What Are Robo Advisors?

Definition and Examples of Robo Advisors

Trading robot
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Robo advisors are automated portfolio managers. You can think of them as an autopilot for investors. After initially answering a series of questions about an investor's resources and financial goals, the robo advisor will make ongoing decisions about how to invest the client's money.

Here's what these products offer, how they work, and whether they could be a good fit for your investing strategy.

What Are Robo Advisors?

Robo advisors are software products that can help you manage your investments without the need to consult a financial advisor or self-manage your portfolio. These products are offered by a wide variety of financial institutions. Some, such as Fidelity, are established financial companies with a lengthy history. Others, like Acorns, were created recently for the sole purpose of providing a robo advisor service.

Robo advisors are an alternative to traditional financial advisors, and they're usually a cheaper option. They're also an alternative to an investor simply picking and choosing investments on their own.

How Robo Advisors Work

A new customer signing up for a robo advisor usually starts by supplying basic information about their investment goals through an online questionnaire. These questions may touch on subjects like your investment timeline, your risk tolerance, and how much money you have in savings. Robo advisors then run those answers through an algorithm to provide an asset allocation approach and build a portfolio of diversified investments that meets your goals.

Once your funds are invested, the software can automatically rebalance your portfolio to ensure that it remains close to that target allocation. Many popular robo advisors encourage investors to regularly contribute to their accounts, such as small weekly deposits. The robo advisor will use those contributions to maintain target allocation.

Some robo advisors even use tax-loss harvesting strategies, which involves selling certain securities at a loss to offset gains in other securities.

Investments In a Robo-Managed Account

Most robo advisors use mutual funds or exchange-traded funds rather than individual stocks to build your portfolio. They typically follow an index fund or another passive investment approach based on modern portfolio theory research, which emphasizes the importance of your allocation to stocks or bonds. Depending on your robo advisor, you may also be able to further specify investments by social values or religious views.

How Taxes Work for a Robo Advisor Account

As with any form of investment, your tax liability for robo-managed assets depends on the type of account in which you hold the assets.

If you hold your assets in an IRA, Roth IRA, or another type of tax-deferred retirement account, you pay no taxes until you withdraw funds. Rollovers or asset transfers from your existing account to a robo advisor generally do not count as a withdrawal. Withdrawals from a Roth IRA account may be tax-free, depending on the circumstances of the withdrawal.

If you own investments in a taxable account, then you will need to report those on your tax return and pay taxes on earnings, similar to investing in a brokerage account. You'll receive a 1099 form each year that reports the interest, dividends, and capital gains on the investments.

If your robo-managed account allows you to transfer in existing investments, those investments will likely be sold, unless they are the same investments that the robo advisor would have invested in with those funds. If sales do occur, you will face capital gains tax liability.

Robo Advisor Fees

Robo advisor fees may be structured as a fixed monthly fee or as a percentage of assets. Fixed monthly fees can be as low as $1. Percentage fees range from roughly 0.15% to 0.50%.

It's important to remember that these fees are separate from any fees associated with the investments. For example, mutual funds and exchange-traded funds within your robo advisor account will likely come with their own expense ratios. This type of fee is taken out of the assets of the fund before returns are distributed to investors.

Some of these online portfolio solutions offer a free trial period so you can see how the service works before you are charged.

Pros and Cons of Robo Advisors

Pros
  • Doesn't require investing knowledge

  • Isn't time-consuming

  • Simple strategies

Cons
  • Hard to get human-to-human interaction

  • Limits investor options

  • May force investors to open multiple accounts

Pros Explained

  • Doesn't require investing knowledge: Robo advisors can be a great option for beginning investors who haven't yet developed the financial knowledge needed to make informed investing decisions.
  • Isn't time-consuming: Working professionals are among those who may not have time to actively manage their investments, so they'd rather put their portfolio on “automatic.” Once a robo advisor account and automated deposits are set up, then the investor doesn't need to do anything else until they want to withdraw money.
  • Simple strategies: Robo advisors often use a simple investment strategy that is easy to understand, such as investing 60% in stocks and 40% in bonds. You likely won't have many investments to watch, so you can easily and quickly assess the performance of your holdings.

Cons Explained

  • Hard to get human-to-human interaction: Some robo advisors offer live assistance, but this usually comes with extra costs. Most robo advisors interact with you almost exclusively through the web. The trade-off is that robo advisor fees are much lower than most financial advisors, but if you enjoy speaking to real people, or you need hand-holding to walk you through the app or website, the savings on fees may not be worth it for you.
  • Limits investor options: If you have ideas about a specific stock you want to invest in, you probably won't be able to tell your robo advisor to buy it. The "options" offered by robo advisors are extremely general ("Do you want to be risky or conservative?") and they won't satisfy investors who want to actively make decisions about their money.
  • May force investors to open multiple accounts: If an investor decides they do want to invest in a stock, they may have to open a separate brokerage account to buy it. Some investors may also need to coordinate company benefit packages and 401(k)s with other accounts, which makes the automation offered by robo advisors less suitable.

Key Takeaways

  • Robo advisors are services that automatically balance an investor's portfolio.
  • Robo advisors make decisions based on basic information and general investing goals.
  • Robo advisors are a low-fee alternative to financial advisors, though there are drawbacks to opting for an automated investing advisor.

Article Sources

  1. Internal Revenue Service. "Traditional and Roth IRAs." Accessed June 17, 2020.

  2. Office of Investor Education and Advocacy. "Form 1099, Investment Income (Interest and Dividends)." Accessed Juen 17, 2020.