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What is a Robo-Advisor? Definition & How They Work

When you want to invest, you may feel inclined to take advantage of technology by having a robo-advisor manage your money. A robo-advisor offers a low-fee, hands-off approach to investing.

Let’s answer the question, “What is a robo-advisor?” and go over the pros and cons of using a robo-advisor. We’ll also take a look at how they make money, how a robo-advisor works, and the costs and fees involved in using this investment approach.

Robo-Advisor Definition

Robo-advisors are algorithm-driven digital trading and investing platforms used to build and maintain financial portfolios with little to no human guidance. Robo-advisors usually offer automatic rebalancing and tax optimization. They automatically invest client assets after using their algorithm to analyze your financial situation and future goals.

How Robo-Advisors Work

Once you download the app, a robo-advisor will typically take you through a survey to gather data to offer advice and automatically invest your money. They often have human advisors available to answer questions, but not always.

Let’s go through the specific steps:

  1. You give a robo-advisor basic information about your investment goals. Each robo-advisor offers an online questionnaire that you can fill out to determine how long you have to invest, your risk tolerance and how much you already have saved.
  2. Based on these answers, robo-advisors tap an algorithm to build a portfolio of diversified investments that meets your goals.
  3. You can arrange for a robo-advisor to automatically add contributions from your bank to maintain your target allocation.
  4. The robo-advisor manages your portfolio, using technology to take advantage of tax-loss harvesting to offset capital gains. They also rebalance your portfolio as needed.

Read More: Do I Need a Financial Advisor?

Benefits of Using a Robo-Advisor

Robo-advisors offer a low-cost option for you to invest. Since they don’t necessarily employ human financial advisors, they require you to pay less out of pocket, both in the short term and over time. Following are a few other benefits that a robo-advisor can help you achieve.

Benefit 1: They generate portfolios based on your personal preferences.

Most robo-advisors go after a passive investment approach to build your portfolio. For example, a robo-advisor may follow an index fund. An index fund is a portfolio of stocks or bonds designed to mimic the returns of a financial market index such as the S&P 500.

They may invest your money in exchange-traded funds, for example, which is a basket of funds that track an underlying index.

However, they will only invest your money as long as they align with your personal preferences, goals and risk profile.

Benefit 2: They help with tax-loss harvesting.

What is tax-loss harvesting? It involves selling securities at a loss so you save on capital gains taxes. By selling a security at a loss, you can reduce your tax bill on income that you make on your investments.

Robo-advisors automate tax-loss harvesting, so you don’t have to manually figure out which investments to sell and which to keep.

Benefit 3: They require low fees.

Robo-advisors typically cost less than paying a financial advisor to handle your money. They have low overheads due to not having to pay a person to run them. Robo-advisors also charge lower fees because they use algorithms to automate trades and tap into indexed strategies that use commission-free, low-cost ETFs.

They often require no minimum deposit. For example, let’s say you choose to purchase a mutual fund with a traditional flesh-and-blood financial advisor. You may need to invest, say, a minimum of $2,000 to get started.

Robo-advisors usually require $0 to open an account.

Benefit 4: They’re easy to use.

Most robo-advisor apps implement many user-friendly features with full access to a suite of portfolio management tools, which you can customize. With the touch of a button or two, you can set a goal, move money into your account, choose your risk tolerance, see your balances and more.

Robo-Advisor Downsides

It’s a good idea to take a look at the cons of robo-advisors so you make the best decision for your needs

Downside 1: They lack the subjectivity of a human advisor.

Robo-advisors do offer cheap investment management services, but the major downside is that they lack the perspective that a human financial advisor can offer.

For example, a human advisor might be able to tell you how to invest in certain situations or contingencies as you experience them and look toward future needs. For example, let’s say you start saving for one child’s college education, then you suddenly welcome triplets into the family. Your needs might change and might require a slightly different investment approach. A human financial advisor would give you more exact advice in this situation, whereas a robo-advisor could not offer you detailed planning advice.

“Almost any change in your financial life is most likely tied to some significant changes in your non-financial life,” Min said. “I gave up my job in order to manage my husband’s daily care. … While the rest of our life was shambolic and exhausting, I knew, as I do now, that at least our financial health is under good stewardship.”

— Min K., a Personal Capital client since 2019 in an unpaid testimonial

Read More: How Min Worked With Her Financial Advisor Following a Life-Changing Diagnosis

In addition, clients may not understand the implications of choosing a specific path, such as risk tolerance. For example, a client may skew toward a particular risk tolerance. However, a human advisor may help them realize that their risk profile isn’t logical, given their life goals and retirement planning needs. A human advisor can also regularly reevaluate client plans and goals amid changes in the market.

Downside 2: They’re not right for everyone.

If you’re not a passive investor, you might want to steer clear of robo-advisors. For example, you wouldn’t want to use a robo-advisor if you spend all your time day trading stocks because they just don’t offer that type of technology.

As your financial life becomes increasingly complex, you may benefit from the personal insights of a financial advisor.

Learn More: How to Get Personalized Advice From an Advisor who Listens

How Robo-Advisors Make Money

Most robo-advisors earn money through a wrap fee based on their assets under management (AUM). This means that the robo-advisor charges clients a flat fee quarterly or annually. This fee covers all administrative costs, commission and management expenses.

 

You may want to watch out for the fund’s management expense ratio, however. This money goes to the fund company, not the robo-advisor. For example, let’s say you invest in ETFs through your robo-advisor. You’ll pay that fund company to manage the fees whether you make money or not. Fund expense ratios can eat up your money, especially over the long term. Look into the terms and conditions on every robo-advisor before you invest your money.

Costs & Fees

Robo-advisors typically cost about 0.25% annually, though you may pay more or less.

For example, let’s say you invest $10,000. You’ll pay 0.25%, or $25 per year. However, remember that the yearly fee grows as your investment portfolio increases. For example, at $100,000, the fee turns into $250 per year. A $1,000,000 portfolio means you’ll pay $2,500 per year.

Decide Whether a Robo-Advisor Fits Your Needs

You may wonder whether a robo-advisor fits your needs best. However, remember that most DIY investors make mistakes that can cost them a lot of money over the course of time.

You can take advantage of Personal Capital’s award-winning financial technology and wealth management services. Personal Capital’s certified financial advisors, who are fiduciaries with decades of combined experience, can help you navigate your financial life.

With the fee-based wealth management services, you get:

  • Access to fiduciary financial advisors
  • Smart Weighting diversification, which provides portfolio balance and diversification to help you weather market volatility
  • Dynamic portfolio allocation based on your complete financial picture
  • Portfolio rebalancing to avoid costly mistakes
  • Tax optimization to potentially lower your tax bill
  • Full transparency into fees and activities

When Min tells her friends and family about Personal Capital, she points to a three-pronged approach.

“First, delivery on your core competence in investing,” she said. “Second, smart deployment of digital technology that nudges clients to do things on their own and for themselves. And third, the overlay of a group of competent and professional advisors who support your clients and provide a human touch. It is personal.”

Frequently Asked Questions

What is a robo-advisor and how do they work?

Put simply, robo-advisors are digital wealth and investing platforms that automatically balance your portfolio. They cost less than financial advisors. Robo-advisors, which are driven by algorithms, invest your money based on the information you provide, including your long- and short-term investing goals and risk tolerance. You can manage your entire portfolio through an app.

Are robo-advisors any good?

Robo-advisors can offer the right suite of options for the right investor. They offer low-cost investment options and a way to select specific investments based on your risk tolerance and goals.

However, they aren’t free and they lack human subjectivity. Robo-advisors usually charge you a percentage of the assets they manage on your behalf — typically 0.25% annually. When you pay $25 per year for $10,000, it doesn’t seem like much, but as your portfolio grows, your fees grow as well.

What is the difference between a robo-advisor and a financial advisor?

The major difference between working with a robo-advisor (a non-human) and a traditional financial advisor (a real human) involves the fact that you’re either working with a real person — or not.

A traditional financial advisor will advise you and invest your money for a fee. Robo-advisors offer a full-on digital solution where you don’t have to monitor your money. It typically costs less to invest with a robo-advisor compared to a traditional financial advisor.

Is Personal Capital a Robo-Advisor?

Personal Capital helps people better their financial lives through technology and people. We’re also often referred to as a “robo-advisor” in the media. However, that’s not true.

Personal Capital is a digital wealth manager. We’re not not a traditional advisor, nor are we a robo-advisor. Watch this video to find out why we do not align with the robo-advisor label we’re so often given.

Get Started with Personal Capital

 

Personal Capital compensates Melissa Brock (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of PCAC. The client testimonials are representative of the clients’ views at the time they were collected.  The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Advisory services are offered for a fee by Personal Capital Advisors Corporation (“PCAC”), a registered investment adviser with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training. PCAC is a wholly owned subsidiary of Personal Capital Corporation (“PCC”), an Empower company. PCC is a wholly owned subsidiary of Empower Holdings, LLC. © 2021 Personal Capital Corporation. All rights reserved.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Melissa Brock spent 12 years in college admission and is the founder of College Money Tips. She also writes financial content and loves helping families navigate the college search process.
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