Is a Robo-Advisor Right for me?
What Is a Robo-Advisor?
A robo-advisor is a low-cost, online investing platform that employs software algorithms to create and manage investment portfolios. While financial professionals typically design the investing strategies employed by robo-advisors, the ongoing day-to-day management of the portfolios is handled by computers.
Traditional investment management companies and many financial advisors require their clients to maintain substantial account balances, and they tend to charge high annual management fees. Most robo-advisors have low or no minimum balance requirements, and charge much more affordable annual fees.
Robo-advisor services include automatic asset allocation, portfolio rebalancing and tax optimization. Many provide access to human financial advisors to help clients with investment planning.
Since they run automatically and are accessible online, robo-advisors can help you get started investing very quickly, often in a matter of minutes. They can help you take the emotion out of investing decisions, using proven strategies that are tailored to each user’s risk tolerance and financial goals.
How Do Robo-Advisors Work?
The robo-advisor experience usually begins with a brief questionnaire. A new user answers questions related to their age, income, investment goals and risk tolerance. Goals can be anything from saving for college expenses or a home down payment, to investing for retirement.
With this information in hand, the robo‑advisor builds the new user a diversified portfolio of exchange-traded funds (ETFs) or index funds from a limited menu of options selected by investment professionals. The choice of funds matches the goals and risk tolerance outlined in the questionnaire.
Once a user’s portfolio is set up, the platform’s software maintains the correct asset allocation in the portfolio, rebalancing holdings as needed so you don’t have to. Tools and visualizations are provided to let users track their progress, add contributions and potentially set up new goals.
What Are Hybrid Robo-Advisors?
Hybrid robo-advisors combine the benefits of human advisors and automated investment management.
They aim to provide the best of both worlds by combining the personalized advice and guidance of live advisors with the automated algorithms of robo-advisors. They typically use technology to streamline portfolio management and create efficiencies, while also providing access to human advisors for personalized advice, financial planning, and other services.
Hybrid robo-advisors may be a good fit for investors who want the low fees and ease-of-use but also want the personalized advice and guidance of human advisors. They may also be a good option for investors with more complex financial situations or higher investment amounts who need more personalized attention.
Are Robo-Advisors Safe?
As with any investment service, there are risks to be aware of with robo-advisors.
One potential risk is the possibility of a security breach or cyber attack. Since robo-advisors are online platforms that manage personal and financial information, there is always a risk of a security breach. However, most reputable robo-advisors use state-of-the-art encryption and security measures to protect against these risks.
Another risk is the possibility of investment losses. Robo-advisors use algorithms and automated portfolio management that include the risk that the algorithms may not perform as expected, or that market conditions may change in a way that adversely affects the portfolio’s performance. All investments carry some degree of risk, and robo-advisors generally aim to minimize risk through diversification and other strategies.
It’s important to note that robo-advisors are typically regulated by the same authorities as traditional human advisors, which helps to ensure that they are held to high standards of conduct and investor protection. As with any investment service, it’s important to do your research and choose a reputable robo-advisor with a solid track record and good customer reviews.
What Should You Look for When Choosing a Robo-Advisor?
If you’re looking for a robo-advisor, you probably want an easy, hands-off investing experience. That makes usability your primary concern: How easy is it to connect a bank account and start investing?
But usability shouldn’t be your only concern. Almost all robo-advisors provide diversified portfolios of low-cost ETFs. Because their offerings are similar, their performance tends to be pretty similar, too. This makes costs—both annual advisory fees and ETF expense ratio fees—the most important thing to watch out for. You want to find a robo-advisor that balances ease of use with low fees.
That said, robo-advisors that charge zero management fee are seldom “free.” Some may keep a disproportionately large portion of your balance uninvested in a cash account, which the firm then lends out to earn interest. This may hinder your overall returns by forcing some of your investing dollars to remain on the sidelines.
Some robo-advisors fill your portfolio with their own proprietary ETFs. While proprietary funds aren’t always a bad thing—Vanguard and Fidelity funds, for instance, are very low cost—newer companies’ proprietary funds may lack the historical return data and liquidity of more established funds. They also may be more likely to unexpectedly close down.
Ensure that your robo-advisor of choice offers the kind of account you want. Almost all offer taxable investment and tax-advantaged retirement accounts, which will probably serve the needs of most prospective robo-advisor investors. But if you’re hoping to invest specifically for a child’s education through a 529 account, your options are very limited. Wealthfront is currently the only major robo-advisor with this offering, though more companies offer custodial brokerage accounts that allow you to invest more broadly on your child’s behalf.
Finally, consider how easy it is to contact customer support. Some robo-advisors rely primarily on chat and email support; if talking to a human live on the phone is important to you, then you’ll want to make sure any prospective robo offers this.
How Many Funds Should You Be Invested In?
You’ll find that some robo-advisors use algorithms that put typical investors into niche ETFs, such as an international emerging market bond fund. At first glance, this amount of targeted diversification may seem nice, but it can cost you and it may not end up providing substantially better diversification than broader funds with lower expense ratios.
Generally speaking, specialized funds charge management fees that are substantially higher than ETFs that mimic a broad index. Some emerging market bond funds, for example, may charge expense fees of up to 0.39%. Compare that to Vanguard’s Total International Bond ETF, which charges 0.07% per year (as of February 2023). This fund offers exposure to both emerging and developed markets, meaning it may provide more bang for your buck (just a comparison, not a recommendation).
What’s more, broader funds keep things simpler. Keeping track of an excessive number of funds can be taxing—and while that’s what a robo-advisor is for, you can create a diversified portfolio with as little as just three funds: U.S. and international total stock market funds and a total bond market fund.
With that level of simplicity, you might feel empowered to handle your investment portfolio on your own. But if you still prefer a robo-advisor to do it for you, perhaps a platform that keeps your portfolio as simple and low-cost as possible might be just the ticket.
Robo-Advisor FAQs
How much money do I need to Invest with a robo-advisor?
Most robo-advisors have low or no minimums to open an account. However, some robos offer lower prices or enhanced services if you have a balance over a certain amount. A minority of robo-advisors require balances of more than $25,000.
How do I open a robo-advisor account?
To open a robo-advisor account, visit the robo-advisor’s website or download its app. Robos all have their own unique registration process, but in general you’ll need to provide the following information:
• Name
• Date of birth
• Mailing address
• Social Security number
• Annual income and net worth
• Years of investing experience
• Investment goals
• Risk tolerance
You have to inform robo-advisors of this information so they can comply with federal regulations and place you in investments matching your goals and ability to tolerate risk.
Can you lose money with a robo-advisor?
Yes, it’s possible to lose money investing with a robo-advisor. While they strive to build portfolios from proven fund options, stock market downturns or other adverse market events can still negatively impact your investment in a robo-advisor portfolio.
Are robo-advisors better than ETFs?
Most robo-advisors build their investment portfolios from ETFs. Typical robo portfolios hold three to ten ETFs, providing a very good level of diversification that’s matched to your goals and risk tolerance. Individual investors can and do create and manage their own portfolios of ETFs, but the advantage of a robo-advisor is that it handles the fund selection and rebalancing automatically.