel entirely. They handle every aspect of your investments, including rebalancing your portfolio, minimizing your tax liabilities (tax-loss harvesting), and reassessing your portfolios as you get closer to your goal.

Others work as a hybrid. They may have prebuilt portfolios but let you choose themes or individual investments to add or remove. Some provide guidance but let you do the investing yourself.

No matter the type of robo-advisor you choose, the bottom line remains the same – you receive investment advice at a fraction of the cost of a human advisor.

Pros:

  • Easy to Get Started: You don’t need any investment knowledge or even a lot of money. You can start with as little as you want (some have no minimum balance requirements) and you can follow the robo-advisors advice, making it a great option for new investors.
  • Not Stressful: Investing is stressful no matter which way you look at it, but when you use a robo-advisor, it removes a lot of the stress. You can choose a robo-advisor that makes it completely hands-off to invest. The robo-advisor handles all decisions for you. If you want a hybrid option, you can do that too, if you feel like you need a little say in what happens.
  • Low-Fees: Robo-advisors charge a fraction of what typical investment brokers charge. If fees are what stands in your way of investing, look no further than one of the many robo-advisors.
  • No Experience Necessary: Anyone can use a robo-advisor. Even if you don’t know anything about ETFs, stocks, or bonds, the online platforms walk you through the investment process, making it easy. Many even offer educational opportunities so that you gain an understanding as you go.
  • Investment Selection: Most robo-advisors invest in ETFs, which are low-cost baskets of securities that mimic certain indexes, like the S&P 500. ETFs are less risky than stocks because they are automatically diversified. Rather than investing in one company, you invest in hundreds.
  • Mitigates Risk: Robo-advisors use data and algorithms to assess your risk tolerance and invest accordingly. Since you primarily invest in ETFs, you automatically have diversification, but robo-advisors use your data to determine the allocation between stock and bond ETFs to best help you reach your financial goals.
  • Automatic Portfolio Rebalancing: Investment values change all the time. Just because you start with one allocation doesn’t mean your portfolio will stay that way. You may end up heavier in stock investments than you want or the opposite, heavier in bonds. Robo-advisors automatically rebalance your portfolio as needed to keep you on track.

Cons:

  • Limited Investment Options: Most robo-advisors only offer ETF investments. A select few offer individual small-cap or large-cap stocks and bonds, but not your traditional robo-advisors who do the investing for you.
  • No Access to Financial Planners: Since they are digital, most platforms don’t offer financial planners access. You may have access to a customer service team or individuals with investment backgrounds, but not certified financial planners.

How Much Do Robo-Advisors Cost?

Robo-advisors are much more affordable than regular investment advisors. On average, they charge 0.25% – 0.30% of assets under management. This means for every $10,000 invested, it might cost you as little as $25 a year.

Each platform has different costs (some don’t charge anything) and others charge higher percentages. The robo-advisors with higher fees, though, typically have higher minimum balance requirements.

Who Are Robo-Advisors Best For?

Robo-advisors are best for hands-off investors. Whether you’re a beginner or you just don’t like watching the market and choosing your own investments, a robo-advisor is a great option.

You must be comfortable without access to a human advisor, though. You’re putting your trust in a digital platform that uses data and historical figures to determine the right portfolio for your investment needs.

How Taxes Work for a Robo-Advisor Account

Just like any investment, you’ll owe taxes on your earnings from a robo-advisor account. How much and when you pay depends on the type of account you hold.

If you have a tax-advantaged account, your earnings grow tax-deferred. You only pay taxes when you withdraw funds if you have a traditional IRA.

If you have a taxable account, you’ll receive a 1099 on any earnings including dividends and capital gains. You’ll pay long-term capital gains taxes on earnings on stocks held for more than one year and ordinary taxes on earnings on stocks held for less one year.

Robo-Advisors and the SEC

Robo-advisors are held to the same regulations as a human advisor. All robo-advisors register with the SEC which means they are held to the same laws and regulations as a human advisor.

How Do Robo-Advisors Make Money?

Robo-advisors make money in a few ways:

  • The management fee they charge for assets under management
  • Interest earned on cash balances (if they don’t pay investors interest)
  • Payment for order flow based helping them minimize the number of trades they make (pocketing the difference)
  • Selling or marketing other financial products to investors

Is a Robo-Advisor Worth it?

Each investor has their own likes and dislikes. If you’re the type of investor who wants a hands-off approach and doesn’t want the burden of making decisions and doing research, then yes, a robo-advisor is right for you.

If you miss the opportunity to make decisions or make regular trades, you may want to consider a hybrid robo-advisor, like M1 Finance. You get the best of both worlds – a digital advisor but the freedom to make your own investments when and how you choose.

Can You Make Money with Robo Advisors?

Like any investment option, there’s no guarantee that you’ll make (or lose) money. Robo-advisors have a reputation for beating the market because of the algorithm based on their data, but no method is foolproof.

What robo-advisors offer is the removal of emotional investing. You won’t jump ship just because the market crashes or dump a stock because you hear bad news about the company. Robo-advisors operate on data and calculations that take the emotion out of it, which may help investors make more money.

Learn More: How to Invest $1,000

Can You Trust Robo-Advisors?

You can trust robo-advisors that register with the SEC and have SIPC insurance. While this doesn’t protect you against market crashes or investment loss, it does provide insurance should a robo-advisor go out of business.

Bottom Line: What is a Robo-Advisor?

If you’ve held off investing because the thought scares you, check out a robo-advisor. You’ll get the handholding you want and the hands-off approach you can handle. You’re in good hands when you use a robo-advisor whether you use one that creates a portfolio for you or guides you in your investment decisions.

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Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.