What Is a Robo-Advisor and How Does It Work?

So what are robo advisors? At its core, a robo-advisor is a digital financial advisor that uses algorithms to build and manage your investment portfolio. By analyzing your goals, risk tolerance, and investment timeline, robo-advisors automate tasks normally handled by traditional, human financial advisors – often at a fraction of the cost.²

These fintech apps and websites are designed to make investing more accessible. They help reduce the intimidation factor for those new to the space while decreasing costs compared to traditional wealth management services. Robo-advisors remove the guesswork by offering a set-it-and-forget-it approach to investing.

Each robo-advisor service is different, and the exact procedures might differ, but in general, here are how robo-advisors work and how you can get started with one:

1. To help a robo-advisor make ongoing decisions about how to invest your money, you’ll start by filling out a form about your financial and investment goals, risk tolerance (low, moderate, or high), and your financial timeline or target dates. The platform uses this information to create a personalized investment strategy tailored to your needs.
2. After depositing money into your account, the robo-advisor will invest it in options that typically consist of low-cost mutual funds, bonds, stocks, or exchange-traded funds (EFTs) based on your risk tolerance. By focusing on low-cost, diversified investments, robo-advisors aim to maximize returns while minimizing risk.
3. After your account is funded, the robo-advisor will regularly monitor market activity and your investments to ensure your portfolio is rebalanced appropriately. Over time, the performance of your investments can shift your portfolio away from its target allocation. Robo-advisors can perform automatic rebalancing, meaning they adjust your portfolio periodically to maintain the desired balance between asset classes.³
4. To help your investment grow over time, you can consider contributing to your account regularly and on a set schedule.

Robo-advisors are designed to make investing more accessible by automating the process and keeping costs low. But are they the right choice for you?

Consider your financial situation, goals, and level of comfort with managing investments. Robo-investing services can generally be classified into three different categories:

• Robo-advisor companies: These are companies that primarily offer investment services through algorithms instead of human advisors. These platforms operate entirely online, using algorithms to create and manage portfolios based on your input. After answering a few questions about your financial goals and risk tolerance, these tools select an investment strategy tailored to your profile. It also handles everything from asset allocation to rebalancing automatically based on market performance.
• Hybrid robo-advisors: Also known as robo + traditional services, these combine the convenience of robo-advising with the personal touch of a human advisor. With a hybrid robo-advisor, users benefit from automated portfolio management and easy access to human advisors who can provide consultation on complex issues. This option is best for those seeking some level of customization while also taking a slightly hands-off approach to investing.
• Traditional advisors: This refers to brokers that offer traditional investment services as well as robo-advisor products. Unlike robo-advisors, traditional brokers provide clients with one-on-one consultations and tailor investment strategies to fit unique financial goals, life stages, and risk tolerances. They often manage a broad range of services, including estate planning, tax strategies, and retirement planning.⁴ Traditional brokers may have access to exclusive investment opportunities that aren’t typically available through robo-advisors. While these services come with higher fees, working with a traditional advisor is best suited for individuals with complex financial needs or significant wealth to manage.

Depending on your situation, financial standing, and goals, opening an account with a robo-advisor can be worthwhile. Robo-advisors can benefit a range of investors, from novice investors who want to learn how investing works to seasoned pros who want a hands-off way to manage their investment portfolios.

Here are some things to consider if you’re wondering whether using a robo-advisor is the best for your financial needs.

Robo-advisor fees and account minimums

Robo-advisors typically charge an annual management fee, usually ranging from 0.25% to 0.50% of your portfolio’s value. Compare this to traditional financial advisors, who often charge around 1% or more, and you’ll see why robo-advisors are considered an affordable option.⁵

Robo-advisors also typically have lower account minimums. While some platforms have no minimums, others may require $500 to get started.⁶ These factors make robo-advisors incredibly accessible for investors on a smaller budget.

Automated investing vs. hands-on investing

The biggest trade-off when using a robo-advisor is the level of control vs. convenience. Automated investing with robo-advisors is great for people who prefer to set their strategy once and leave it to the algorithms.

Hands-on investing is better for experienced investors who want agency over individual stock choices or to execute real-time trades.

If you decide not to go with a robo advisor, find out how to choose the best financial advisor for your situation.

Access to personalized advice

Another factor to consider is the level of personalized advice you might need. While pure robo-advisors rely solely on algorithms, hybrid options provide access to human advisors for an additional cost. If your financial situation is complex – such as needing guidance on estate planning, taxes, or multiple income streams – a hybrid or traditional advisor may offer more value.

On the other hand, if your goals are straightforward, such as saving for retirement or building a general investment portfolio, the automated advice provided by robo-advisors can be more than sufficient.

Potential increased risk of scams

When using robo-advisor services, the risk of falling victim to investment scams may increase, as scammers often exploit the absence of personal interaction to deceive investors.

Scammers might pose as legitimate robo-advisor representatives, offering too-good-to-be-true returns or pressuring you to provide sensitive financial information over the phone or online. To spot and avoid these scams, always verify the legitimacy of the robo-advisor platform by checking its registration with regulatory bodies like the SEC or FINRA.

Be cautious of unsolicited offers, especially those that require immediate action or upfront payments. Also, look for secure websites (with “https” in the URL), and never share account login information or personal details unless you’re certain that the platform is credible.

Robo-advisors have revolutionized the way people invest by offering accessible, low-cost, and technology-driven solutions for achieving financial goals. It doesn’t take a lot of time to set up an account and start investing. You can take a hands-off approach and utilize benefits such as automatic portfolio rebalancing.

While this can be a great option for anyone with straightforward financial goals who wants a cost-effective alternative to traditional advisory services, it may not be the best option for investors who want personalized financial advice for complex financial situations or those who enjoy actively managing their portfolios.

Ultimately, the choice depends on your goals, preferences, and desired level of involvement in managing your finances. Use these tips to find the best robo advisor for you and continue learning how to start investing and building a diversified portfolio.