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Personal Finance

What Is a Robo-Advisor?

Deciding how to invest your money can be tough. For decades, financial advisors have helped clients pick stocks, bonds, mutual funds and other investments that align with their financial goals. Now, centuries after the founding of the New York Stock Exchange, the world's largest marketplace for buying and selling stocks, investors have a tech-powered alternative for making investment decisions. It's called a robo-advisor.

A robo-advisor is an online automated investing service that typically requires little if any human interaction and often costs less to use than traditional advisors. It can be a tool for guiding your investment strategies, putting you on the path toward building your wealth and securing your financial future.

Robo-advisors are growing in popularity. The amount of assets they manage in the U.S. is expected to exceed $682.7 billion in 2020. By 2024, the number of robo-advisor users around the world is predicted to surpass 436.3 million. More than 200 robo-advisors are available in the U.S.

Invest a little of your time to learn more about robo-advisors.

How Does a Robo-Advisor Work?

A robo-advisor typically refers to an automated digital platform that helps you make investments without meeting with a financial advisor. While investing involves buying assets that you hope will increase in value over time—anything from a rare baseball card to shares of stock in a company—robo-advisors tend to invest in funds that hold different types of assets, such as stocks and bonds.

You'll interact with a robo-advisor online using your computer or other device or on a mobile app. Generally, a robo-advisor asks you to fill out an online questionnaire that gathers information about your financial goals, income and assets, investment timetable, risk tolerance and how much you plan to invest. Relying on that data, the robo-advisor's complex computer algorithms automatically create and manage your investment portfolio.

In this country, robo-advisors must be registered with the U.S. Securities and Exchange Commission (SEC). Well-known operators of robo-advisors include Ally, Betterment, Charles Schwab, Ellevest, Fidelity, SoFi, TD Ameritrade, Vanguard, Wealthfront and Wealthsimple.

Robo-Advisor Fees

Robo-advisors typically make money by charging fees, though the types and amounts of fees can vary widely between services and even within one brand depending on the level of service you desire, your account balance and other factors.

Several providers charge annual management, or advisory, fees which can range from about 0.20% to 0.50% of your account balance (fee percentages can increase or decrease as your account balance reaches certain levels). Other robo-advisors may not charge advisory fees at all, though you may have to pay a fee if, for example, your cash balance falls below a certain percentage of your holdings.

By comparison, management fees for financial advisors typically are around 1% to 2%. Robo-advisor fees tend to be lower than fees for traditional financial advisors because the robo-advisors rely heavily on technology, while traditional financial advisors depend more on direct contact with an advisor.

In many cases, robo-advisors focus on investing in what are known as exchange-traded funds (ETFs). ETFs let investors pool their money in a fund that invests in stocks, bonds and other assets. The average ETF expense ratio is about 0.45%. This means you'd pay $45 in annual fees for every $1,000 you invest in an ETF—in addition to any fees your service charges.

Portfolio Performance

Once your portfolio is up and running, the robo-advisor monitors its performance. Based on changes in economic conditions, a robo-advisor will automatically rebalance your portfolio by adjusting your asset mix to ease volatility and manage risk. For instance, your robo-advisor might buy or sell certain assets to ensure they don't represent too big or too small a share of your portfolio. All of this is done in line with your financial goals and risk tolerance.

Pros and Cons of Robo-Advisors

As with any investment method, robo-advisors offer pros and cons.

Pros of Robo-Advisors

Robo-advisors deliver several advantages. They include:

  • Relatively low fees: Robo-advisors typically provide investment management services at a lower cost than human financial advisors do.
  • Lower required dollar amounts: Robo-advisors might require lower initial investments and minimum investments compared with their traditional counterparts.
  • Ease of use: An investor can work with a robo-advisor—such as adding cash to be invested or reviewing their portfolio's performance—through an online platform or a mobile app at any time.
  • Little emotion: With little to no human intervention, a robo-advisor largely takes the emotion out of investing.
  • Portfolio diversification: Robo-advisors typically spread your investments among different asset types rather than placing most or all of your money in one type of asset. This helps decrease investment risks.
  • Sophisticated investment models: Companies that operate robo-advisors don't reveal how their algorithms work. However, they do incorporate several sophisticated investment approaches that DIY investors might not be able to employ on their own.

Cons of Robo-Advisors

While robo-advisors offer several advantages, they also come with disadvantages. These include:

  • Limited support from a human advisor or staff: You might not be able to visit an investment professional in person to seek investment advice, or your portfolio may have to reach a certain dollar amount before you do. Certain robo-advisors might provide tech support but no other human support. Meanwhile, some robo-advisors might offer a hybrid of automated and human advice. Operators of robo-advisors point out, though, that humans do work behind the scenes to help manage investment portfolios.
  • Lack of customization: In some cases, robo-advisors might provide designed portfolios that don't allow an investor to make simple tweaks.
  • Narrow focus: Some robo-advisors might concentrate only on a single basket of investment products, such as ETFs, rather than a bigger basket of various investment products.
  • Lack of flexibility: The "one size fits all" nature of some robo-advisor questionnaires might be inadequate for gauging an investor's needs.
  • Brief history: Robo-advisors haven't been around too long, so they likely don't have the same robust track record that traditional investment firms do.

Alternatives to Robo-Advisors

If you've looked into robo-advisors and feel they aren't for you, what are your alternatives? Fortunately, there are several, such as:

  • Traditional financial advisors: If you prefer the human touch, you can seek advice from a flesh-and-blood investment professional. Keep in mind, though, that the expenses might be higher than if you use a robo-advisor if you go with a standard investment firm. One alternative is a fee-only financial planner, who can help you establish your portfolio and to whom you may pay only an annual fee or fee to help you get your portfolio up and running.
  • DIY: Not wild about robo-advisors or human investors? You can always try picking and choosing investments on your own, as long as you feel comfortable with it. Investing can be complicated, and without any guidance, you may be tempted to move your money at times that may not be to your advantage. So if you do decide to go it alone, make sure you've done extensive research and considered your different investment options.
  • Real estate: You can avoid ETFs, stocks, bonds and the like, at least in part, by allocating money toward buying and selling property. If you don't want to buy a property outright, you might consider investing in real estate through a crowdfunding platform. Real estate investments tend to carry high risk, particularly in the short term, so this is another area where a good foundation of knowledge is important.

The Bottom Line

Risk accompanies pretty much any kind investing, and robo-advisors are no exception. However, a robo-advisor might be appealing if you want to essentially put your investment strategy on autopilot and save some money. On the other side of the coin, robo-advisors could be missing the human element that you want as an investor, particularly if you're new to investing. Furthermore, a robo-advisor might not let you adjust your investment portfolio the way you'd like to.

Whichever option you select, be sure to review your financial goals and weigh the financial risks before investing your hard-earned dollars.