What is a Robo-Advisor? A Guide to Automated Portfolio Management
It’s not surprising that the popularity of robo-advisors is growing at a steady pace. After all, automated investing services like robo-advisors make leaning into the conversation more accessible for everyone.
With a hands-off approach to investing and low management fees, robo-advisors grant anyone the opportunity to increase their wealth, whether or not they’re privy to the ins and outs of investing.
So, what is a robo-advisor anyway? And how does a robo-advisor work?
In this article, WealthRocket covers the basics of automated investing and what a new investor needs to know before choosing the robo-advisor that’s right for them.
Table of Contents
What is a Robo-Advisor?
A robo-advisor is an automated investing platform that makes trading and investing decisions on behalf of investors, guided by a Nobel Peace Prize–winning algorithm.
This type of investment platform provides a portal to hands-off investing that does not require frequent monitoring or decision making, with little knowledge of investing required.
Investment managers do not manage accounts, which allows robo-advisors to charge much lower fees than alternative investing methods.
Robo-advisors are most popular among tech-savvy millennials, who, in recent years, have preferred managing their own investments at a lower price. Nonetheless, people of all ages and financial backgrounds choose robo-advisors for their affordability and ease of access.
How Does a Robo-Advisor Work?
Unlike financial advisors, fund managers, and stockbrokers, a robo-advisor service uses a computer-driven algorithm to manage investments on behalf of the client. It does not come with detailed financial advice, though depending on the service, several resources are available.
Traditional portfolio managers handle research and decision making on behalf of their clients, while robo-investors handle trading, investing, and portfolio rebalancing. There is little to no human involvement in automatedinvesting.
Robo-advisors invest in Exchange-Traded Funds (ETFs). ETFs act as baskets holding various investments, such as stocks, bonds, and equities. The amount that goes into each investment depends on the type of portfolio built for the investor.
Robo-advisors create investment plans for customers based on a questionnaire. Upon sign-up, new investors must provide their age, income, net worth, and long-term financial planning goals (such as homeownership or retirement, for example). The questions determine each investor’s risk tolerance and the type of portfolio the robo-advisor will build for them.
Risk tolerance determines the amount of risk that an investor is willing to take since trading markets are volatile and subject to losses.
An investment portfolio is a collection of different investments.
Should is the operative word here. Firstly, when we are talking about savings in this case, it’s mostly referring to retirement savings, which, as you know, are an entirely different beast than rainy-day savings.
How Much Does a Robo Advisor Cost?
Robo-advisors charge a percentage known as a Management Expense Ratio (MER) and a management fee. Alternatively, some robo-advisors offer flat-rate pricing as a monthly subscription.
MERs are different for every robo-advisor. The percentage is charged by third-party companies who manage the investments on behalf of the robo-advisor. Investors won't notice these charges on their return.
Robo-advisors also charge a management fee for facilitating the investment.
Since robo-advisors do not come with active management, they provide lower management fees than banks, financial advisors, and stockbrokers.
In addition, these services operate mostly online, thus eliminating the overheads that come with brick-and-mortar businesses.
How to Choose a Robo-Advisor
Shopping for a robo-advisor is easier than it sounds. Here are a few points to take into consideration before investing with any of the best available robo-advisors.
1. Pricing and minimum investments
Naturally, pricing is the leading contributing factor in finding the right investing service.
Robo-advisors are known for having some of the lowest fees for financial services in the market. That said, pricing is incredibly competitive.
Assessing the expense management ratio and management fees is a must before signing the (virtual) dotted line.
Along with minimum investments, new customers should review the minimum investment requires.
Some management firms, like Wealthsimple for example, do not require a minimum deposit, while others, such as Charles Schwab, require a higher minimum deposit.
2. Personal goals and accounts
Choosing the best suited brokerage account for the right goals goes hand in hand.
If you’re looking to stash money away for a vacation, home, or retirement, using the appropriate account for the right goal impacts the user’s returns, tax-loss harvesting options (in the U.S.), and their overarching purpose behind investing.
3. Promotions and offerings
Why not save money on saving money? Myriads of robo-advisors entice new customers with sign-up promotions, which often include free management of funds, access to resources, and financial consultations. Typically, promotions offer discounts and additional perks.
Nevertheless, ensure your chosen investing platform is the right fit. A robo-advisor could offer an attractive opening offer but it may cost more in the long run.
How Do Robo Advisors Make Money?
Robo-advisors are stand-out products for their low operating fees. Pricing from platform to platform varies, yet it consistently remains true to their affordable pricing ethos. Still, some options are more affordable than others.
Robo-advisors in the United States and Canada charge a management fee that helps them run their business.
Are Robo-Advisors Safe?
The short answer is: yes, robo-advisors are safe and legitimate investing platforms.
Reputable robo-advisors come with insurance or are recognized members of government-approved financial regulators.
Approved investing platforms come with insurance in case they become insolvent or go out of business—not against market changes or losses.
Robo-Adisors Pros & Cons
Robo-advisors are a great option for hands-off investing but might not be right for everybody. Let’s look at the pros and cons of using a robo-advisor..
Pros: The Good Stuff
No experience required: Robo-advisors do not require prior investing experience or a self-developed investing strategy. Robo-advisors build portfolios and allow investors to monitor and manage their investments with no prior experience.
Lower fees: Robo-advisors tout lower fees, and with good reason. Other passive investing options, such as mutual funds, charge almost double the rates that robo-advisors do.
Low or no minimum balance: Most providers do not require a minimum balance when opening an account. If they do, the minimum investment is typically lower. This feature makes it a great option for beginners who wouldn’t regularly meet minimum account requirements.
Cons: The Not So Good Stuff
Lack of human advisors: Investing advisors and stockbrokers come with a price, and there’s a reason for that. They come with a human touch and provide insight that robo-advisors generally can’t.
Lack of additional investing options: While robo-advisors provide hands-off investing, there isn’t much flexibility in allowing customizable features, meaning customers can’t choose their investments.