How Automated Investing Works (2024)

Automated investing is the practice of using algorithms to automatically manage your portfolio. It’s a relatively new tool with investing, and is typically used to build long-term, passive portfolios. There are several benefits to automated investing, particularly given that these systems can often build well-indexed portfolios with lower fees than a legacy mutual fund or ETF. As a result, automated investing has taken off in recent years, and by now many (if not most) brokerages have some form of automation built into their services. Here’s what you should know.

If you prefer a hands-on approach, a financial advisor can help you evaluate and select investments for your portfolio.

What Is Automated Investing?

Automated investing uses computer-controlled systems to help manage your money. What this means in practice is a very broad concept, because there are alotof ways that you can do this.

At its most basic, automated investing can involve passive transfers and savings. At its most complex, some firms use it to run entire portfolios without any human interaction.

Much, if not most, of automated investing lies somewhere in between these two poles, with individuals and brokerages using automated tools to streamline and improve their investments. Broadly, there are three general categories of automated investing: individual, brokerage and robo-advisors.

However you use it, automated investing is typically a form of passive investment. While these tools are often used in day trading, in most cases automated investment is used as a way to build long-term, low-touch strategies.

Automated investment should not be confused with passive investment overall. This should be thought of as a category of tools, while passive investing is an overall strategy. For example, investing long-term in an fund is a passive investment strategy, while the index fund you choose will most likely be managed with automated investment tools.

Automated Investing and Personal Finance

Many banks and other personal finance services give you the opportunity to automatically assign your money based on investment and other financial goals. For example, you might use an automatic system to transfer 5% of your after-tax income your investment portfolio. Or you might set up a system to pay your bills, then divert whatever is left in that account to your brokerage each month.

In both cases, this would be considered a form of automated investing. You have set up an automatic, computer-controlled system to manage and invest your money for you. This is often a tool for mimicking traditional savings activity, like the workplace retirement plan that diverts pre-tax income from your paycheck. It allows you to create a digital third party to manage that savings and investment behavior on your behalf.

Automated Investing and Brokerage Tools

Most, if not all, professional brokers use some form of automated investing. For retail investors, automated investing tools are algorithm-controlled systems that trade or manage assets based on a set of pre-defined conditions. For example, you might buy a stock and set an upper/lower price boundary. If it ever crosses that line (the resistance/support bands, respectively), the system will automatically sell your asset.

With broker-managed accounts, a common form of automated investing is the target date fund. This is a portfolio where your broker sets the algorithm based on your goals and timelines. For example, you might say “I want to retire in 40 years.” From there, the broker will use an automated system to rebalance the portfolio around that goal as time goes on. In the early years, the system will invest for higher risks and more growth. In the later years, it will automatically shift to lower risks and more security. This uses an automated tool referred to as a “glide path” algorithm.

Brokers also commonly use automated tools to manage risk, returns and taxes. In all cases, the broker will tell the system to seek a specific outcome and the algorithm will manage assets around it. For example, a broker might tell the system to seek certain price points as a way of managing risk in the client’s portfolio. Or to manage taxes they might tell the system to sell for a certain amount of losses by a given date. In all cases, and many others, the broker will set a financial goal and allow the computer to make trades that meet those instructions.

This is common, if not universal, for ETFs and mutual funds, which use automated tools to rebalance their portfolios around the fund’s index.

Automated investing is also extremely common in high-volume, active investing such as day trading and currency markets. This has become an essential tool for those industries, because it allows them to respond to markets in real time.

Automated brokerage tools have become extremely successful because they occupy a category of tasks known as “high-complexity, high-routine.” This means that the task involves numerous and difficult steps, for example complex math or constant price monitoring, which are the same for each iteration of the task.And since this tends to be the category of tasks at which computers excel, automated brokerage tools can make investing easier and less expensive.

Automated Investing and Robo-Advisors

Like an ETF or mutual fund, a robo-advisor is generally a type of passive investment. However, in this case, there is no human involvement at all. The entire portfolio is managed by an algorithm with no broker involvement.

With a robo-advisor you set your investment goals when you open your account. Generally this means taking a survey that asks about your risk tolerances, what kind of returns you want and if you have any target goals, among other similar questions. Then, based on this survey, the system automatically creates a portfolio for you.

A robo-advisor typically invests heavily in ETFs and other equity-market assets. The system then automatically rebalances your portfolio over time based on its own algorithm and your stated preferences. In general you can change your preferences at any time, and the system will again rebalance around your new goals.

Robo-advisors are typically low-cost, often charging between fees around 0.5% and 0.25%, compared with a professional broker’s average 1% fee.And can create well-indexed, long-term portfolios that are suited for average investors.

That said, entirely automated systems come with several shortfalls. You cannot buy any individual assets, which means that you will need to hold any speculation segment of your portfolio elsewhere. You also can’t get any individual advice. The robo-advisor’s portfolio will be built for a generic market, not for your personal needs, and it cannot help you with specific questions or financial consultations.

Bottom Line

Automated investing is a series of tools that allow you to make financial and investment transactions without human involvement. From a simple direct deposit all the way up to fully automated portfolios, they have changed the way that investment works.

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