What Is a Robo-Advisor and How Do They Work?

by Casper du Toit
Updated: January 5, 2021

Robo-advisors have been around since 2010 when Betterment launched the first one. Despite becoming popular over the years, this investment vehicle is often misunderstood.

The term “robo-advisor” is a bit of a controversial term… This adds to the confusion of what is a robo-advisor and how they work. The exact origin of the term remains a mystery but it has nothing to do with getting advice from a robot 😉

Robo-advisors help you invest on the stock exchange. They fall somewhere between active investing and passive investing and are ideal for a buy-and-hold investor.

Want to invest on the stock exchange but don’t have a huge budget or the time to be an active investor? Investing through a robo-advisor may be the perfect solution for you!

What Is a Robo-Advisor?

A robo-advisor is an online investment platform. It uses an algorithm to automatically create and manage a personalized investment portfolio based on your goals and risk tolerance. In principle, there’s no or little human interaction which helps keep costs down.

Robo-advisors typically invest your money in low cost, high performance exchange-traded funds (ETFs). These are funds that are bought and sold on a stock exchange.

Most robo-advisors invest in low cost ETFs that aren’t actively managed such as the S&P 500 Index.

How Does a Robo-Advisor Work?

You: Sign up ➡️ Risk Tolerance Questionnaire ➡️ Goals Questionnaire

Robo-Advisor: Create Portfolio ➡️ Rebalance & Tax Loss Harvesting

After you sign up for a robo-advisor, you’ll complete a risk tolerance questionnaire and a goals questionnaire. Once completed, your robo-advisor will automatically create a portfolio for you based on your risk tolerance and goals.

A good robo-advisor will rebalance your portfolio from time to time. Some, but not all, also offer a tax loss harvesting service.

Risk Tolerance

As a rule of thumb, the bigger the potential reward, the higher the risk. For example, stocks are normally more risky than bonds but should give you a better return over the long-term.

By answering some questions, your robo-advisor will put together a portfolio that matches your tolerance for taking risks.

Investment Goals

Your goals can be anything from saving for college to investing for your retirement.

Have SMART goals. These are goals that are Specific, Measurable, Achievable, Relevant and Timely.

An example of a SMART goal is:

“I want to invest $100 per month for 5 years towards my deposit on a new [model] car”.

Assuming you can afford to invest $100 per month, it’s specific, measurable, achievable, relevant, and timely.

Create Portfolio

A robo-adviser will automatically create an investment portfolio for you based on your risk tolerance and goals. You are normally able to tweak it a bit if you want to.

Rebalancing

Robo-advisors will rebalance the assets in your portfolio when the ratio between assets changes. It happens automatically and is normally done on a monthly basis.

For example, let’s assume your portfolio consists of 70% stocks and 30% bonds. Due to changes in the stock market the value ratio may change to 80% stocks and 20% bonds. In this case the robo-advisor will sell stocks and buy bonds to get the ratio back to 70:30.

Tax-Loss Harvesting

When you buy and sell something like stocks and shares it has tax implications. Tax-loss harvesting is a tax management strategy to offset losses against gains. This helps to minimize taxes.

Robo-Advisor Pros and Cons

Like all investment vehicles, investing through a robo-advisor has pros and cons.

Robo-Advisor Benefits

The main benefits of investing through a robo-advisor include the following:

Low Fees

Robo-advisors are able to charge low fees by using a digital platform that avoids the need for human interaction.

For example, Betterment only charges 0.25% per year for their Digital plan and that includes rebalancing and tax loss harvesting.

Note: Exchange-traded fund (ETF) fees are not included and will vary from ETF to ETF.

No or Low Minimum Balance and Deposit

Most robo-advisors don’t require you to maintain a minimum balance or make large deposits. This makes them ideal for people who want to invest but have a tight budget.

For example, Betterment’s Digital plan does not require a minimum balance, and their minimum deposit is only $10.

Save Time

With 2,000+ ETFs to choose from in the United States, picking the right ETFs to invest in is not easy. Robo-advisors make it easy by selecting ETFs on your behalf based on your goals and tolerance for risk.

Diversification

ETFs often have hundreds of stocks per fund. This way you’re not putting all your eggs in one basket. Diversification helps to spread your risk.

Lower Risk

By selecting ETFs based in part on your tolerance for risk, robo-advisors help to reduce your risk. And by automatically rebalancing your portfolio when it’s out of balance they make sure you’re not overexposed to certain assets.

Higher After Tax Returns

Tax-loss harvesting can help reduce your taxes thereby increasing your wealth.

As pointed out by Betterment: “Realized losses on investments can offset gains and reduce ordinary taxable income by as much as $3,000 per year.”

Robo-Advisor Drawbacks

The main drawbacks of investing through a robo-advisor include the following:

Limited Number of Funds

There may be 2,000+ ETFs in the United States alone but a robo-advisor won’t give you access to all of them. A robo-advisor only works with a limited number of funds.

It’s quite possible you’ll have no access to a precious metals fund or a real estate investment trust (REIT). This does limit you from benefiting from certain markets.

No Human Financial Advisor

Having a computer algorithm put together your portfolio does keep costs down. A computer algorithm isn’t a substitute for a real life financial advisor.

Some robo-advisors do offer you the opportunity to get advice from a real human being. You can expect to pay higher fees though for such a service.

Won't Beat Market

The goal of a robo-advisor isn’t to beat the market. A robo-advisor will typically invest in an index fund that tries to match an index such as the S&P 500. They are not designed or intended to beat a certain benchmark.

What’s Inside Your Portfolio?

Robo-advisors can invest in a variety of ETFs. These include:

Stocks – Large-cap stocks, mid-cap stocks, or small-cap stocks.
Bonds – Government bonds, corporate bonds, municipal bonds, etc.
REITs – Real estate investment trusts.
Precious metal funds – Gold, silver and other precious metals.

The above options can be further broken down into regions, such as USA, Europe, Asia, etc.

Note: Not all robo-advisors will give you access to all of the above-mentioned options. For example, Betterment doesn’t offer any REIT ETFs or precious metals ETFs.

As an investor, it’s important to understand what’s in your portfolio.

For example, according to Betterment: “VTI is the primary ETF used to gain exposure to the entire U.S. stock market.”

But what is VTI?

The easiest way to get information on the ETFs in your portfolio is to visit Yahoo Finance.

If you search for VTI on finance.yahoo.com you get the following result:

VTI is the ticker code for Vanguard Total Stock Market Index Fund ETF Shares.

Things to look for:

Costs (Summary tab): VTI has an expense ratio (net) of only 0.03% which is very good!
Holdings (Holdings tab): Shows market segments, and main stocks VTI buys.
Objectives (Profile tab): Read the fund summary section for a good overview.
Performance (Performance tab): The historical performance of the fund compared to the category / benchmark.

How to Choose a Robo-Advisor

There are many robo-advisors to choose from. If you want to choose the right one, you have to ask the right questions.

7 Things to Look at in a Robo-Advisor:

What’s the minimum you need to invest to get started?
What fee does the robo-advisor charge?
Do they offer tax-loss harvesting? Is it included in the fee or an optional extra?
Do they offer rebalancing? Is it included in the fee or an optional extra?
Are they flexible? Can you tweak your automatically generated portfolio?
What ETFs do they invest in? Do you have access to real estate investment trusts (REITs), precious metals, and international markets?
What other services do they offer? Banking? Loans?

There is a saying one shoe doesn’t fit all. This also applies to the world of robo-advisors.

1. Decide how much money you’re able or willing to invest.

Many robo-advisors don’t have a minimum amount you have to invest. Find one that can accommodate you.

2. How much do they charge?

A good robo-advisor should not charge more than 0.25% per year. If they do offer services such as access to a real human being it’s normal they’ll charge extra for it.

Note: Remember, the fee charged by the robo-advisor doesn’t include ETF fees.

3. Your robo-advisor should offer tax-loss harvesting.

If tax-loss harvesting isn’t automatically included, sign up for it unless you can get a better deal elsewhere.

4. Your robo-advisor should offer rebalancing.

If rebalancing isn’t automatically included, sign up for it unless you can get a better deal elsewhere.

5. Look what’s inside your portfolio and tweak it if necessary.

Your robo-advisor should give you some flexibility to tweak your portfolio if you want to.

6. What ETFs do they invest in? Do those meet your needs?

Some investors believe in having exposure to real estate, precious metals, international markets, etc. However, not all robo-advisors can give you this exposure.

Make sure the one you choose is a good fit and can give you what you want.

7. What other services, besides investments, do they offer?

Many robo-advisors don’t only invest your money in ETFs.

Some also offer basic banking services that may be cheaper than your existing bank. It’s also common for many to offer loans, often at very competitive interest rates.

Before you decide on a robo-advisor consider the overall value they can offer you.

Recommended Robo-Advisors

It falls outside the scope of this article to review the many robo-advisors available on the market. Here are 3 of the best robo-advisors I recommend you look at, namely:

Betterment
M1 Finance
Wealthfront

Betterment

Betterment is the largest privately-owned robo-advisor and a pioneer in the industry. With 500,000+ clients and $21 billion+ invested, they are a highly respected company.

Betterment has no account minimum. They only charge a 0.25% annual fee for their digital plan and this includes automatic tax-loss harvesting and rebalancing. In addition, they offer you a lot of flexibility in designing your own portfolio.

M1 Finance

M1 Finance has become one of the most popular robo-advisors on the market with 500,000+ clients.

It’s not surprising considering they have no annual fee. Their account minimum is only $100 ($500 for retirement accounts). You can even borrow against the value of your portfolio.

M1 Finance offers automatic rebalancing but doesn’t offer tax-loss harvesting. They do have a “tax minimization” feature though which helps reduce the amount of taxes owed.

Wealthfront

Wealthfront has 400,000+ clients and has earned a great reputation in the market.

Wealthfront charges an annual fee of 0.25% which includes automatic rebalancing and tax-loss harvesting. To open an account you’ll need $500 minimum.

Conclusion

I trust after reading this article you have a good idea of what is a robo-advisor and how they work.

To summarize:

A robo-advisor is an online investment platform that helps you invest on the stock exchange. There’s no or very little human interaction which keeps costs down.
You’ll receive an automatically created investment portfolio based on your goals and appetite for risk.
Robo-advisors mainly focus on low cost, high performance ETFs.
They are a great option if you don’t have a lot of money to invest and want to keep costs down to a minimum.
They are perfect for buy-and-hold investors that have an investment horizon of at least 5 years.

Investing through a robo-advisor is only one of many possible ways you can invest your money. I do recommend investing with a robo-advisor as part of your overall investment strategy.

Investing is only one component of personal finance. Feel free to look at the other articles on xUSD to learn more about the other components. They are budgeting, saving money, paying off debt, and making money.

FAQs

Robo-Advisors vs Financial Advisors

Robo-advisors use a computer algorithm to automatically create an investment portfolio based on their client’s goals and risk tolerance. There is no or little human interaction which keeps costs down.

Financial advisors are able to provide their clients with more investment options, advice and personalized recommendations. The downside is the cost of using the services of a financial advisor is higher than investing with a robo-advisor.

Are robo-advisors worth it?

Robo-advisors mainly focus on low cost, high performance ETFs. This, combined with their low cost structure, makes them an attractive option worth considering.

In addition, most robo-advisors have low or no account minimums. They’re a great option for people who want to invest but are on a tight budget.

Do robo-advisors beat the market?

Robo-advisors are not designed to beat the market. They typically track index funds and use them as a benchmark. Their goal is to match the benchmark or get as close to it as possible, not beat it.

Are robo-advisors safe?

Robo-advisors are regulated by FINRA (Financial Industry Regulatory Authority). They have to be registered with the U.S. Securities and Exchange Commission (SEC). They’re subject to the same laws and regulations as broker-dealers and financial advisors.

Due to market fluctuations, robo-advisors can’t guarantee you’ll make money or won’t lose money using their services.

Are robo-advisors a short-term or long-term investment vehicle?

Robo-advisors are passive, long-term investment vehicles. They’re ideally suited for buy-and-hold investors with an investment horizon of at least 5 years.

They’re not suited for day traders, active investors, or anyone who’s only interested in short-term gains.