What is a Robo-Advisor? – Defined & Explained

Are you looking for a hassle-free investment option that allows you to sit back and let your money work for you? Do you want to avoid paying excessive fees to financial advisors for financial advice?

If so, robo-advisors might be right for you. Read on to learn what robo-advisors are, how they work and whether they can help you build wealth.

Robo-Advisor Definition

It uses algorithms to decide on an allocation strategy for your funds, depending on your risk tolerance and goals. Because robo-advisors require minimal human interaction, robo-advisor brokerage fees are very affordable.

How Does a Robo-Advisor Work?

Brokerages started offering robo-advisor services due to the high management fees and account minimums that traditional investment accounts require.

These high fees make investing difficult for retail investors. Robo-advisors are a great low-cost alternative to traditional financial advisors. Robo-advisors are simple to use and don’t require a significant investment.

You start by filling out a quick questionnaire about your financial situation, asset allocation goals, retirement planning goals and more.

Then, the robo-advisor will create an automated portfolio and invest your funds into assets such as exchange-traded funds (ETFs), cryptocurrencies, and bonds.

You don’t need to speak to a human financial advisor, although human advisors are typically available to answer questions. A robo-advisor brokerage account might offer additional investment management options.

For example, it might automatically adjust the ratio of high-to-low-risk assets depending on the market volatility. Alternatively, it might automatically sell assets at a loss to help you save on taxes.

Example of a Robo-Advisor

Let’s take a look at Betterment, one of the most popular automated asset management platforms. It uses automation to create investment strategies that work for you.

You’ll start by signing up, choosing how much you want to invest and telling Betterment why you want to invest. Betterment enables hands-off investing.

It uses portfolio rebalancing and dividend reinvestment to balance your portfolio and ensure you stay on track to meet your goals.

Some prebuilt portfolios you can choose from include:

• Betterment Core Portfolio: This portfolio contains stocks and bonds from across the world. It’s low cost, low risk and best for long-term investing.
• Innovative Technology: This portfolio invests in tech stocks and bonds in industries such as clean energy, nanotechnology and robots. It has the potential for high growth but also involves more risk.
• Social Impact: This portfolio is great for the conscious investor who wants to invest in companies that are making a difference.
• Cash Reserve: This portfolio is cash only and comes with a generous 3.75% APY.

Other examples of robo-advisors include:

• Sofi Automated Investing
• Vanguard Digital Advisor
• Schwab Intelligent Portfolios
• Fidelity Go

Benefits of Using a Robo-Advisor

Robo-advisors are becoming more popular, and more financial services are offering them. Here are the top reasons to use automated investment services to manage your wealth:

Low fees: Robo-advisor accounts offer lower fees than personal advisor services, as they automate most of the process.

Automated rebalancing: Managing your own investments might be the cheapest option, but you won’t get access to automatic portfolio rebalancing. A robo-advisor will continually analyze your portfolio and sell or buy assets based on the stock market conditions and your long-term goals.

Low minimum investment: You don’t need a lot of money to open a robo-advisor account, unlike certified financial planners and other financial products such as fully managed investment management.

Available 24/7: You can log into your robo-advisor account at any time. It also works for you 24/7, making investment decisions to help you stay aligned with your goals.

Efficient: Robo-advisors are effective. FinTech companies use advanced algorithms and machine learning to manage your investment portfolio.

Tax-loss harvesting: Tax-loss harvesting is an investment tactic that avoids capital gains taxes on assets you sell at a profit by offsetting those profits by selling other assets at a loss.

Robo-advisors do this for you automatically.

Diversification: A diversified portfolio is one of the most important aspects of a sound financial planning strategy. A robo-advisor will invest in assets depending on your goals and risk tolerance.

Drawbacks of Using a Robo-Advisor

Robo-advisors also have several disadvantages. Here are some potential downsides of using a robo-advisor:

Limited flexibility: Robo-advisors might only offer certain asset classes or pre-built portfolios, and you might be unable to buy individual stocks or certain assets.

Limited human interaction: You may be able to get human support, but a robo-advisor will never offer the same level of personal interaction and support you would get from a certified financial planner or full-service investment management platform.

No personalization: Different robo-advisors offer different levels of personalization. You may be able to adjust the ratio of stocks to crypto, for example, but robo-advisors offer limited portfolio customization compared with self-managed accounts.

Robo-Advisor Returns & Performance

Are robo-advisors worth it? What returns can you expect from them? On average, you can expect annual returns of 5-7% from the best robo-advisor services. Wealthfront, for example, has given its clients an average annual return of 6.79% from its inception.

According to data from Backend Benchmarking, Fidelity Go, Betterment, and Axos Invest provide an annual two-year return of between 4.76% and 7.1%.

Overall, these returns are pretty good, although they might underperform when you compare them with the traditional stock market. The Nasdaq 100 Index, for example, has experienced growth of more than 79% over the past five years.

Nevertheless, they are more diverse and allow you to choose a lower risk level than investing in specific stocks. Furthermore, they provide an extra level of convenience.

Who are Robo-Advisors Best For?

Robo-advisors are not for everyone. However, if you fall into one of the following categories, you should consider using one:

How to Start Investing with a Robo-Advisor

Here’s a quick, hassle-free guide to investing with a robo-advisor:

1. Choose a robo-advisor, such as Betterment, and create an account.
2. Fill out your account information and choose an investing goal, such as retirement planning with an IRA or building an emergency fund.
3. Set up a one-time or recurring deposit.
4. Choose from one of the recommended portfolios.

Is a Robo-Advisor Right for You?

If you want to start investing, but don’t want to pay excessive fees, invest a large amount of money upfront or deal with the hassle of figuring out which assets to invest in, a robo-advisor might be right for you.

Enter your email on Betterment.com to begin, or check out Wealthfront or Fidelity Go.

Robo-Advisor FAQs

Do you still have questions about using robo-advisors? Here are the most common questions that our readers ask us.