The Robo-Advisor: What They Are and How Investing Got Easier

Before creating robo-advisors, your investment options were either to hire a financial advisor for a “small” fee or to research and pick the funds yourself. Now there’s another way. Robo-advisors have become increasingly popular. But why should you consider using one?

Because robo-advisors offer investment management services for a fraction of the cost.

This post details what a Robo-Advisor is, how it works, and the services it provides. I’ll also point out whether using one is right for you. In short, if you’re looking for a simple, hands-off approach to investing, keep reading.

What Is a Robo-Advisor?

A Robo-Advisor is an automated, digital investment management service. It uses algorithms to monitor your portfolio and execute trades, automatically rebalance, and perform advanced investment strategies, including tax-loss harvesting.

Because its portfolio management services operate with little to no human interaction, its costs are lower than what you’d pay for a traditional financial advisor.

When creating an investment account, you’ll complete an online questionnaire related to your financial goals, time horizon, and risk tolerance.

Before robo-advisors you could either:

1) Use a human financial advisor. It usually requires meeting in-person. They’ll ask you a series of questions and walk you through the steps of selecting your portfolio.

Once you settle on your investment criteria, your advisor constructs your portfolio, monitors it, and provides continuous financial advice.

The end-goal is to earn you the highest return for the assumed level of risk. This dedicated service carries a higher cost, typically 1%-3% of assets under management (AUM).

2) Do it yourself. It requires more time; you’re performing all the research, choosing which mutual funds to use, determining your portfolio’s asset allocation, executing trades, rebalancing, and any other necessary strategies.

The DIY-approach costs less money because you’re doing all the work.

Robo-advisors offer a third approach to build a portfolio that didn’t exist before. It requires little to no human involvement because the process is digitized and performed online.

Once you’ve completed your questionnaire, it constructs your portfolio in minutes and manages it. This approach is slightly more expensive than doing it yourself but considerably lower than a traditional advisor.

Compared to Alternative Strategies

How Much Does a Robo-Advisor Cost?

They keep costs low because they offer a digital, automated service, invest your money passively, and don’t attempt to beat the market (but instead, mirror it).

They also use low-cost index funds or exchange-traded funds (ETFs) to build your portfolio. These funds have low operating costs (known as expense ratios).

Typical account management fees range from 0.25% to 0.50%, while account minimums needed to invest typically don’t exceed $500.

Certain robo-advisors also offer a level of human oversight, which is either included in its account management fee or bought as an add-on financial package.

For a deeper dive on their costs and fees, read our detailed post. Or, analyze your portfolio using Personal Capital’s free tool.

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Account Types and Portfolio Options

Robo-advisors come in all shapes and sizes. There’s one to satisfy every kind of investor.

You can open taxable accounts individually or jointly; retirement accounts including Traditional, Roth, and SEP IRAs; rollovers from an existing 401(k), and even 529 college savings accounts.

They build portfolios using index funds or ETFs with conservative to aggressive asset allocations. The number of ETFs varies. For example, Acorns makes its portfolios using seven ETFs, while Betterment uses 32 ETFs and fourteen asset classes.

How Much Money Can You Make with Robo-Advisors?

All investments carry risk. Using a Robo-Advisor is no different. You assume the risk of having your money in the stock market, and it’s that risk that rewards you.

Because they only attempt to mirror the index it tracks, you can expect average market returns of that index.

Conservatively, returns fall between 6% to 7%. However, the ride can vary widely from year to year because you’re investing in the stock market.

They aren’t trying to time the market nor beat it. But, if your investing style embraces a long-term, buy-and-hold strategy, 6% to 7% returns compounded over thirty years can make you a millionaire.

A Short History

Financial advisors used robo-advisors as far back as the early 2000s to manage and rebalance its client’s target-date funds. This software bought, held, and rebalanced according to the portfolio’s target asset allocation.

Financial advisors benefited immensely from the technology, although retail investors were excluded from this service (and were stuck paying management fees between 1% and 3%).

The success of Mint’s automated personal finance software in 2006 revealed an untapped consumer market that preferred to remain mostly hands-off. It spurred further funding for the use of robo-advisors targeting retail investors.

The two earliest were Betterment and Wealthfront, founded in 2008. Wealthfront founders originally started their business model, providing financial advice to the tech industry.

They changed course, seeing the profit potential when serving more people at a lower cost.

Betterment’s CEO Jon Stein streamlined the entire investment process through automation. Ordinary investors could begin with little money, fund their portfolio for pennies on the dollar, and start investing in minutes.

Robo-investing employs a passive-indexing strategy and is heavily rooted in Modern Portfolio Theory (MPT).

Disrupting Wall Street

Perhaps you’ve encountered the phrase, “Robo-advisors are democratizing the financial industry.” It’s become a cliche, but the statement has merit.

They do make investing more accessible while making their client’s financial lives manageable.

Computers generate algorithms that follow specific criteria designed to maximize investments – all with little human interaction.

You no longer need to be a mathematician to manage your investment account, call a broker to place a trade, or have a high net worth. All you need to know are your savings goals, time horizon, and risk tolerance.

Robo-advisors beat Wall Street by reducing costs through automation, low fees, and inexpensive fund choices.

Management fees are a fraction of what you’d pay a human advisor for the level of service. Tax-optimized portfolios are typical, with some even offering commission-free trades (e.g., Public and Robinhood).

Features including tax-loss harvesting, direct indexing, and automatic portfolio rebalancing are par for the course at no additional cost.

They offer complete transparency, including the funds they use and its investment strategies.

Robo-investing provides retail investors who want to remain hands-off, are skeptical of human advisors and don’t trust Wall Street, with an affordable advisory service.

Assets Under Management  

While surpassing $1 trillion in global assets under management (AUM), the above table represents a closer look at the top five robo-advisors in the United States.

U.S. robo-advisors AUM is nearly $682 billion. The same report from Statista estimates robo advisors will hit $2.7 trillion global AUM by 2024.

Brokerage juggernaut Vanguard, already carrying a substantial lead in this space, has released a digital-only Robo-Advisor, reducing the minimum investment requirement from $50,000 (for its hybrid personal robo advisor service) to $3,000.

How They Make Money

Most robo-advisors make money from the number of assets under management in the form of a wrap fee. It’s an all-in-one, flat fee covering brokerage and administrative services, advice, and any other additional expenses associated with investment management.

Payment for order flow is another way. Similar to how you have plenty of streaming options for watching TV (e.g., Hulu, Netflix, Amazon), your broker has many places they can send trades.

When your broker places a trade, they sell it to a third party. For example, if your broker sends your trade to an exchange, it pays the Robo-Advisor for the order.

Robo-advisors bundle orders together, which means trading less frequently and lower costs for you.

Some now offer cash management services and collect money on the interest from those accounts. Others provide a host of accompanying financial products for an enhanced level of service.

Does the SEC Regulate Robo-Advisors?

Robo advisors are registered investment advisors and regulated by the SEC. They have a fiduciary duty to serve their clients’ best interests as set forth by the Investment Advisers Act of 1940.

Simply put, the act protects retail investors from unethical financial advice.

They also belong to the Financial Industry Regulatory Authority (FINRA), which oversees the financial industry and ensures brokers act honestly.

You can use BrokerCheck to find out information about your robo advisor.

Robo-advisors must follow protocols for all tasks involving investor outcomes. The SEC has strict guidelines, including a description of algorithmic functions used, when the robo advisor might override the algorithm, and explain the level of human involvement used in portfolio management.

What Is the Best Robo-Advisor?

There is no hard-and-fast rule about who the best Robo-Advisor is. Your situation differs from everyone else’s. If you’d like one with virtually no human interaction, Wealthfront might make a good fit.

If you’d like access to a human advisor, Betterment could be better.

Consider costs, customer support, and investment selection. For a look at our picks for the best robo-advisors and who each is best for, read our in-depth post here.

Is a Robo-Advisor Worth It?

You’ll need to consider what kind of an investor you are. If you’re looking for goal-based, automated portfolio management with little human interaction, robo-advisors might be worth a look.

You’ll pay considerably less for their services.

If you’d like a Robo-Advisor with access to a human advisor, with a bit of financial guidance, a hybrid model may be more your style.

Human financial advisors are necessary when you have a complex portfolio, want to meet in-person, and prefer dedicated support.

Robo-advisors are best for people with little money to invest, are comfortable with an online process, and prefer a straightforward, hands-off approach (while retaining a sense of control).

Considering what you get for the money, a Robo-Advisor is worth a look. If you’re still unsure, read our detailed post Should You Use a Robo-Advisor to Manage Your Investments This Year.

Final Thoughts

Robo-advisors provide a service. They’re not all financial planners, and guidance can be limited. If your needs require more attention, a Robo-Advisor may not be worth it.

However, some robo-advisors offer fee-based financial planning packages or access to a financial advisor if you prefer a little human interaction. If your needs are simple, this might be the better option.

The best choice is the one that lets you sleep at night. Not all robo-advisors are created equal, and everyone’s needs are different.

Consider the level of time you’d like to spend managing your finances. If you’d prefer to do it yourself, a Robo-Advisor may not be your best option.

But if you’re the type of person who doesn’t want to think about it, has simple financial goals, and prefers an automated, digital, hands-off style, a Robo-Advisor could be what you need.