Table of Contents
Understanding automated investing
How do robo-advisors work?
Features of robo-advisors
How much do robo-advisors cost?
What Is a Robo-Advisor?
What Is a Robo-Advisor?
Feb 10, 2022
7 min read
A robo-advisor is a digital investment tool that automates portfolio management. Your target asset allocation is determined by your current financial situation and your future goals.
Many people put off investing because they’re unfamiliar or uncomfortable making decisions. And for many, hiring a financial advisor is either out of reach due to high account minimums or over-the-top fees. That’s where robo-advisors come in: they make investing more accessible to investors of all kinds. Robo-investing offers a hands-off approach that relies on computer programs and algorithms to maximize returns while saving investors costly management fees.
A robo-advisor is a digital investment tool that automates portfolio management. Your target asset allocation is determined by your current financial situation and your future goals. Algorithms are built by economists and financial advisors to tailor investment decisions to an individual’s financial status and future goals. The entire process is handled either online with a computer or on a mobile app.
You can also select different investment accounts based on your needs, just as you would with a traditional financial advisor. In addition to taxable investment accounts, most robo-advisors also offer tax-advantaged accounts such as individual retirement accounts, or IRAs.
Robo-investments do not include day trading. You can’t buy individual stocks, since robo-advisor algorithms are based on purchasing diversified asset classes, usually exchange-traded and index funds, that help you reach certain goals by a specific date. Buying and selling individual stocks is volatile and difficult to automate, so you’ll need a separate brokerage account if you want to invest in specific companies.
Robo-advisors are regulated by the U.S. Securities and Exchange Commission (SEC) just like any other type of financial advisor. The robo-advisor must register with the SEC, and you can research their disclosures, any potential enforcement actions, and other details online.
The algorithms built into a robo-advisor are based on a set of rules related to asset prices, timing, and other variables. When researching different robo-advisors, look for data on their algorithmic formulas to get an idea of how they created their models. You can also research robo-advisor returns to compare performance.
When you first sign up for a robo-advisor, you often begin the process by filling out a questionnaire about your finances and future goals. You’ll identify what you’re saving for, such as retirement, education, or investing. It digs deeper into your timeline, contribution amount, risk tolerance, and other details to create a detailed financial plan to help you meet your goals.
Once you complete the questionnaire, the robo-advisor makes a recommendation of portfolio asset allocations. You may see a variety of options depending on your own risk tolerance. Some portfolios may be more aggressive, while others may be more conservative (and consequently, less risky).
After selecting a portfolio, you can set up automated contributions to your robo-advisor account. That way you won’t forget about transferring funds into your investment account.
From here, the robo-advisor takes over. Unlike a financial advisor, portfolio rebalancing is automated so your asset allocation always meets your target. Some traditional advisors only rebalance at set intervals, such as quarterly, which could leave your portfolio out of balance for weeks or even months.
Whenever your financial goals change, you can update your details so that your portfolio recommendations are working toward those new goals. Maybe you have a baby and want to add an education fund. Or maybe you want to be more aggressive with your savings so you can retire 10 years early.
Here are common robo-advisor features to compare before you choose one, keeping in mind that not all operate the same way.
Most robo-advisors charge an annual fee of about 0.25% that’s calculated as a percentage of your managed assets, though fees can be higher if you want additional services. Some robo-advisors also charge a flat monthly rate, similar to a subscription fee.
Robo-advisors are known for helping you set it and forget it. The reason for this is their automatic account rebalancing features. When you choose a recommended portfolio designed to meet your investment goals, your contributions are split up accordingly in order to be properly diversified. As markets fluctuate, the percentage of your allocations in various asset classes can change. Automatic rebalancing regularly buys and sells to keep your portfolio in check. For example, if you select a portfolio that’s 60% stocks and 40% bonds, the robo-advisor will sell stocks if equity markets rise a lot and buy bonds.
Most robo-advisors have a low account minimum—and some don’t have any. No matter how much money you have to start investing, robo-advisors make it easy to get started. You can open an account with just a few dollars, then contribute as much as you want each month.
Tax-loss harvesting is an investment strategy that helps you offset your capital gains. Some financial advisors may offer a manual version of this strategy, but some robo-advisors build it directly into their platforms. When an asset is sold and gains are realized (resulting in capital gains subject to tax), the robo-advisor then sells another asset at a loss to offset those gains. It will replace the losing asset with something similar to keep your asset allocation in balance, all while remaining in compliance with IRS regulations.
The best robo-advisors bake in financial planning models so you can test different decisions and see the possible result. You may also have access to in-depth research about markets and the company’s investment strategy.
Many robo-advisors charge an annual percentage based on your assets under management (AUM). For no-frills service and lower balances, robo-advisor fees start at about 0.25% or lower. As the services expand and your assets grow, that fee can increase.
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