A robo-advisor provides cost-effective financial solutions that utilize algorithms to automate investment processes in alignment with an individual’s objectives and risk appetite.
These services democratize the investment landscape, motivating people to invest and prepare for their financial future. With the advent of robo-advisory services, investing has become more attainable for everyday consumers who may not have significant funds to invest through traditional brokerage firms or the time to actively manage and adjust their portfolios.
This method of investing also enhances accessibility to financial planning. It opens up resources to everyone, not just affluent clients of large investment institutions, by providing access to a digital financial advisor.
Grasping the mechanics of how a robo-advisor operates can boost your confidence in where you allocate your resources and how you plan for future savings.
What is a robo-advisor?
A robo-advisor is an automated investment platform that employs computer algorithms to create and manage investment portfolios instead of relying solely on human advisors (or sometimes in conjunction with them). Generally, robo-advisors have lower fees and reduced minimum balance requirements compared to conventional investment services.
The majority of functions performed by a robo-advisor can be executed entirely by algorithms, often outperforming human capabilities. Services typically include automatic rebalancing, tax-loss harvesting, retirement planning, and investment selection.
Some robo-advisor platforms provide a hybrid model where the algorithm handles most tasks, while clients still retain access to a human advisor for questions and validation of their investment strategy. Although these hybrid services may be pricier than standard robo-advisors, they are frequently more affordable than in-person consultations with traditional financial advisors.
How do robo-advisors work?
Robo-advisors offer a digital environment that manages your investments automatically. You can access this platform around the clock via your phone, tablet, or computer.
While the specifics may vary among different robo-advisors, most follow a similar operational procedure. Upon registering, the robo-advisor typically prompts you to fill out a questionnaire to gather essential personal and financial information. You may be asked to provide:
- Your full name
- Date of birth
- Employment status (currently working or retired)
- Your tax filing status
- Retirement accounts you contribute to
- Estimated household expenses
- Your financial objectives, like saving for a home, retirement, a vehicle, or other significant expenditures.
Determining risk tolerance and building a portfolio
The robo-advisor needs to assess your risk tolerance to recommend suitable investments. This assessment often involves gauging your attitudes towards various risk-reward scenarios.
Based on your responses, the algorithm will create a customized portfolio. Some robo-advisors offer only one investment option based on the available ETFs or index funds, while others might present several portfolio choices aligned with varying risk levels, investment preferences, or social considerations such as ESG (environmental, social, and governance) criteria.
Robo-advisors typically adopt passive investing strategies, meaning you don’t select the specific index funds and ETFs that go into your portfolio. The algorithms determine these based on modern portfolio theory (MPT), which aims to optimize overall returns while managing acceptable risk levels.
This approach is beneficial for maintaining a diversified investment strategy, which spreads your risks across various assets instead of concentrating funds in a single place. For novice investors, a robo-advisor can help ensure your investment is balanced across multiple indexes, providing a safeguard against market downturns.
It’s essential to keep in mind that all investing comes with risks. There are no assurances of earning returns on your investment, nor even of recovering your initial capital.
After selecting your portfolio, you will collaborate with the robo-advisor firm to finalize the setup and fund your account.
What about fees?
As with any investment vehicle, inquiring about fees and minimum balance requirements is crucial. Each firm varies, so it’s important to compare the fee structures and stipulations of the different options available before selecting a robo-advisor.
Most robo-advisors impose an annual management fee, which can be either a flat monthly fee or a percentage of the assets managed. Common fees range from 0.25% to 0.50% of assets under management (AUM). Thus, investing $10,000 through a robo-advisor could cost you between $25 and $50 annually.
In addition, you will incur the fund’s expense ratios. These fees are associated with the index funds or ETFs that your robo-advisor invests in on your behalf. Typically, robo-advisors opt for low-cost funds, ensuring minimal financial strain.
Here are examples of various robo-advisor fee structures:
- Betterment levies a standard $4 monthly fee, transitioning to an annual management fee once you establish recurring monthly contributions of $250 or reach an account balance of $20,000 or higher.
- SoFi Automated Investing does not charge management fees, although fund or brokerage fees may apply to your investments, so it’s advisable to check how your money is allocated before proceeding.
- Vanguard’s Digital Advisor has no fees for the initial 90 days. Following this period, annual advisory fees apply, and a minimum balance is necessary to register for its digital advisory services.
Most large investment firms, such as Fidelity and Schwab, incorporate robo-advisory services into their offerings. If you already possess a retirement account through your employer, investigate whether that investment institution provides a robo-advisor choice. Alternatively, you may opt to invest with a company solely offering robo-advisor or hybrid services.
Is a robo-advisor right for me?
A robo-advisor could be an excellent choice for those who favor a ‘set it and forget it’ approach to investing. It is also ideal for individuals wanting to check their portfolios occasionally without engaging in labor-intensive rebalancing or tax-loss harvesting.
You might find that a robo-advisor suits your needs if:
- You desire a low-cost investment managed by a professional investment firm.
- You are open to paying a fee for a company to make investment choices on your behalf.
- You seek 24/7 online access to your account but don’t frequently require communication via phone or video chat.
- You would prefer someone else to take care of rebalancing your portfolio or locating tax-efficient solutions.
Bottom line
Robo-advisors simplify access to investment opportunities and establishing a diversified portfolio. Although all investment comes with inherent risks and there’s no guarantee of recovering your funds, robo-advisors can be a valuable option for new investors to consider.
Ensure you conduct thorough research on various companies to understand their fees, minimum balance requirements, and available investment options before committing your funds.
