What Is a Robo-Advisor and Should You Get One?

A 2017 survey found that almost two-thirds of millennials were afraid to invest. I get it. Investing can be complicated, and for many people, it feels better not to do anything rather than to make the wrong decision.

That’s where robo-advisors come in. Robo advisors can simplify the investing process, no matter how scared, nervous, or confused you are. The best part? They don’t even cost that much.

What is a robo advisor? 

A robo-advisor is an automated digital platform that uses algorithms to determine how you should invest in the stock market. Human financial advisors can determine your investing needs based on your unique situation. A robo advisor, on the other hand, uses more general tools to decide on your ideal investments based on your financial goals, risk tolerance, and time horizon.

Robo advisors use internal calculators and other tools before recommending an investing strategy, which will include how much you should invest and what to invest in.

There are many different robo-advisors on the market. The most popular companies are:

• Betterment
• Wealthfront
• Wealthsimple
• Ellevest
• M1 Finance

Also, many investment companies, including Vanguard and Fidelity, offer their own robo-advising services. These may have comparable fees to third-party companies.

Most robo-advisors will select mutual funds or exchange-traded funds (ETFs), including index funds. These funds usually have low fees and are designed to mimic the market. Most robo-advisors will also typically select a variety of funds to create a diversified investment portfolio.

Pros and cons of robo advisors

Robo advisors can be a great tool for investing, especially if you’re just getting started. They have many advantages for new investors, but there are also some downsides to keep in mind.

Pros 

• Cheap to get started. Many robo-advisors have low minimum opening deposit requirements, and most charge fairly low fees to manage your assets. 
• Easy and simple to set up. You can create an account and fund it almost immediately. It usually doesn’t take more than a few days from start to finish.
• Low fees: Robo advisors typically charge lower fees than a human advisor would.
• Follow time-tested market principles. Many robo-advisors follow modern portfolio theory (MPT), which is still held up as a viable investing theory.
• Continuous monitoring. Robo advisors continuously track your portfolio’s asset allocation and rebalance your investments to stay true to your investment goals and risk tolerance.

Cons

• You can easily DIY. If you know enough investing basics, you can easily set up an investment account yourself. 
• Less flexibility. Because robo-advisors use an algorithm, they cannot tweak their recommendations to your specific needs.  
• May create a complicated portfolio. Some robo advisors may invest your money in more than a dozen different funds, which may be unnecessary.
• Requires correct input from you to achieve results. Because a robo advisor cannot fact-check the information you provide, you may end up with flawed recommendations. A human advisor would be more likely to catch errors and ask follow-up questions to determine your best direction. 

How does a robo-advisor work? 

When you create a robo-advisor account, you'll be asked a series of questions about your finances. These may include:

• Employment status
• Tax status
• How much do you currently earn?
• How much you currently have invested?
• How much experience do you have investing?
• Etc

The robo advisor will also ask you questions about your investing style, like how comfortable you are with taking risks or if you want to avoid certain companies in your portfolio. 

For example, many robo-advisors will let customers state if they want to invest in sustainable and socially conscious funds. The robo advisor Ellevest claims that it can help women bridge the gender pay gap with its investing recommendations.

Once you sign up, you can link your bank account and set up automatic contributions to your investment account. Then, the robo advisor will begin automated investing for you.

Related: What is asset allocation and why is it essential to investing?

How much does a robo-advisor cost?

Robo advisors generally have low fees, often around .25% of the portfolio value. Traditional financial advisors will usually charge 1% or more for portfolio management. Remember, these fees do not include any fees charged by the investments themselves. Those will be extra.

Fees may also depend on how much money you have invested with the robo advisor, with some offering even lower rates if you meet a certain threshold. 

There are also some robo-advisors that charge a monthly fee instead of a percentage-based fee. For example, Ellevest charges a $12/monthly fee that includes 50% off financial planning sessions. It's harder to compare monthly fees to percentage fees since the amount paid will depend on your portfolio. 

Also, while many robo-advisors have little or no minimum deposit requirements, some robo-advisors do require that you deposit a minimum amount of around $500 to $1,000 to get started. 

Robo advisor compared to a traditional advisor

Robo advisors are much less expensive than traditional financial advisors. Some human advisors charge a flat hourly fee for investment advice. However, if you hire an investment advisor who personally manages your portfolio, they may charge you a percentage of assets under management (AUM), often 1%. 

When you meet with a traditional advisor, they may ask similar questions to a robo-advisor. But, you will also get the opportunity to ask them questions to learn more about investing and their individualized recommendations.

Some robo-advisors do offer one-on-one financial planning services with a human advisor, but you may have to pay extra for this service. Before signing up, you should compare the prices to see if it’s less expensive than hiring an independent advisor. 

Who should use a robo-advisor?

If you've always been intimidated by the idea of investing and have put off getting started, then using a robo advisor can give you the push you need. Robo advisors are designed to create as little work as possible for you. 

Plus, using a robo-advisor can help you avoid making emotionally driven financial decisions. A robo advisor will not sell your stocks just because the market is down or invest all your money in Gamestop because of some Reddit posts.

But, if you fall into a high-income tax bracket or have a complicated financial situation, then a robo advisor may not be sophisticated enough to handle your needs. For example, if you have a windfall and want to know how to set up a trust for your kids, you’ll benefit from hiring a financial planner.

Robo advisors are also unable to advise you on other financial aspects, like building a sufficient emergency fund, determining your life insurance needs or choosing a health insurance plan. 

Related: Active vs Passive Investing: Which Strategy is best for you

FAQs

Interested in using a robo advisor, but not sure if it makes sense for you? Here are some common questions.

Is it a good idea to use a robo-advisor?

If you're young or just starting to invest, using a robo advisor may be a great entry to investing. Also, if you feel like you're too busy to start investing or you can't afford a professional financial planner, then a robo advisor is your next best bet. They're the most accessible way to start investing, even if you don’t know the difference between an IRA and a 401(k).

However, if you're interested in investing, you may be able to create your own portfolio without using a robo advisor. You can also hire a financial planner to review your current investments, offer advice, and help you get started.

One of the biggest downsides of a robo advisor is that they cannot adequately explain their investing decisions to you. For example, if you say that you have a low-risk tolerance, then they may recommend a conservative portfolio. But, if you’re in your 20s, then you should have an aggressive portfolio. 

If you had a personal financial advisor, they would be able to explain why you need to have more funds in stocks when you’re young. 

Can I withdraw money from a robo-advisor?

If you want to take your funds out of your robot advisor account, you can do so. It will usually only take a few days to process the request.

If you are investing in a retirement account, like a Roth IRA, there may be some tax consequences, but that would be true whether you were invested with a robo advisor or not.

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