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What Is a Robo-Advisor?

If you’ve thought about investing any time over the past decade, you might have heard people talking about robo-advisors. The first big robo-advisor popped around the time of the Great Recession. Since then, hundreds more have opened. Betterment, which is one of the biggest robo-advisors, has assets under management that total about $10 billion. So what are these companies that people are now investing billions of dollars with?

Build your savings with a financial advisor who understands your goals.

What Is a Robo-Advisor?

A robo-advisor digitally manages your investment portfolio – trading, rebalancing, tax-loss harvesting, etc. It doesn’t rely on human intervention the way traditional advisors do. In fact, most robo-advisors don’t have any human advisors who clients can discuss their portfolios with.

In slightly more technical terms, a robo-advisor is a company that uses software and tools to digitally manage their clients’ financial investments. The tools and software that robo-advisors use aren’t actually new. Traditional advisors have been using them for years. The difference is that traditional advisors require you to go through a human, which is usually much more costly.

Robo-advisors are still pretty new and they all operate a bit differently, so you might see a slightly different definition somewhere else.

Why Robo-Advisors Are Popular

The biggest reason that robo-advisors are growing in popularity is their usually low costs. With a traditional advisor, you typically pay an annual fee of 1% – 2% of your assets under management (the amount you have invested with the advisor). Some advisors charge you even more though. That adds up to a lot of money going to a middle man. Many traditional advisors also require you to have a certain amount of money to invest in order to become a client. The threshold may be too high for the average person to qualify. Many robo-advisors charge an annual fee between 0.25% and 0.50%. That’s less than half of what you would pay with a traditional advisor. They may also have a minimum in order to open an account, but it’s usually far less than what you’d find with a traditional advisor.

Another reason for the popularity of robo-advisors is the fact that everything is automated and online. You don’t have to worry about meeting with another human to discuss your profile. Of course, it’s good to meet talk with a human sometimes. Some people also feel more comfortable when they can discuss what’s happening with their money. However, many people also like the ability to just set their goals and then watch their portfolio work on autopilot. Robo-advisors allow you to do that. And if you want to change something, just log in to your account and make necessary changes – all without picking up a phone or scheduling a meeting.

How a Robo-Advisor Handles Your Money

What Is a Robo-Advisor?

When you create an account with a robo-advisor, you will have to answer a series of questions. You’ll provide information such as your age, income, current savings and financial goals (like planning for retirement). You will also answer questions about your risk tolerance. Risk is the possibility that your investments lose money if a company or if a market doesn’t perform well. Your risk tolerance is the amount of variability you can handle with your investments. If you will need your money in five years and you can’t afford to lose any of it, you have a lower risk tolerance than someone who won’t need their money for 20 years and can thus afford to wait out a downswing in the stock market.

All robo-advisors ask slightly different questions and some differentiate themselves by asking about particular aspects of your life. For example, Motif Investing tries to align your investments with social causes that are important to you. Regardless of the exact questions, the robo-advisor will use your answers to create a balanced portfolio that matches your financial goals.

Most robo-advisors create your portfolio with exchange-traded funds (ETFs). An ETF is a fund that contains multiple individual stocks. This makes it safer to invest in a few ETFs instead of a few individual companies. ETFs add diversity to your portfolio and diversity is an important part of the strategy that robo-advisors use. Robo-advisors typically invest based on modern portfolio theory (MPT). MPT states that you can maximize your returns, while minimizing risk, by investing in a diverse and balanced portfolio.

Once the robo-advisor creates a portfolio for you, all management happens digitally. You don’t have to worry about things like trading or rebalancing. Some robo-advisors will also use more advanced management techniques. A good example is tax-loss harvesting. Tax-loss harvesting is a technique that buys and sells stocks in a way that minimizes the taxes you have to pay on your gains. Not every robo-advisor will offer tax-loss harvesting and some may only offer it with certain payment plans.

The Takeaway

What Is a Robo-Advisor?

Robo-advisors are relatively new to the investing game. You certainly aren’t alone if you didn’t know exactly what they are. They emerged around 2008 and have grown a lot since. Some now have billions of dollars in assets under management.

A robo-advisor could be especially useful if you are a beginning investor. They focus on an end goal (like reaching a certain amount of retirement savings) and then don’t bother you with the day-to-day management of your money. This is great for people who don’t want to learn the in and outs of investing on their own. You should probably consider a human advisor if you have a complex portfolio that requires more intimate knowledge of your life.

Tips for Investing Success

  • Robo-advisors make investing affordable for the average person. However, there is an even more affordable option: Manage your own portfolio. Managing a portfolio sounds difficult and it might not be for you if you don’t have much time to learn. However, it is certainly doable once you learn a few basics. There are also a lot of resources that can help you to along the way with things like asset allocation.
  • Experts, like Jim Cramer, often advise that new investors put their money into things like index funds or ETFs (the same thing most robo-advisors do). So if you’re just beginning to invest, you might want to learn a little bit about how you can use these funds in your portfolio.
  • The best advice with investing is probably to start early. Of course, everyone is in a different place financially and not everyone is ready to start investing. For example, someone with a lot of credit card debt might want to focus on paying off that debt before investing. If you’re in a position where you have some money that you could invest, you should start as soon as you can. Many people invest in order to save for retirement and as this retirement calculator can show you, you will have more in retirement savings if you invest early and often.
  • If you don’t feel confident in your ability to manage your own investments, you should consider finding an expert, like a financial advisor, to help you. A financial advisor can get you started and help you create a plan that allows you to achieve your retirement goals. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: ©iStock.com/kupicoo, ©iStock.com/t:utah778, ©iStock.com/Rawpixel Ltd

Derek Silva, CEPF® Derek Silva is determined to make personal finance accessible to everyone. He writes on a variety of personal finance topics for SmartAsset, serving as a retirement and credit card expert. Derek is a member of the Society for Advancing Business Editing and Writing and a Certified Educator in Personal Finance® (CEPF®). He has a degree from the University of Massachusetts Amherst and has spent time as an English language teacher in the Portuguese autonomous region of the Azores. The message Derek hopes people take away from his writing is, “Don’t forget that money is just a tool to help you reach your goals and live the lifestyle you want.”
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