Robo-Advisor

What is a Robo-Advisor?

A robo-advisor is an automated platform that provides financial planning services with minimal human intervention.

Techopedia Explains the Robo-Advisor Meaning

A robo-advisor is essentially a digital platform that uses algorithms and mathematical models to automate investment management.

This robo-advisor definition might sound futuristic, but the robo-advisor meaning is simple enough to grasp. When you engage with a robo-advisor, you’re asked to provide information about your financial status, investment goals, and risk tolerance. The robo-advisor then uses this data to offer investment suggestions and automatically manage your portfolio.

By offering a hands-off approach to investing, robo-advisors allow you to focus on your personal and professional life without the constant need to monitor the markets. As such, robo-investing has democratized access to investment management.

The History of Robo-Advisors

The history of robo-advisors is marked by the entry of two pioneering firms in the wake of the 2008 financial crisis.

Betterment and Wealthfront launched their robo-advisor platforms in 2008 and 2011, respectively. These first platforms were groundbreaking, offering automated portfolio management that was previously only accessible through human financial advisors.

Over the years, robo-advisors have evolved significantly, incorporating more sophisticated technologies and offering a wider array of services.

How a Robo-Advisor Works

You might be wondering, how does a robot (or a computer program) know what are the best investments for me, and how can my investments be automated?

Actually, a lot of what goes into successful long-term investing to take advantage of concepts like compound interest follows a set of well-established principles. Although each robo-advisor works slightly differently, there are eight generally accepted ways a robo-advisor decides what you should invest in.

How Robo-Advisor Works — Source: eliftech

How a Robo-Advisor Chooses Your Investments

Modern Portfolio Theory (MPT)

Rooted in MPT, robo-advisors aim to optimize investment portfolios for the best possible return relative to your accepted level of risk. This theory underscores the importance of diversification across various asset classes to achieve a desired risk-return balance.
Risk Tolerance and Time Horizon

By evaluating your comfort with risk and the length of time you plan to invest, robo-advisors can tailor portfolios to your specific needs.
Asset Allocation

The algorithms are designed to allocate your capital across different asset categories, such as equities, bonds, and commodities. This strategic distribution is designed to manage risk while targeting an optimal return.
Selection of Investment Vehicles

To implement the asset allocation, robo-advisors select appropriate investment vehicles, typically ETFs or index funds, due to their broad market exposure and cost efficiency.
Automation and Algorithmic Trading

Robo-advisors utilize algorithmic trading to automate the investment process, executing trades to establish and maintain the user’s portfolio according to the predetermined strategy and at the lowest available cost.
Continuous Monitoring and Rebalancing

Robo-advisors continuously monitor portfolios against market performance and rebalance them as necessary. This proactive approach helps maintain the intended asset allocation over time.
Tax Efficiency

Advanced robo-advisors also incorporate strategies like tax-loss harvesting,and identifying opportunities to sell securities at a loss to offset taxes on gains or income. Simultaneously, the robo-advisor reinvests the proceeds, maintaining the portfolio’s overall strategic composition while optimizing for tax impact.

How Much Does a Robo-Advisor Cost?

Generally, robo-advisors charge a percentage of the assets under management (AUM) as their fee. The exact cost of using a robo-advisor can vary depending on the provider and the range of services offered.

This management fee usually ranges from about 0.25% to 0.50% per annum, though it can be higher or lower depending on the provider and the amount of assets being managed.

To put that into context, on a $10,000 investment, a 0.25% fee would amount to $25 per year.

A few robo-advisors charge a flat monthly or annual fee regardless of account balance, which can be beneficial for investors with larger balances.

You will, of course, also pay any fees for the underlying investments, just as if you had chosen the investments yourself. The most common is to pay expense ratios for the ETFs or mutual funds selected by the robo-advisor.

How a Robo-Advisor Gets Paid

Robo-advisors get paid primarily through the fees they charge their clients for the investment management services they provide.

Some robo-advisors charge extra for specific services, such as tax-loss harvesting, access to human financial advisors, or premium investment options. These fees can be structured as flat rates or as additional percentages of AUM.

Robo-advisors may also earn revenue from the interest on uninvested cash in client accounts, especially if they sweep this cash into interest-bearing accounts or money market funds.

Robo-Advisor Features

Today’s robo-advisors include features such as:

AI and Machine Learning

Modern robo-advisors use artificial intelligence (AI) and machine learning (ML) to enhance their investment algorithms, providing more personalized and dynamic investment advice.

Goal-Based Planning

Many robo-advisors now offer tools for goal-based financial planning, helping users to tailor their investments to specific objectives like retirement, education, or home ownership.

Multi-Asset Diversification

Beyond stocks and bonds, current robo-advisors often include a variety of asset classes like real estate or commodities, providing broader diversification options.

Human-Advisor Hybrid Models

Recognizing the value of the human touch, some firms have introduced hybrid models that offer automated investing with access to human financial advisors, catering to clients who desire a more personalized service.

Robo-Advisors vs. Traditional Financial Advisors

While robo-investing offers automated, algorithm-driven investment strategies, traditional financial advisors provide personalized advice, often building deeper, one-on-one relationships with their clients.

Human advisors really earn their keep during financial market downturns when investors will need reassurance about whether they are still on track to meet their goals. Unlike algorithms, human advisors can offer empathy, interpret market conditions, and provide tailored advice, providing a level of emotional support that automated systems cannot replicate.

Robo-Advisor Examples

As of early 2024, here are some of the best-known robo-advisors:

Betterment
Wealthfront
Schwab Intelligent Portfolios
Vanguard Personal Advisor Services
Personal Capital
Ellevest
Better
Wealthsimple
Acorns
SoFi Automated Investing

Robo-Advisor Pros and Cons

Pros

Cost-effective
Accessible
Efficient and avoids emotions
Simple and transparent

Cons

Limited personalization
Lack of human interaction
Entirely depends on algorithms
Less effective for complex situations

Limitations of Robo-Advisors

Aside from the previously discussed absence of emotional support during challenging market periods, another notable limitation of robo-advisors is their restricted flexibility for specific investment choices, such as individual stocks an investor may wish to select.

Consequently, maintaining a separate investment account for personalized trading decisions can be advantageous, although this isn’t a concern for individuals who prefer entirely automated investment management.

Robo-Advisors and Regulations

Robo-advisors must follow the same rules as all financial service providers and adhere to stringent regulations designed to protect investors.

In the United States, robo-advisors are regulated by the Securities and Exchange Commission (SEC) and must comply with the same laws as traditional investment advisors. This includes maintaining transparency, acting in the best interest of their clients, and ensuring the security of client assets. Additionally, they are required to register with the appropriate regulatory bodies, follow anti-money laundering (AML) practices, and adhere to know-your-customer (KYC) procedures.

The Bottom Line

Robo-advisors automate investment management using algorithms, offering a cost-effective, accessible alternative to traditional financial advising. From simple asset allocation, they’ve evolved to include advanced features like tax-loss harvesting.

Despite their benefits, they lack the personal touch and investment flexibility of human advisors. In terms of keeping your money safe, they operate under the same strict regulatory frameworks as other financial accounts to ensure investor protection.