Robo-advisors are software programs designed with the intention of helping you manage your investments. Think of robo-advisors as the digital version of a financial advisor. Based on your answers to a set of questions that are asked upon signup, the robo advisor will help you make important financial decisions. Not only do they help you figure out decisions about where and when to invest your money, but they can also even be set to make ongoing financial decisions on your behalf.
Robo advisors are seen as an alternative to traditional financial advisors, but they are much cheaper in comparison. They can also be an alternative to picking and choosing your investments by yourself.
There are many finance companies that offer services like robo-advisors, such as companies with longstanding histories in the industry such as Fidelity, or newer services like Acorns which were created with the specific purpose of robo-advising. Most online robo-advisor platforms also offer free trial periods, so you can try them out to see whether you like them before making a commitment.
How Do Robo-Advisors Work?
When a customer signs up for a robo-advisor, they are asked to fill out an online questionnaire. This includes basic information such as your investment goals as well as deeper questions such as how much money they have in their savings, their intended timeline for investment, and their risk tolerance levels. These answers are then run through an algorithm, through which the robo-advisor is able to provide asset allocation and help you build a portfolio of diversified investments that suit your personal goals.
The software is also able to rebalance your portfolio once the funds have been interested to ensure it remains close to the ideal allocation. Most robo-advisors also encourage customers to make weekly or monthly contributions, however big or small they can afford. These deposits are then utilized to maintain the target allocation.
Robo-advisors are also able to use tax-loss harvesting strategies, which involve selling specific securities at a loss to offset gains in other securities.
Low-cost exchange-traded funds (ETFs) are typically the choice of investment that robo-advisors prefer, rather than individual stocks or mutual funds. This way, they can use an index fund or other passive investment approach to build your portfolio, emphasizing the importance of your allocation to stocks or bonds. Certain robo-advisors are also able to allow parameters such as environmental, social, or governance (ESG) investing criteria to specify the type of investment that you want to make.
How Much Do Robo-Advisors Cost?
The fee structure for robo-advisors can be either a fixed monthly amount or a percentage of assets. Fixed fee robo-advisor services can be availed for as low as $1, and percentage fees generally range from around 0.15% to 0.50%.
Keep in mind that fees are charged on top of other fees associated with investing. For instance, mutual funds and ETFs that are in your account are likely to have their own expense ratios. These kinds of fees are taken out of the assets of the fund before the distribution of returns.
Robo-Advisors and Taxes
Similar to any other type of investment, how much taxes you need to pay when using robo-managed assets will depend on the type of account in which you hold the assets in. For instance, there are no taxes charges on tax-deferred retirement accounts such as a traditional IRA or other, until you withdraw funds. In the case of a Roth IRA, withdrawals are also tax-free. Rolling your assets from an existing account to a robo-advisor does not count as withdrawals.
On the other hand, assets or investments held in a taxable account will need to be reported on your tax return. Similar to a brokerage account, taxes will be levied on earnings as well. An annual 1099 form will need to be filed, which accounts for the interest, dividends, and capital gains on your investments.
Existing investments that are transferred into a robo-managed account will typically be sold off unless they are the same investments that the robo-advisor would have chosen to allocate those funds to. In case a sale is made, any profits earned will have capital gains taxes to be paid for as well.
Pros and Cons of Robo-Advisors
As always, there are two sides to consider when deciding whether you should go for a robo advisor over a traditional financial advisor, or even choosing your own investments. Here, we’ve discussed them both:
Pros of Robo-Advisors
Zero Investing Knowledge Required
Robo advisors are a great option for beginners who are just starting out on their investment journey. You may not have the financial expertise required to make informed decisions, nor the funds to secure the services of a financial advisor. In such a case, robo-advisors can be a godsend!
Rob-advisors have the option of being put on autopilot once the initial setups are made. You can also set up automated deposits into the robo-advisor account to further remove the hassle of doing it manually. From there, the robo-advisor makes investment decisions based on the parameters you have set. This way, you don’t even have to think about it until you want to withdraw money!
Robo-advisors typically use simple investment strategies that do not require much expertise to understand. For instance, it may allocate 55% to stocks and 45% to bonds. Without too many investments to watch, it makes it easier to track the performance of your investments.
Cons of Robo-Advisors
No Human Interaction
Robo advisors come at a much lower cost than most financial advisors, but this also means that you are only interacting with software, not a human. While some robo-advisors do offer live assistance, it usually comes at an added cost. If you are someone who prefers speaking to actual people, this may be a dealbreaker for you.
Limited Investment Options
Robo advisors may not be ideal for you if you prefer to be actively involved in the decision-making process of how your money is allocated. While questions regarding your preferences are registered, robo-advisors typically offer very general options. Your robo-advisor may not be able to take input about specific stocks you want to invest in.
May Need to Open Multiple Accounts
If there is a specific stock that you cannot let pass by, you may be forced to open up a separate brokerage account to invest in it. It may also be imperative that you need separate accounts to coordinate company benefit packages and 401(k)s. Given that the automation aspect of a robo-managed account is one of its major selling points, it may end up seeming pointless when you have to open up multiple accounts to manage other things.