Table of Contents
What are robo-advisors?
Pros and cons of robo-advisors
What are the types of robo-advisors?
How do robo-advisors make money?
Further understanding robo investment fees
How can I calculate investment fees?
The bottom line
Jun 21, 2022
6 min read
Learn how robo-advisors use algorithms and software to execute automated investing for clients at a low cost without in-person advisors.
Investing can seem daunting; even understanding how to invest in the stock market can seem tricky. Wanting professional help with reaching your investment goals is understandable, but wealth management firms can often be inaccessible and expensive.
With new technology, access to financial management has become more accessible. Many people will use robo-advisors to start investing at a lower cost. Read on to learn how a robo-advisor can help with investing and what all the fees mean if you decide to sign up.
The definition of robo-advising is just as it sounds: an automated investment management service.
Robo-advisors use algorithms to manage your investment portfolio, and as a result, you typically have very little or no human interaction. They usually have lower fees and lower minimum balances than atraditional investment advisor.
When you open an account, a robo-advisor will typically prompt you to fill out a questionnaire to learn more about your economic status, risk tolerance, and financial goals, among other questions specific to the robo-advisor.
The software and algorithms robo-advisors utilize also have been used by investment advisors for years, specifically automated portfolio allocation.
Robo-advisors create a passively managed portfolio; holdings in particular types of assets can fluctuate between a set range. If those assets fluctuate outside the scope, the robo-advisor will automatically rebalance the portfolio. Robo-advisors will manage asset allocation for you and typically have no fees for rebalancing.
Some robo-advisors also have retirement planning and tax loss-harvesting services, which are considered more advanced investment strategies that many individuals use in-person advisors to execute.
Robo-advisors can be a good option for many beginners to start investing, but there are also drawbacks to automated financial services.
It's typically easy to set up an account that's managed by robo-advisor and access it either via a website or mobile app. So easy, in fact, that many consider robo-advisors an excellent tool for stock market beginners.
Robo-advisors allow for easy access to automated investing, particularly for beginner investors. It can be less stressful to let an algorithm manage investments. The stocks that robo-advisors invest in are the same ones you can invest in on your own, but you don’t have the pressure of balancing and diversifying a portfolio.
Many people opt for robo-advisors because they're significantly less costly than traditional financial advisors.
If you don’t have much disposable income to start investing, robo-advisors typically have low account minimums. Some robo-advisors even have no minimum balance required, so you can start investing right away.
While the fees may be lower than a traditional advisor's, they're still there.
Robo-advisors invest based on algorithms and software, meaning the chances of you ever actually talking to a person are slim.
A robo-advisor can only do so much, which if you want to start investing in a more advanced way, you may feel limited with a robo-advisor.
When it comes to robo-advisors, you have many investment options depending on your personal financial goals.
Some robo-advisors are directly connected to a bank or brokerage firm, allowing for easy transfers.
Step-up robo-advisors offer a full-service approach to automated investment and are a good option if you plan to branch into more advanced investing.
Suppose you want your portfolio to consist of more than just exchange-traded funds (ETFs) or index funds. In that case, you can find a robo-advisor that offers portfolio management that includes various assets.
Cash management robo-advisors will "sweep" your earnings into a partner bank. This partner bank will offer Federal Deposit Insurance Corporation (FDIC) insurance that the robo-advisor does not.
Some robo-advisors have limited human financial advisors available if you would prefer to connect with an actual person who can give you financial advice rather than just working with an algorithm full-time.
Robo-advisors make money through annual fees, primarily management fees called a wrap fee. The wrap fee covers a percentage of the assets under management (AUM). Compared to a traditional financial advisor, robo-advisors charge lower advisory fees, typically around 0.25%. For example, if you have $10,000 in assets with a robo-advisor, and the wrap fee is 0.25%, you would pay $25 in fees. Robo-advisors can also earn interest on cash management in accounts.
Understanding the fees you are responsible for is crucial when deciding if robo-advising is suitable for your investment plan.
Robo-advisors will charge you a fee for assets under management, and you will also be responsible for the expense ratios of the funds you invest with. Many robo-advisors may invest in ETFs, which still have fees (called expense ratios) that will come out of your returns.
ETFs are a middle ground between a passively managed index fund and a mutual fund.
Robo-advisors will also not charge you transaction fees that you may encounter with a traditional brokerage account. Brokerage firms often charge a rebalancing fee on your account, while robo-advisors automatically rebalance your portfolio.
In short, you pay fees for the funds you invest with, along with a wrap fee to the robo-advisor for your assets under management.
To calculate the costs of using a robo-advisor, you would first need the rate of return on your investments.
For example, let's say you use a robo-advisor with a 0.25% fee for assets under management, and you invest $10,000 in an ETF with an expense ratio of 0.05%. You would pay the advisor fee and the expense ratio each year, including your returns as your assets grow.
The money you pay in fees to a robo-advisor is more than if you invest directly, although the goal of an investment service like a robo-advisor is that you might be able to have higher returns than if you invested on your own.
What’s the average minimum cost of robo-advisors? Depending on your account balance, your robo-advisor fee may change. For a balance of $5,000, the average advisory fee is 0.25%; the fee increases as your account balance increases.
For example, if you have $100,000 in your account, your advisory fee average is 0.36%. After you reach a certain account balance, many robo-advisor’s fees begin to drop. For example, when investing $1,000,000, your average fee is 0.30%.
The lowest fee for a robo-advisor, at any account balance is 0%, which, albeit somewhat rare, means you are not charged an advisory fee whatsoever. Even the robo-advisors that do not charge advisor fees, may invest your money in a selection of funds, and you pay expense fees.
Managing your investment accounts can seem daunting and potentially overwhelming when it comes to financial planning. On the other hand, you may not be willing or able to pay the fees that a traditional investment adviser would charge.
This is why people choose to utilize robo-advisors when seeking assistance with their investment strategies for a lower cost. Robo-investing, in particular, is a more accessible way to use managed investing services.
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