What Are Robo-Advisors?

Definition and examples of robo-advisors

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Robo-advisors are automated portfolio managers that use algorithms to offer financial advice. You can think of these apps as an autopilot for investors. When you sign up to use one, you will first answer a series of questions about your risk tolerance, financial resources, and goals. Then, the robo-advisor will make ongoing decisions about how to invest your money and monitor any changes going forward.

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

What Are Robo-Advisors?

Robo-advisors are software products that can help you manage your investments. It's all done without the need for you to consult a financial advisor or manage your own portfolio. These products are offered by a wide variety of financial institutions. Some, such as Fidelity, are established 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. They're often a cheaper option, too. These products are also an alternative to an investor simply picking and choosing investments on their own.

How Do Robo Advisors Work?

A new customer signing up for a robo-advisor usually starts by giving basic information about their investment goals through an online questionnaire. These questions may touch on subjects like your timeline, your risk tolerance, and how much money you have in savings. Then, robo-advisors run those answers through an algorithm. This will provide an asset allocation approach; it will also help you build a portfolio of diversified investments that meet your goals.

Once your funds are invested, the software can automatically rebalance your portfolio. This will ensure that it remains close to that target allocation. Many popular robo-advisors encourage you to regularly contribute to your account. This could even be small weekly deposits, for instance. Then, the robo-advisor will use those contributions to maintain target allocation.

Note

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

Investments In a Robo-Managed Account

Most robo-advisors use low-cost exchange-traded funds (ETFs) rather than individual stocks or mutual funds to build your portfolio. They often follow an index fund or another passive investment approach based on modern portfolio theory research. This 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. It depends 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. You'll also need to pay taxes on earnings, similar to investing in a brokerage account. You'll receive a 1099 form each year. It will report 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, it can be as a percentage of assets. Fixed monthly fees can be as low as $1. Percentage fees range from roughly 0.15% to 0.50%.

Remember that these robo-advisor fees are separate from any fees associated with the investments. For instance, mutual funds and ETFs within your 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.

Tip

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

Pros and Cons of Robo-Advisors

Pros
  • No investing knowledge needed

  • 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

  • No investing knowledge needed: Robo-advisors can be a great option for beginning investors. Then you can get started investing, even if you haven't yet developed the financial knowledge needed to make informed decisions.
  • Isn't time-consuming: Many people don't have time to actively manage their investments, so they'd rather put their portfolio on autopilot. Once a robo-advisor account and automated deposits are set up, then you don't need to do anything else until you want to withdraw money.
  • Simple strategies: Robo-advisors often use a simple investment strategy that is easy to understand; for instance, investing 60% in stocks and 40% in bonds. You likely won't have many investments to watch. That means 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. Many robo-advisors interact with you only through online methods. The trade-off is that robo-advisor fees are much lower than most financial advisors. So, what if you enjoy speaking to real people, or you need hand-holding to walk you through the app or website? In that case, 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. For instance, they may ask you: "Do you want to be risky or conservative?" Robo-advisors may not satisfy those who want to actively make decisions about their money.
  • May force investors to open multiple accounts: If you decide you want to invest in a certain stock, you 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. This may make the automation offered by robo-advisors less useful.

Key Takeaways

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