What Is a Robo Advisor and How Do They Work?

Automated Investment Services Can Make Portfolio Management Easier

Trading robot
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A new type of online software has emerged that can help you manage your investments. These software products are called “robo advisors.”

A robo advisor can be a good solution for someone who does not want to hire a financial advisor, doesn’t have enough assets to hire a financial advisor yet, or for someone who has typically been a do-it-yourself investor, but no longer wants to select investments, rebalance and place trades on their accounts.

Robo advisors can automatically select investments and build a diversified portfolio for you. Once your funds are invested, on an ongoing basis, the software automatically makes changes to the investments to align your portfolio back to a target allocation. Some robo advisors even automatically make trades that can help reduce your tax bill; a process called tax-loss harvesting.

If you are a do-it-yourself investor, these low-cost online robo advisors can help you build a better portfolio. Here’s how they work.

What Fees Are Involved?

With a robo advisor you pay a service fee and you pay the expenses of the investments used.

Each robo advisor has a reasonable 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 size.

With a percentage of assets structure, you’ll see fees in the range of about .15% to .50% of your account size per year. If you had a $100,000 a .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.

That type of fee is taken out of the assets of the fund before any returns are allocated to investors.

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

What Are the Benefits?

One of the biggest benefits of using a robo advisor is to avoid costly investing mistakes. It has been documented many times over that one of the biggest reasons investors get poor outcomes is due to their own behavior. Investors make emotional decisions at market highs and market lows and based on gut feelings. Software does not make these kinds of mistakes.

Another benefit is reduced stress. Once you open your account the robo advisor software automates the whole process. You no longer have to worry if you should make changes to your portfolio, or wonder if you should invest more in technology or less in financials. You don’t have to log in and place trades. You don’t have to worry that a broker or other financial sales person is making a recommendation that is not in your best interest.

Who Are Robo Advisors Best For?

Robo advisors can be a great solution for beginning investors, young professionals who want to put their portfolio on “automatic”, and for investors that have a relatively simple situation.

Investors who have stock options, need to coordinate company benefit packages and 401(k)s with other accounts, or who need a customized approach to the tax impact of investing may find that an automated solution is not ideal.

What Investments Are Used?

Most robo advisors use mutual funds, or exchange-traded funds to build the portfolio – not individual stocks. Rob advisors typically follow an index fund or passive investment approach based on modern portfolio theory research. This research says the most important factor is your allocation to stocks or bonds. Then you focus on which underlying stock asset classes, such as large cap, small cap, or international. Then you focus on which underlying bond asset classes, such as short, intermediate or long-term. With a robo advisor, the software does all this for you!

How Do Taxes Work on a Robo Account?

If you have an IRA, Roth IRA or another type of tax-deferred retirement account, there are not tax consequences to be concerned about with an automated process. With these types of accounts, you pay no tax until the day you take a withdrawal. Rollovers or transferring your account from its existing place to a robo advisor does not count as a withdrawal.

If you own investments that are not tucked inside a retirement account then you receive a 109 each year that reports the interest, dividends, and capital gains. You report those on your tax return and pay tax on these types of investment income.

Robo accounts most typically must be funded with cash. If they do allow you to transfer in existing investments, those investments are likely to be sold 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. If it was a gain, this may result in a large than normal tax bill during the year that you transition to the robo advisor.

What Else Should I Know?

A robo advisor is not a financial planner. Some robo advisors have additional software tools that can help you project how your accounts will grow, but you do not receive customized planning advice on how much to save, whether to use a Roth IRA or Traditional IRA, how to allocate investments in other accounts like your 401(k), etc.

Some robo advisors offer live assistance (this usually costs slightly more), while others interact with you almost exclusively through the web. If you like hand-holding and a familiar voice to talk to, a robo advisor is probably not for you.

In addition, once you are near retirement, the allocation models used in the robo advisor tools may not help you align your investments for the withdrawal phase. At that point, you may want to seek the services of a professional retirement income planner.

Where Do I Find a Robo Advisor?

Below is a list of popular robo advisors. Some offer more human assistance than other.

For a more comprehensive list, along with a review of each service see Investor Junkie’s article The Rise of the Robo-Advisor – Should You Use One?