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Updated on Friday, July 17, 2020
A robo-advisor is a digital investment advisor that creates a portfolio on your behalf, usually with the help of algorithms. Many robo-advisors have basic guidelines and use the principles of Modern Portfolio Theory (MPT), which asserts that asset allocation matters more than the individual investments in a portfolio when deciding how to assemble your account.
If you’re looking for help choosing the investments to build your portfolio, a robo-advisor can be a great option. We’ll take a look at robo-investing so you can decide if it’s right for you.
- What is a robo-advisor and how does it work?
- How much do robo-advisors cost?
- Pros and cons of robo-advisors
- How to choose a robo-advisor
- robo-advisor alternatives
What is a robo-advisor and how does it work?
When signing up with a robo-advisor, you typically respond to a questionnaire that’s used to establish a general idea of your risk tolerance, investing time frame and financial goals. Once you’ve completed the questionnaire, a portfolio is constructed for you, usually from a selection of exchange-traded funds (ETFs) and similar investments. The idea is to create an asset allocation that matches the general principles of investing for those who have similar characteristics to you.
While some robo-advisors might offer some financial planning help and a small degree of customization, you probably won’t get fully tailored investment solutions. Instead, many investors are drawn to robo-advisors for their ease of use, low cost and low barrier to entry.
Many robo-advisors follow similar rules to other investment advisory firms and are registered with the U.S. Securities and Exchange Commission (SEC). They also carry SIPC insurance, protecting investors against failure by the firm.
While not every robo-advisor offers the exact same features, here’s a sampling of what you might find.
- Investment recommendations and portfolio management: You might receive suggestions for what percentage of your portfolio should be invested in certain asset classes. Some robo-advisors also offer performance projections so you can see how different adjustments can impact your potential returns.
- Portfolio rebalancing: If your portfolio strays outside a desired asset allocation range, a robo-advisor might sell some shares and use the proceeds to buy others. With portfolio rebalancing, the goal is to help keep your asset allocation close to your desired makeup.
- Tax loss harvesting: Depending on the robo-advisor, you might receive tax loss harvesting services, in which some of the holdings in your portfolio are sold in order to reduce your tax liability.
- Financial planning tools: You might be able to access different financial planning tools, such as help planning for college or even assistance in creating a basic financial plan. However, some of these services might cost extra.
- Impact investing: Some robo-advisors offer socially responsible investment choices or values-based. Those choices might come with higher expense ratios, but they allow you to use your money to make a positive social impact.
- Access to a human advisor: In some cases, you can get access to a human financial advisor, whether through message, over the phone or by appointment. The amount of access you get can vary widely though, and such services usually cost extra or come with a higher annual management fee.
How much do robo-advisors cost?
Depending on the robo-advisor, you might pay an annual fee based on your account balance, or you might pay a flat monthly fee. For example, the average fee charged by robo-advisors, based on an account balance of $50,000, was 0.36% per year, or about $180. If you sign up for some robo-advisors, though, you might just pay a flat fee of $1 per month. Depending on your account size, that might be a better deal.
It’s important to note, however, that these management fees charged by robo financial advisors don’t always include the expense ratios from the ETFs they use. So that could add another layer of cost. However, ETFs, in general, have low expense ratios.
The cost of a robo-advisor vs. a traditional advisor or DIY investing
In general, one of the reasons that people consider a robo investment advisor has to do with the relatively low cost. With automated investing, there isn’t as much required of humans to manage your portfolio, so the idea is that costs are lower. On top of that, with robo investing, many of the portfolios are constructed using ETFs, which generally have low expense ratios. This also contributes to the relatively low cost.
On the other hand, a human investment advisor might charge more for their services. Many charge a percentage of your assets under management. According to a study by RIA in a Box, the total average fee for a traditional advisor is 1.17% of assets under management. This is over three times the cost of a robo-advisor.
You might be tempted to just manage your own investments to save money on management fees altogether. Some brokers have gotten rid of transaction fees for stocks and ETFs, making it possible for you to trade without paying these fees. However, you still have to pay expense ratios and other possible costs. Additionally, you might have to pay a transaction fee (in addition to fund fees) to trade mutual funds with some brokers. Most robo-advisors don’t charge transaction fees, as those are baked into the annual management fee.
Pros and cons of robo-advisors
When trying to decide if robo-advisors are worth it, you should compare the pros and cons. Here’s what you need to know.
- Typically lower fees than with human advisors: With a robo investing, you can usually invest for a lower cost than you’d see with a human investment advisor.
- Instant portfolio diversification: Because many robo-advisors focus on broad-based ETFs, you end up with exposure to a wide variety of investments at once. Plus, using the MPT approach gives you asset diversification based on your risk tolerance.
- Start investing with a small amount of money: Many robo-advisors will let you open an account with no minimum balance requirement. Additionally, you might be able to invest a small amount of money, including using robo-advisors that allow you to invest pocket change. Traditional financial advisors, on the other hand, can have minimum investment requirements ranging into the hundreds of thousands of dollars.
- Accessibility: Because you access robo-advisors online or through an app, you can manage your account at any time.
- Harder to customize for specific needs: While it’s possible to get some customization, you might have a harder time tailoring a portfolio for specific needs. You won’t get the nuanced advice you’d get from a human investment advisor.
- May not have access to as many services: When you work with a human advisor, you could get access to a wider variety of services, including wealth management, private banking, tax planning and other specific planning help. With a robo-advisor, the menu of services is generally much smaller.
- Limited ability to trade individual stocks: Because robo-advisors generally construct your portfolio for you using ETFs, you aren’t usually able to trade individual stocks. If you want to day trade or buy specific shares of a company, you likely won’t have that flexibility with a robo-advisor. There are some hybrid brokers that offer robo-advising and access to individual stocks, but the stock choices are usually limited.
- Limited human interaction: While some robo-advisors allow you to buy premium services that include human interaction, you’re largely limited when it comes to a personal touch. Many robo-advisors don’t have offices, and you might not be able to sit down face-to-face with someone. If that’s important to you, a robo-advisor might not meet your needs.
How to choose a robo-advisor
When choosing a robo-advisor, it’s important to consider your needs and financial goals Here are a few things to keep in mind.
In general, robo-advisor fees are based on your account size and charged as a percentage of your assets under management. There are some robo-advisors, however, that charge a flat monthly fee. If there are other services, like financial planning, you might pay an additional one-time fee for the session.
While there are some free robo-advisors, the average fee for a balance of $50,000 is 0.36%. This is much lower than the average fee of 1.17% seen with human investment advisors. Still, you’ll want to compare costs between robo-advisors to make sure you’re selecting the best option for your financial situation.
Make sure you meet the minimum investment requirement
Many robo-advisors don’t require a minimum investment. Often, you can open an account with $0 and then invest when it’s convenient. There are some robo-advisors that do have minimum balance requirements of $5,000 or more though, so it’s a good idea to check. Look for a robo-advisor whose minimum you can meet.
Also, be aware that some robo-advisors allow you to “unlock” certain premium services once your account balance reaches a certain amount. For example, with Betterment, once you have $100,000 in your account, you get access to a financial planner (although the management fee is higher). If you’re hoping to get more advanced and personalized help later, check to see if a growing balance allows you to gain access to these additional services.
Look at available account options
Depending on your situation, you might want different types of accounts. While most managed investment accounts offer individual and joint taxable accounts, you might also be looking for other types of accounts, like trusts. Alternatively, you might also want a robo-advisor Roth IRA or a SEP IRA. Some robo-advisors offer help with college savings and allow you to set up custodial accounts for your kids, too.
However, not all robo-advisors offer all possible account options. Before opening an account, review the types of accounts to make sure you’re getting what you want.
Review the investment selection and strategy
Many robo-advisors use their own investment algorithm based on the principles of MPT, which favors asset allocation over individual stock picks and holds that risk and reward are correlated. Additionally, many use different ETFs to construct portfolios. A robo ETF selection usually includes stocks, bonds and real estate investments.
Check the robo-advisor returns to see how different model portfolios perform. You can also get an idea of robo-advisor performance by looking at a prospectus from the different funds used. This will give you an idea of what to expect, even though past robo investing returns can’t predict future results.
Robo-advisor vs. index funds
An index fund allows you to own a small piece of each investment in the fund. To buy an index fund, you normally need to go through a brokerage. Depending on the brokerage, there might be a selection of index funds that don’t come with transaction fees. If you want to build your own portfolio, this can be one way to go about it. However, you still have to be aware of potential transaction fees and expense ratios.
With a robo-advisor, your portfolio is constructed for you, from a selection of ETFs the advisor favors. It’s important to note that, with ETFs, you don’t own the underlying assets. If you don’t mind a hands-off approach and don’t care if you pick your own funds, this can be a good choice.
When choosing your own index funds and managing your own investment account, you’re responsible for rebalancing and managing any tax strategy. With a robo-advisor, depending on the offered features, that can all be taken care of on your behalf.
Robo-advisor vs. financial advisor
With a robo-advisor, you can choose the general direction of your portfolio, in that it’s possible for you to adjust your asset allocation. However, you won’t be able to do a lot of serious customization, and you might not get personal attention. Portfolio decisions are largely handled by algorithms, whether it has to do with tax minimization or portfolio rebalancing.
On the other hand, a financial advisor can provide you with more tailored advice. They can look at your situation and provide guidance based on your unique circumstances. Plus, depending on the services they provide, you might get access to a wider variety of asset classes and investment choices. If you want more involvement from a financial advisor, going this route — instead of choosing a robo-advisor — may make more sense.
In the end, a robo-advisor can be a smart choice, especially for beginning investors. It can provide you with a low-cost way to start investing without the need for a lot of specialized knowledge. If you decide later that you need more help with financial planning, or if you learn enough to branch out into managing your own portfolio, you can always move your money and invest in a way that makes more sense to your changing situation.