A Beginner's Guide: What is a Robo Advisor?

The net asset under management by robo advisors is set to reach $1.4 trillion in 2021.

Financial management could be somewhat tricky for most people, especially if you have limited time for investment research or little understanding of how different assets work.

The good news is that there is help available for financial planning.

Robo advisors are among the latest paradigm in the investment management industry. These automated investment platforms can create investing strategies, do tax planning, and rebalance your portfolio to achieve your target financial goals.

What is a Robo Advisor?

Robo advisors are automated investment management algorithms, software that create custom investment portfolios based on the modern portfolio theory. Robo advisors take into account your investment goals, savings goals, and risk profile when creating an investment portfolio.

“Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk.” ~ Investopedia

Robo advisors have some significant differences in comparison to traditional human advisors or investment management agencies. The minimum investment requirements are low with robos.

A growing number of robo advisors provide add-on services, including tax-loss harvesting, portfolio rebalancing, advanced money management tools, and some form of savings products for high-account balances.

How Robo Advisors Work

Most robo advisors provide online registration, deposit, and management services.

You start with a questionnaire about your personal financial choices, retirement goals, wealth goals, and risk profile. Robo advisors use this information when creating portfolio allocations. Most robo firms provide portfolio templates with a varying degree of risk (aggressive, moderate, or conservative).

You can choose a custom portfolio to make room for short-term as well as long-term investment goals. Robo advisors create diversified portfolio allocations to minimize or optimizes risks in accordance with your financial goals.

Robo advisors provide various types of retirement accounts, including IRAs, Roth IRAs, and even brokerage or trading accounts.
You can rollover funds from your existing Vanguard or Fidelity accounts. Additionally, you can make regular contributions to these accounts.
It is essential to understand that most robo advisors invest in ETFs, which means you will lose some of the investment discretion you receive with traditional platforms. Additionally, since robo advisors are computerized, algorithm-driven solutions, you will have little control over investment decisions.

What You Need to Understand Before Investing with Robo Advisors

What are the minimum investment requirements with Robo advisors?

One of the primary differences between robo advisors and traditional money managers is their minimum investment requirements.

While most professional money management firms have account minimums of $100,000, $250,000, and even $1 million in some cases, robo advisors allow you to invest with as little as $100.

We created a list of some of the top robo advisors and minimum investment requirements for these advisors.

How do robo advisors invest your funds?

Robo advisors follow the modern portfolio theory that supports investments with lower risk profiles. Robo advisors invest your funds across exchange-traded funds (ETFs), mutual funds, index funds, and in some rare cases, bond funds.

Unlike traditional investment advisors, robo advisors do not hold individual stocks in your portfolio.

How much do robo advisors cost?

One of the primary reasons robo advisors are gaining popularity is their low cost of fund management.

A traditional financial advisory would cost anywhere between 1.45% to 1.05% for a portfolio of $50,000 to $1 million, respectively. The fund management charges drop for account balances above $1 million. Nonetheless, higher fees and account minimums make professional money management out of reach for retail investors.

Robo advisors, on the contrary, are transforming the cost structure of professional money management. In our analysis, the average portfolio management charges for robo advisors are between 0.25% and 0.50%, with the latter being charged by very few automated advisors.

Most robo advisors run promotional offers for new clients on top of the low fees, managing up to $10,000 for free.

Do robo advisors provide add-on financial services?

In addition to their investment management services, most robo advisors offer additional financial planning services. Some of the most common features we found in our analysis are:

Tax-loss harvesting
Dividend reinvesting
Portfolio rebalancing
Financial planning advice
Tax-efficient funds
Socially responsible investing
Custom investment portfolios
Team of advisors for higher account balances.

Pros and Cons of Investing with Robo Advisors

Pros of Investing with Robo Advisors

Lower account minimums: Robo advisors make professional money management services more accessible to retail investors. Unlike traditional investment management firms, you can start investing with as little as $100 or nil account minimums.
Low account management fees: Robo advisors charge a fraction of what conventional financial advisors charge for managing your investments.
Personalized investment portfolios: Robo advisors provide personalized investment portfolios. Investors can pick from template portfolios or opt for custom investment portfolios.
Automatic portfolio rebalancing, tax-loss harvesting: Robo advisors provide add-on financial planning services, including automatic portfolio rebalancing, tax-loss harvesting, and dividend reinvesting services.

Cons of Investing with Robo Advisors

Lack of investment discretion: Robo advisors invest in ETFs, index funds, and mutual funds, which means the account owner has little to no say in the choice of investments. Robo advisors may miss out on the bull run of specific stocks or sectors because of their broader investment approach.
Higher fees in comparison to some target-date funds: Some target-date funds or index mutual funds charge lower fees in comparison to robo advisors. Although, they do not offer additional features, such as tax-loss harvesting.
Lack of human interaction: Most people prefer human interaction when it comes to financial planning and investment management. Robo advisors are automated investment platforms with limited to no human interaction, which could be a setback for some investors.
No performance guarantees: Robo advisors do not provide any performance guarantees or minimum return assurances. Since robo advisors invest in ETFs, index funds, you may witness a decline in your portfolio performance in a downward rally. A traditional investment manager, on the other hand, may use creative investing, hedging strategies to minimize losses.

Top Robo Advisors to Invest Your Funds

At DollarGeek, our team spends countless hours analyzing the performance, cost efficiency, and other financial planning features offered by robo advisors. View our top robo advisors below: