What Is a Robo Advisor?

By Dan Miller, WCI Contributor

Probably the easiest way to define a robo advisor is as a computer-based, automated service that performs investment management for a low fee. Robo advisors have become more popular recently as many people are looking for an advisor that charges lower fees than most traditional financial advisors.

How Do Robo Advisors Work?

Typically, a robo advisor will ask you a series of questions to determine your investment preference and risk tolerance. Based on those criteria, the robo advisor will design a collection of funds for your portfolio. Often, this is an allocation of different index and mutual funds in specific percentages to fit your stated investment criteria.

Robo advisors typically rebalance your portfolio periodically, buying or selling from different investments. This is done to keep your investments in line with your investment goals. Many robo advisors also do automatic tax-loss harvesting, where you sell one investment at a loss and buy a similar investment to offset gains.

Robo Advisor Performance

There are many different robo advisors out there, and each robo advisor has many different portfolio options. So, it's impossible to make a generic statement about how robo advisors perform—instead, it's important to do your research and be aware that there may be a wide range in how different robo advisors perform.

Some robo advisor portfolios may beat the market over a specific period of time, while others may not. Before deciding to invest with a robo advisor, make sure that you understand how they have performed previously, while also understanding that past performance is not a guarantee of future results.

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How Much Do Robo Advisors Cost?

There are several different ways that robo advisors charge fees for their services, and one of the most common is to charge a fee based on the total assets under management (AUM). While robo advisor AUM fees vary, many robo advisors charge a fee of 0.25%-0.50% of the total AUM. While this fee is calculated annually, the fee may be charged monthly, quarterly, or on some other cadence. For context, a human financial advisor will often charge 1% of AUM, meaning a robo advisor would likely be less expensive.

Robo Advisors for High Net Worth Individuals

Many robo advisors allow people to invest with relatively modest minimum amounts. Conversely, if you are a high net worth individual (HNWI), a robo advisor may still be an attractive option as part of your investment portfolio. A HNWI will want to make sure to find a robo advisor that offers the ability to diversify investments, do tax-loss harvesting, and have access to alternative investment classes. A HNWI may also want to look for a robo advisor that also offers easy access to a traditional financial advisor as part of their package.

Are Robo Advisors Worth It?

Robo advisors can certainly be worth it, depending on your risk tolerance and investment goals. Many investors choose robo advisors because they appreciate some of the benefits (like automated trading, tax-loss harvesting, and lower fees than most traditional financial advisors). If you enjoy the process of investing (and have the time), you may find that you can capture many of the benefits of using a robo advisor without having to pay the fees by just doing it yourself.

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Benefits of Robo Advisors

Here are a few of the top benefits of robo advisors:

A Good Enough Portfolio — A robo advisor portfolio might not be personalized, but the truth is you probably don't need a personalized portfolio. Robo advisor portfolios are good enough, and many of them are surprisingly sophisticated. The vast majority of portfolios that investors hold out there are far worse than all of the robo advisor portfolios.
Automated Portfolio Management — One real benefit of having a robo advisor, even if you are a sophisticated investor capable of doing it on your own, is that you don't have to do the tasks of investing. These include rebalancing, tax-loss harvesting, designing a portfolio, making individual investment purchases, etc.
Low Fees — While there are some investment managers with very low fees, the fact is most of them aren't doing anything that is very different from what the robo advisors are doing. The 0.3% you would pay for a rob0 advisor is a fraction of what you'd pay the average advisor to manage your money.

Robo Advisors vs. Index Funds

One of the negative aspects of investing with a robo advisor is that there is a cost to hiring one, and that fee comes directly out of your returns. Over the course of 30 years, even a very low fee like 0.3% adds up. Consider a doctor investing $50,000 a year and earning 8% by themselves vs. 7.7% with a robo advisor. You retire with 6% more ($6.12 million vs $5.77 million) assets (and thus a retirement income 6% higher) by doing it yourself. Some investors may feel comfortable managing their investments, even with something as simple as investing in an S&P 500 index fund.

Robo Advisors vs. Financial Advisors

While robo advisors can do many of the things that traditional financial advisors do (at a fraction of the cost), it's important to understand that they are not the same as traditional financial advisors. If your investing style is one that benefits from having a person to talk to you about your investments, you might consider either solely working with a traditional financial advisor or working with a robo advisor that also offers access to traditional advisors.

Hiring a Robo Advisor

Since robo advisors are typically companies rather than individuals, you don't hire a robo advisor in the same way that you might hire a traditional financial advisor. If you want to start using a robo advisor, you will usually sign up on their website or through their mobile app. You'll enter basic demographic information about yourself, answer a few questions to determine your investment priorities and risk tolerance, and then transfer your money.

Robo Advisors and Regulation

Robo advisors are regulated in much the same way as human advisors. Robo advisors must be registered with the Securities and Exchange Commission (SEC), and they are also subject to securities laws and regulations, just like traditional financial advisors. In addition, most robo advisors are also members of the Financial Industry Regulatory Authority (FINRA). Before investing with a robo advisor, check to make sure what type of regulation and insurance your advisor is covered by.

Will Financial Advisors Be Replaced by Robo Advisors?

It is extremely unlikely that traditional financial advisors will be completely replaced by robo advisors. There will always be a group of people that either prefers a traditional financial advisor or managing their investments themselves. Still, it makes sense to be aware of what robo advisors are and how they work so you can decide if using one is right for you.

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