What Is A Robo-Advisor? How Do They Work? (2024)

A robo-advisor can help you automate the process of investing for retirement and other financial goals. The robo-advisor concept is simple, but for new investors the idea of letting a software algorithm choose your investments may seem somewhat unfamiliar. We’ll take a deep dive into the concept and tell you everything you need to know about robo-advisors.

What Is a Robo-Advisor?

A robo-advisor—also known as a robo, a roboadvisor or a robo-adviser—is a type of brokerage account that automates the process of investing.

Most robos charge lower fees than conventional financial advisors because they invest your money in prebaked portfolios made primarily of specially chosen, low-fee exchange-traded funds . Some robo-advisors also offer access to other more customized investment options for advanced investors or those with larger account balances.

You can opt for either taxable brokerage accounts or tax-advantaged individual retirement accounts (IRAs) with a robo-advisor. Most robos offer multiple types of IRAs, including traditional IRAs, Roth IRAs and SEP IRAs—and they’ll help you choose the right account type based on your needs.

Many robo-advisors can help you save for different personal finance goals simultaneously by providing sub portfolios with different asset allocations—think a growth-oriented allocation for your home down payment goal, and a more income-oriented allocation for your retirement goals. Increasingly, robo-advisors are also offering basic banking services, like cash management accountsand savings accounts.

Like conventional human financial advisors, robo-advisors are regulated by the Securities and Exchange Commission, meaning they have a fiduciary duty to look out for your best interests when it comes to investment choices. Robo-advisors generally insure their accounts via the Securities Investor Protection Corporation (SIPC).

How Does a Robo-Advisor Work?

The “robo” in robo-advisor is a nod to the automated features that are at the heart of this type of investing platform. The automation begins as soon as you sign up, and the onboarding process generally begins with a questionnaire that’s designed to help the software that runs a robo-advisor understand your current finances, your financial goals and your risk tolerance.

If you indicated that you’d prefer to save for retirement, for example, the robo-advisor would likely recommend an IRA, rather than a taxable account, with a portfolio of ETFs balanced for long-term growth. If you answered that you were looking to save for a home down payment, however, the robo might recommend a taxable account with a portfolio of ETFs balanced for short-term growth.

Some robo-advisors allow you to tweak your asset allocation. Continuing the example above, if this feature were available and your new robo-advisor recommended that your retirement portfolio comprise 80% stocks and 20% bonds, you might be allowed to adjust the allocation to 90% stocks and 10% bonds, adding a bit more risk to the mix.

Robo-Advisors Choose Your Investments

It’s important to understand that a core advantage of robo-advisors is that you generally do not choose the individual securities and ETFs that make up your portfolio. Robo-advisors pre-select low-cost index fund ETFs (and sometimes other investments, like mutual funds). These are mainly broad-market funds that invest in U.S. stocks, international stocks, bonds and real estate investment trusts (REITs). You may be able to choose themed portfolios, such as a socially responsible investing portfolio.

Index fund ETFs charge very low fees and offer strong diversification. Historically, lower cost index fund investments have been associated with better investment returns over time than higher-cost, actively managed funds.

Modern Portfolio Theory

Robo-advisors use Modern Portfolio Theoryto design their portfolios. MPT aims to optimize portfolios for returns while minimizing risk through diversification.

Think of MPT as applying the “don’t put all of your eggs in one basket” mindset to your investment portfolio. By investing in a wide range of asset types, MPT increases the odds that when some of your investments are down, others will be up. This aims to keep your portfolio trending steadily upward, even during volatile times.

In addition to diversification, most robo-advisors provide automatic portfolio rebalancing and, increasingly, tax-loss harvesting. Portfolio rebalancing helps ensure you keep the right balance of investment types to reach your goals as market conditions change, and tax-loss harvesting can help decrease the amount you owe long term on capital gains taxes.

How Much Does a Robo-Advisor Cost?

Robo-advisors generally charge annual management fees of 0.25% to 0.50% of your assets under management (AUM), although some charge a fixed monthly subscription fee instead. Low fees compared to traditional financial advisors are considered one of the key advantages of robo-advisors.

Traditional financial advisors typicallycharge around 1.0% of AUM per year(fees may decrease for clients with larger balances). On an investment balance of $100,000, a 0.25% robo-advisor fee would amount to $250 a year—while a 1.0% fee would equal $1,000 a year.

Like your investment balance, fees compound over time and can cost you a significant portion of your long-term gains: Over 20 years, for example, a 1% advisory fee may cost you almost $30,000 morethan a 0.25% fee on a $100,000 starting balance.

Free Robo-Advisors Aren’t Always Free

A few robo-advisors—SoFi Automated Investing, M1 Finance, Axos Invest (formerly Wisebanyan), Schwab Intelligent Portfolios and Fidelity Go—claim that they charge zero management fees. Read the fine print, and you discover that Schwab Intelligent Portfolios requires you to keep a percentage of your portfolio in cash (Schwab earns interest on that balance, not you) while Fidelity’s service is only free for balances less than $10,000.

Expense Ratio Fees

In addition to management fees, you’re generally on the hook for fees associated with the products in which your money is invested by the robo-advisor. ETFs may have much lower expense ratios than mutual funds, but you’ll still be paying them, one way or another.

Expense ratios for index fund ETFs average 0.21% but can run as low as 0.02%. That’s equal to 21 cents or 2 cents per $100 you invest a year. You won’t receive a bill for these charges, though. They are generally deducted from funds’ earnings or cash holdings and are automatically deducted from the rate of return.

Common Robo-Advisor Features

Many robo-advisors offer similar features. These include:

• Automated investing: All robo-advisors let you schedule regular contributions into your diversified portfolio. The platform decides how to allocate your contributions in your portfolios. After completing your initial questionnaire, you are generally not involved in choosing investments.
• Automatic rebalancing: Many robo-advisors provide automatic portfolio rebalancing. This means they adjust the percentage of investment types you hold based on market performance to keep them in line with your financial goals. Portfolio drift might happen if your stock values fell one year and their value occupied less of your portfolio than desired. Rebalancing keeps you on target to meet your goals and your portfolio in check. Some robos (Betterment, Wealthsimple and Acorns) rebalance based on set drift percentages. Others (Ellevest, Wealthfront¹, Personal Capital and SoFi) regularly rebalance portfolios.
• Tax-loss harvesting: Some robo-advisors will optimize your portfolio for tax efficiency. For example, Betterment² and Wealthfrontoffer tax-loss harvesting services where losing investments are sold in a tax-efficient way to offset capital gains taxes. This is done without charging an extra fee. Other robo-advisor platforms, like Axos, charge an extra fee for this service, which it calls “Tax Protection.”
• Personalized financial planning: Some robo-advisors, like Betterment, offer financial planning services that can bepurchased a la carte. Others, like Personal Capitaland Wealthsimple, offer tiered management services based on how much you have invested. These services are included in the advisory fee you pay and include dedicated financial advisors to create personalized plans and customize your wealth management.
• Goal-based accounts: While robo-advisors almost universally offer access to taxable investment accounts and retirement accounts, most robo-advisors also allow you to create goal-based accounts. Wealthfront, for example, offers the ability to save for college with a 529. Other robos, including Acornsand Stash, let you open custodial accounts to invest for your children. Leading robo-advisors will also allow you to invest for multiple goals at once through different account types.
• Other banking services: Many robo-advisors now also offer FDIC-insured checking, savings or cash management accounts. Wealthfront’s and Betterment’s cash management accounts allow you to make unlimited monthly withdrawals and offer competitive interest rates. Platforms like M1 even offer low-interest loans.

Do You Need a Robo-Advisor or a Financial Advisor?

Robo-advisors aren’t for everyone. If your financial situation is complicated or you want to invest in more than index ETFs or a very limited selection of other securities, it might make more sense to work with a financial advisor. You might choose a conventional financial advisor if you:

• Value customization: While some robo-advisors let you customize certain aspects of your portfolio, most place you in a preset portfolio designed for someone with your investing timeline and risk tolerance. Financial advisors may also use software to craft portfolios, but they offer much more tailored choices and a much wider array of investment options.
• Want to trade: If you want to trade stocks or invest in individual stocks and bonds, you may want to use a financial advisor or a brokerage account in addition to a robo-advisor. Very few robo-advisors allow you to trade. If you want the ability to invest in individual stocks in addition to a prebuilt portfolio, consider a robo like Stash.
• Want a comprehensive financial plan: Robo-advisors excel at ETF-based portfolio construction. If you’d like advice for your entire financial life, including recommendations for products like insurance or estate planning services, you probably want a traditional financial advisor.
• Have a complex financial situation: If you need help strategizing how to divide assets in a divorce, have a complicated tax situation, have large amounts of debt or want aid in planning for college and end of life costs, a conventional financial advisor is the right choice.

Keep in mind, even with a financial advisor, you may need to consult with other types of financial professionals. You may face situations where you could need access to a tax professional or an estate planning attorney. The more complex your finances, the more likely it is that you need an actual dedicated financial advisor or wealth planning team to help you stay on top of things.

The Bottom Line

A robo-advisor can be a good choice when you’re starting out and just looking for a simple way to begin growing your wealth. However, as your net worth improves and your situation becomes more complex, you might need to consider turning to a human financial advisor to help you navigate your financial future.

¹Forbes Advisor receives cash compensation from Wealthfront Advisers LLC (“Wealthfront Advisers”) for each new client that applies for a Wealthfront Automated Investing Account through our links. This creates an incentive that results in a material conflict of interest. Forbes Advisor is not a Wealthfront Advisers client, and this is a paid endorsem*nt. More information is available via our links to Wealthfront Advisers.

²Betterment is not a licensed tax advisor. Tax Loss Harvesting+ is not suitable for all investors. Investing involves risk. Performance not guaranteed.