Robo-advisors are automated portfolio managers that use algorithms to offer financial advice. You can think of these apps as an autopilot for investors. When you sign up to use one, you will first answer a series of questions about your risk tolerance, financial resources, and goals. Then, the robo-advisor will make ongoing decisions about investing your money and monitor any changes in the future.
Here's what these products offer, how they work, and whether they could be a good fit for you.
Definition and Examples of Robo-Advisors
Robo-advisors are software products that can help you manage your investments. It’s all done without the need for you to consult a financial advisor or manage your portfolio. A wide variety of financial institutions offer these products. Some, such as Fidelity, are established companies with a lengthy history. Others, like Acorns, were created recently for the sole purpose of providing a robo-advisor service.
Robo-advisors are an alternative to traditional financial advisors, and they're often much cheaper. These products are also an alternative to simply picking and choosing investments on your own.
How Do Robo-Advisors Work?
A new customer signing up for a robo-advisor usually starts by giving basic information about their investment goals through an online questionnaire. These questions may touch on subjects like your timeline, your risk tolerance, and how much money you have in savings. Then, robo-advisors run those answers through an algorithm. This will provide an asset allocation approach and help you build a diversified investment portfolio that meets your goals.
Once your funds are invested, the software can automatically rebalance your portfolio. This will ensure that it remains close to that target allocation. Many popular robo-advisors encourage you to regularly contribute to your account. This could even be small weekly deposits, for instance. Then, the robo-advisor will use those contributions to maintain your target allocation.
Some robo-advisors even use tax-loss harvesting strategies, which involve selling specific securities at a loss to offset gains in other securities.
Investments In a Robo-Managed Account
Most robo-advisors use low-cost exchange-traded funds (ETFs) rather than individual stocks or mutual funds to build your portfolio. They can follow an index fund or another passive investment approach. This emphasizes the importance of your allocation to stocks or bonds. Depending on your robo-advisor, you may also be able to further specify investments using environmental, social, or governance (ESG) investing criteria.
How Taxes Work for a Robo-Advisor Account
As with any investment, your tax liability when using robo-managed assets depends on the type of account in which you hold the assets.
If you hold your assets in a traditional IRA or another tax-deferred retirement account, you pay no taxes until you withdraw funds. Rollovers or asset transfers from your existing account to a robo-advisor generally do not count as a withdrawal. Withdrawals from a Roth IRA account are generally tax-free if they are qualified distributions.
Some of these online portfolio solutions offer a free trial period. That way, you can see how the service works before you are charged.
If you own investments in a taxable account, then you will need to report those on your tax return. You'll also need to pay taxes on earnings, similar to investing in a brokerage account. You'll receive a 1099 form each year, which reports the interest, dividends, and capital gains on your investments.
If your robo-managed account allows you to transfer in existing investments, those investments will likely be sold unless they are the same investments that the robo-advisor would have invested in with those funds. If sales do occur and you earn a profit, you will have capital gains taxes on those sales.
Robo-advisor fees may be structured as a fixed monthly fee; or, it can be as a percentage of assets. Fixed monthly fees can be as low as $1. Percentage fees range from roughly 0.15% to 0.50%.
Remember that robo-advisor fees are in addition to any fees associated with the investments. For instance, mutual funds and ETFs within your account will likely come with their own expense ratios. This type of fee is taken out of the assets of the fund before returns are distributed.
Pros and Cons of Robo-Advisors
No investing knowledge needed
Hard to get human-to-human interaction
Limits investor options
May force investors to open multiple accounts
- No investing knowledge needed: Robo-advisors can be an excellent option for beginning investors. You can start investing even if you haven’t yet developed the financial expertise required to make informed decisions.
- Isn’t time-consuming: Many people don’t have time to manage their investments actively, so they’d rather put their portfolio on autopilot. Once a robo-advisor account and automated deposits are set up, you don’t need to do anything else but watch until you want to withdraw money.
- Simple strategies: Robo-advisors often use a simple investment strategy that is easy to understand. For instance, your advisor might allocate 60% to stocks and 40% to bonds. You likely won’t have many investments to watch, so you can easily and quickly assess the performance of your holdings.
- Hard to get human-to-human interaction: Some robo-advisors offer live assistance. But this usually comes with extra costs. Many robo-advisors interact with you only through online methods. The trade-off is that robo-advisor fees are much lower than most financial advisors. So, what if you enjoy speaking to actual people or need someone to walk you through the app or website? In that case, the savings on fees may not be worth it for you.
- Limits investor options: If you have ideas about a specific stock you want to invest in, you probably won’t be able to tell your robo-advisor to buy it. The “options” offered by robo-advisors are very general. For instance, they may ask you: “Do you want to be risky or conservative?” Robo-advisors may not satisfy those who want to actively make decisions about their money.
- May force investors to open multiple accounts: If you decide you want to invest in a specific stock, you may have to open a separate brokerage account to buy it. Some investors may also need to coordinate company benefit packages and 401(k)s with other accounts. This may make the automation offered by robo-advisors less useful.
- Robo-advisors are services that automatically balance an investor's portfolio.
- They make decisions based on your basic information and investing goals.
- Robo-advisors are a low-fee alternative to financial advisors. But there are some drawbacks to opting for an automated investing advisor.