What Is a Robo Advisor and How Do They Work?

This automated investment service can make portfolio management easier

Trading robot
••• Daumier/iStock

Investors are increasingly choosing low-cost software products called “robo advisors” to put their portfolio management on autopilot. Learn about what these products offer to determine whether they're right for your investing strategy.

Basics of Robo Advisors

Investors today can build and manage their portfolio in one of three main ways:

  • Hire a financial advisor to create an expertly curated portfolio.
  • Use a do-it-yourself approach to pick investments.
  • Enlist a robo advisor to put together a portfolio.

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. You usually open a robo-managed account and then supply basic information about your investment goals through an online questionnaire. Robo advisors then crunch the data you provide to provide an asset allocation approach and build a portfolio of diversified investments for you that meets your target allocation percentages for those investments.

Once your funds are invested, on an ongoing basis, the software can automatically rebalance your portfolio—that is, make the changes to the investments needed to align your portfolio back to a target allocation. Some robo advisors can even sell certain securities at a loss to offset gains in other securities—a process called tax-loss harvesting that can help reduce your tax bill.

Who Should Consider Robo Advisors

Robo advisors can be a great solution for the following types of investors:

  • Beginner or young investors: These investors may not yet have the financial knowledge needed to make informed investing decisions but may be comfortable managing their portfolio online with limited or no human assistance.
  • Professionals: These individuals may not have time to actively manage their fund and may want to put their portfolio on “automatic.”
  • Investors with simple strategies: If you have a simple asset allocation (60% stock and 40% bonds, for example), you may not need guidance from a financial advisor to continually rebalance your account.
  • Investors who don't want to hire a financial advisor or go at it alone: If you don't have the assets or the desire to hire a financial advisor, but no longer wants to select investments on your own, you may want to choose a robo advisor to select investments, rebalance them, and place trades on your accounts.

In contrast, an automated portfolio-management solution is not ideal for these types of investors:

  • Investors who prefer human assistance: Some robo advisors offer live assistance (this usually costs slightly more), while others interact with you almost exclusively through the web. If you need hand-holding or a familiar voice to talk to, a robo advisor is probably not for you.
  • Investors with multiple investment accounts: Some investors may need to coordinate company benefit packages and 401(k)s with other accounts, which makes automation offered by robo advisors less suitable.
  • Investors who need a tailored approach: Robo advisors won't offer customized planning or advice on how much to save, whether to use a Roth IRA or Traditional IRA, or how to allocate investments in other accounts, such as your 401(k).

Benefits of Using a Robo Advisor

There are a few key advantages to outsourcing portfolio management to software:

You can avoid investing mistakes. It has been documented many times over that one of the biggest reasons investors get poor outcomes is because of their own behavior. Investors make emotional decisions at market highs and market lows and based on gut feelings. Software doesn't make these kinds of mistakes.

You can automate the process. Once you open your account, the robo-advisor software takes care of the investment process. You don't have to worry whether you should make changes to your portfolio or invest more or less in a given market sector. You don’t even have to log in to the account and place trades.

You can invest a smaller amount at a lower cost. Advisory firms generally require a higher amount to initially invest and impose fees that are often higher than those charged by robo advisors. What's more, you don’t have to worry that a broker or other financial salesperson is making a recommendation that isn't in your best interest.

Robo-Advisor Fees

You'll generally pay one of these digital advisors a service fee that may be structured as a fixed monthly fee or as a percentage of assets. With robo advisors that charge a fixed monthly fee, the fee typically ranges from about $15 per month to $200 per month depending on portfolio value. With a percentage of assets structure, you’ll see fees in the range of about 0.15% to 0.50% of your account value per year. If you had $100,000, a 0.50% fee would equate to $500 a year.

You also pay any expenses associated with the investments used by the robo advisors. For example, mutual funds and exchange-traded funds have 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.

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.

With your asset allocation determined, you can focus on the underlying stock asset classes for your portfolio, such as large-cap, small-cap, or international stocks. Then, you can settle on the underlying bond asset classes to include, such as short, intermediate, or long-term bonds. Of course, a robo advisor does all this for you.

How Taxes Work for a Robo-Managed Account

Your tax liability for assets managed by a robo advisor 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 tax until you take a withdrawal. Rollovers or asset transfers from your existing account to a robo advisor generally do not count as a withdrawal.

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

If your robo-managed account allows you to transfer in existing investments, those investments may be sold and incur a tax liability. Existing investments will be sold first unless they are investments already used in the robo model portfolio. If these investments are not inside retirement accounts when they are sold, any capital gains (or losses) will be realized, which may result in a tax bill.

If you have to sell assets held in a taxable account during the transfer to a robo-managed account, you may incur a larger-than-normal tax bill during the year you transfer because of capital gains.

Where to Find a Robo Advisor

Once you've determined that automated portfolio management is right for you, shop around for robo advisors that suit your budget and planned investment amount. These popular robo advisors offer different levels of human assistance:

  • Betterment charges a 0.25% fee and offers a $0 account minimum for robo-advisor services.
  • Fidelity Go imposes a 0.35% fee but requires no minimum investment.
  • Vanguard Personal Advisor Services offers an online interface and access to a financial advisor for a 0.30% fee for assets up to $5 million. The account minimum is $50,000.
  • WealthFront charges a 0.25% fee for robo-advisor services and requires a $500 account minimum.
  • Wealthsimple charges a 0.50% fee and requires no account minimum.

Are Robo Advisors Worth It?

Robo advisors offer tools that can help you build and manage a diversified portfolio and project how your accounts will grow over time. As they often come with lower fees and account minimums than traditional financial advisors, they can be a good option for investors who don't want to fork over a lot of money for a financial advisor or spend the time or effort required for self-directing investing.

While often equated with digital financial advisors, robo advisors aren't financial planners. They can't provide the customized solutions that are often needed for unique investing strategies. In addition, once you are near retirement, the allocation models used in the robo-advisor tools may not help you align your investments with the withdrawal phase. For this reason, interested investors may benefit from using a robo advisor earlier in their career and seeking the services of a professional retirement income planner as they advance in age.