In this article:
- How Do Robo-Advisors Work?
- Are Robo-Advisors Safe?
- Pros and Cons of Robo-Advisors
- When Should I Choose a Robo-Advisor?
Robo-advisors can be a safe and affordable way to invest your money. These automated services can also make managing your investments easier than trying to tackle everything on your own.
However, investing always involves taking on risk, and you may want to have a more personalized (and human) touch during a major life event or market downturn.
How Do Robo-Advisors Work?
A robo-advisor is an automated investment platform that uses computers to manage your investments. These services tend to focus on the investments in a brokerage or tax-advantaged retirement account, and they often invest clients' money in mutual funds and exchange-traded funds (ETFs).
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When you sign up for a robo-advisor, you might start by answering a questionnaire about your income, assets, age, goals and risk tolerance, which the service will then use to help suggest investment options. Based on your answers, the robo-advisor may create a portfolio or offer suggestions from its list of portfolios.
Robo-advisors also take on many of the ongoing maintenance tasks that can increase your long-term returns or maintain the appropriate amount of risk, such as portfolio rebalancing and tax-loss harvesting. And because much of the work is automated, robo-advisors may have lower account minimums and charge lower fees than traditional financial advisors.
Are Robo-Advisors Safe?
While it's smart to be cautious when trusting others with your money, a robo-advisor may be just as safe as a human financial advisor. But investing always comes with the risk of losing money, and that's true whether you're investing on your own, hiring a financial advisor or using a robo-advisor.
In fact, while robo-advisors were popularized by fintech companies like Betterment and Wealthfront, some of the largest traditional investment management companies, including Charles Schwab, Fidelity and Vanguard also have robo-advisor services.
Still, that doesn't mean all robo-advisors are the same. Here are some facts to know if you're considering using one to manage your money:
Robo-Advisors Are Fiduciaries
A fiduciary is a person or company that has a legal obligation to put a client's interests above their own. As registered investment advisors, robo-advisors have a fiduciary duty to their clients.
The U.S. Securities and Exchange Commission (SEC) has charged and fined some robo-advisors for breaching their fiduciary duty. But the same is true of financial advisors. Before signing up or hiring someone, you can look up the advisor in the SEC's public disclosure database to see their disciplinary history and license status.
Robo-Advisors Can't Guarantee Profits
Robo-advisors tend to create diversified portfolios with low-cost ETFs. They may also use modern portfolio theory to find a mix of investments that will give you the greatest return for the amount of risk you take on. They may also rebalance your portfolio to try and maintain your asset allocation.
However, that doesn't mean you can avoid a drop during a general downturn, or even guarantee that you'll do well when the market is going up. One advantage of working with a financial advisor is the person may be able to offer advice based on your personality and fears, something robo-advisors cannot offer.
Robo-Advisors Can't Answer Your Investing Questions
Robo-advisors may have customer and tech support representatives. However, depending on the platform you choose, you might not have the option to connect with a financial advisor who can answer your investment questions.
Some robo-advisors offer a hybrid model that gives you access to a financial planner. But look into how you'll be able to communicate with them (by phone, email or chat) and the requirements for this access. You may need to have a minimum balance or pay a higher fee if you want access to a financial planner.
Robo-Advisors Have Different Methods for Choosing Investments
Research how the robo-advisor chooses your recommended portfolio. Often, the answers to a questionnaire will narrow down the best options. However, some platforms may give you additional options for personalizing your portfolio. For example, you may be able to add crypto investments, choose a domestic or international focus or sign up for a socially responsible investing fund.
Robo-Advisors Have Various Fee Structures
You generally pay the robo-advisor a fee based on how much money it's managing, and the fee could increase as your portfolio grows. There are a few exceptions, such as Schwab Intelligent Portfolios. This service offers a free robo-advisor service, but Schwab makes money by keeping part of your fund in cash at its affiliated bank and lending out the deposits to earn interest.
Robo-advisors from investment management companies may also invest money in funds that they own. These funds may have separate fund management fees, which you have to pay whether you're investing on your own, with an advisor or with a robo-advisor.
Pros and Cons of Robo-Advisors
Understanding the benefits and drawbacks of a robo-advisor can help you decide if the service is a good fit.
Pros
- Lower fees: Robo-advisors tend to charge lower fees than human advisors. The fee is often a percentage of the money you're investing, or assets under management (AUM), and may range from around 0.25% to 0.89% with robo-advisors. Financial advisors may charge around 1% to 2% for investors who have less than $1 million AUM.
- Lower minimums: Robo-advisors may have low minimum account requirements; some don't have any minimum investment amount.
- Easy to use: The web-first approach could make robo-advising platforms easy to navigate and understand if you're comfortable with technology.
Cons
- Potentially no human investment support: While some robo-advisors let you speak with a financial advisor, it's not always an option. And, even when it is, the advisors may only be available to people who meet certain account minimums or pay for a higher-tiered subscription.
- Limited investment options: Robo-advisors may create a limited list of portfolios and then choose the one that's the closest match. These portfolios could be a good fit for many investors, but might not be right for everyone.
- Narrow focus: While robo-advisors might help you create a portfolio for a specific goal, they don't create financial plans that take all your goals and investments in mind.
When Should I Choose a Robo-Advisor?
A robo-advisor could be a good option if you want to start investing but don't want to choose or manage your investments on your own. The services can give you a largely hands-off experience, and they're often much less expensive and easier to get started with than traditional advisors.
Many robo-advisors also offer tax-advantaged retirement accounts, such as IRAs. The non-retirement accounts may also include tax-loss harvesting—the strategic selling and buying of investments to realize capital losses—which could help lower your tax bill for the year.
However, if you tend to want personalized advice or have lots of specific questions, working with a financial advisor may be a better option. A financial advisor may also be a good idea if you have a more complex financial situation—such as various investment accounts, trust funds and retirement accounts—or have a lot of assets and could benefit from a more customized approach.
You can find financial advisors who charge by the hour or project if you have a question or want a financial plan but don't want to pay for ongoing investment management.
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