How Do Robo-Advisors Work?

How do robo advisers work? What are robo adviser algorithms and features?

Answers to all of your robo-advisor questions!

*Disclosure: Please note that this article may contain affiliate links to help pay for this site. We are committed to the highest standards of honest reviews.

Robo-advisors have stormed onto the investment scene as a way for all investors to participate in the wealth-building possibilities of the markets. Finally, get the answer – How do robo-advisors work?

No longer do you need deep pockets to hire a financial advisor or  to invest in a professionally managed portfolio. From Betterment to Schwab or M1 Finance, the robo-advisory choices are vast. But, if you’re wondering What is a robo-advisor and how do they work? read on.

A robo-advisor is an investment manager that uses computer programs to professionally invest your money. Beyond that, there are many varieties of robo-advisors with diverse fees, investment minimums and features.

If you’re interested in a low-cost, professionally managed investment approach, then a robo-advisor might be for you.

How do robo advisers work? What are robo adviser algorithms and features?

How a Robo-Advisor Works 

Robo-advisor algorithms are at the center of the robo-advisor investment manager. In fact, synthesizing algorithms has been the backbone of successful programs in various fields. Waze and Uber are known for their transportation algorithms and Google for its search engine algorithms.

But, what is a robo-advisor algorithm – in plain Engligh?

Here’s how an algorithm works.

An algorithm is a fancy word for the process that a computer uses to solve a problem. A robo-advisor’s computer algorithm is the steps the computer takes to create your investment portfolio. It’s kind of like a roadmap that the computer creates just for you – after integrating your responses to a few basic question.

For example, after you respond to questions about your age, goals, risk tolerance and current financial status, the robo-advisor computerized algorithm computes the best inverment portfolio for you. The computer is taught or programmed to take your information and integrate it with important investment research to create a portfolio with the best returns at your given time line and risk level!

Computerized robo-advisor algorithms are perfect for investors due to their inherent efficiency and cost-effectiveness. And, picking investments based upon the best-practices investing research can actually be done better by a computer than a human.

Find out: M1 vs. Betterment – Which is the Best Robo-Advisor for Me?

At first glance, the robo-advisor concept might seem doubtful and risky. After all, traditional investment management was grounded in meeting with a financial advisor, coordinating with a stockbroker, or even becoming your own financial manager. In contrast, most robo-advisors were founded on Nobel Prize winner Harry Markowitz’s Modern Portfolio Theory, which explains how to create diversified investment portfolios with the greatest returns for each risk level.

So how do robo-advisors work? Robo-advisors are computerized financial advisors that excel in one thing: creating diversified investment portfolio following sound computer algorithms based on well-recognized modern portfolio management strategies.

Who Benefits from a Robo-Advisor?

Beginning investors – Those Just starting out and don’t know much about investing will benefit from a robo. And, if you don’t have much money, these robo-advisors have low investment minimums:

Investors seeking financial advisors – Many robo-advisors now offer access to financial advisors. Even small investors can get financial advisory help! These robo-advisors offer financial advisors:

  • Betterment
  • Personal Capital
  • Ellevest
  • FutureAdvisor
  • Wealthsimple
  • TIAA Personal Portfolios

Investors who want a managed investment portfolio and the opportunity to trade investments – Many major investment firms offer robo-advisors plus a wealth of other investment and banking services. Several of our favorites include:

  • M1 Finance
  • Ally Invest Cash Enhanced Managed Portfolios
  • Schwab Intelligent Portfolios
  • Vanguard Personal Advisor Services and Digital Advisor      

High net worth investors and retirees – You might be surprised to discover that even those with a lot of money may want low fee investment management. There are several robo-advisors specifically designed for these individuals including:

How do Robo-advisors Work?

The Questionnaire

These automated advisors ask you your age and a few questions about risk, goals and your time horizon. Then the platform runs your choices through their computerized robo-advisor algorithms. Next, you’re assigned a risk level ranging from conservative to aggressive.

Most robo-advisors divide their investment portfolios by risk.  So, based upon your risk level, from conservative through aggressive, you’re provided with a collection of investments, in specific proportions, that meet your criteria.

The Investment Portfolio

After robo-advisors question your goals, age, risk tolerance and more they create a group of investments, or portfolio to match your preverences.

For example, a young, aggressive investor might receive a recommendation for 90% stock investments and 10% bonds, like this one from Betterment. Each of the colors on the “recommended allocation” circle represents investments in various exchange traded funds.

The circle represents the investors asset allocation or percentages invested in each type of investment, like stock or bond funds.

Betterment Retirement Goal

For example, Betterment, one of the oldest robo-advisors, creates your collection of investments according to your goals and risk tolerance from conservative to aggressive. The aggressive portfolio above is for the retirement goal.

The Investment List

Robo-advisor investing incorporates many different types of investments along with various investment styles. The typical robo-advisor invests in a passive style using index funds in various mixes for distinct types of investors, from conservative to aggressive investors.

Other robo-advisors like Vanguard and Personal Capital tailor their robo-advisors to the client and add in various investment styles. Socially responsible robo-advisors are becoming more popular with more platforms including them in their asset mix.

Betterment is one our favorite robo advisors. To get an idea about what is robo-investing and what types of funds are available, we’ll use Betterment’s investments for an example.

These are the exchange-traded funds available in the Betterment investment portfolios (caveat; funds are subject to change). More conservative portfolios hold a larger percentage of bonds and the aggressive Betterment portfolios are more stock fund-heavy.

You’ll find distinct groups of investment funds in each robo-advisor. Betterment’s funds are shown as an example of typical robo-advisor investments.

SectorTicker
U.S. Total Stock MarketVTI, SCHB, ITOT
U. S. Large-Cap ValueIVTV. SCHV, IVE
U.S. Mid-Cap ValueVOE, IWS, IJJ
U. S. Small-Cap ValueVBR, IWN, IJS
International -Developed MarketVEA, SCHF, IEFA
International - Emerging MarketVWO, IEMG, SCHE
SectorTicker
U.S. High Quality BndsAGG, BND
U.S. Municipal BondsMUB, TFI
U.S. Inflation-Protected BondsVTIP
U.S. High-YIeld Corporate BondsHYLB, JNK, HYG
U.S. Short-Term Treasury BondsSHV
US Short-Term Investment-Grade BondsNEAR
International Developed Market BondsBNDX
International Emerging Market BondsEMB, VWOB, PCY

Most robo-advisors invest your money in exchange-traded stock and bond funds. Some companies also include commodity, real estate and other types of ETFs as well. The list of investments offered within each company is a distinguishing feature of specific firms.

Small and mid-cap value stock funds and foreign emerging market bonds differentiate Betterment’s investments list from competitors. Other companies might not have the value offerings but might include U.S. and global real estate ETFs or commodity funds.

While some micro investing and robo-advisor apps also offer access to individual stocks like Robinhood and M1 Finance.

The Services

Robo-advisors come in different categories giving clients a wide range of options. Currently, in our robo advisor comparison chart we profile 17 robo-advisors. While our list of robo-advisors now includes 34 and more are added regularly. They differ regarding key features, free services provided, minimum investment amounts and more.

Depending upon your preferences, there are many varieties from which to choose. For example, M1 Finance and SoFi Invest, offer free robo-advisors suitable for investors seeking investment management or DIY investing tools. Betterment and Ellevest are, low cost robo-advisors with access to financial advisors. There’s a robo-advisor for everyone, regardless of the services and features requested..

Bonus: Robo Advisor Frequently Asked Questions

Rebalancing

All robo-advisors rebalance your investments. That means if the proportions of your funds drift from your original choices, the service will buy and sell shares to return the portfolio to your preferred allocation. So, let’s say you start with a 60% stock and 40% bond asset allocation.

Assume that stocks increase in value, more than bonds and your portfolio percentages grow to 70% stocks and 30% bonds. The platform will sell some stocks and buy more bond funds to return to your pre-decided 60% stock – 40% bond mix.

Tax-Loss Harvesting

Many robo-advisors sell losing investments and replace them with others, to offset gains and reduce your tax bill. This is called tax loss harvesting and is a strategy for taxable investment accounts.

Choose a robo-advisor in under one minute with our Robo-Advisor Selection Wizard!

how do robo advisors work

Image by Anastasia Gepp from Pixabay

Human Financial Advisors

Other robo-advisors provide users with access to financial advisors for investment-related questions. This hybrid model of digital investment advice combined with online financial planning is becoming much more popular.

There’s usually an additional fee for this service, although not always.

  • Betterment allows users to text with robo-advisors for it’s .25% management fee and to speak with certified financial planners for their Premium Plan that costs .40% of assets under management.
  • Wealthsimple includes financial advisors in their basic .50% management fee. For accounts over $100,000, the management fee drops to .40%.
  • Ellevest offers a premium access to online financial planners for .50% of AUM per year.
  • TIAA offers financial consultant access to all customers for .30%.

Read: Robo-advisors With Human Financial Advisors

Specialty  Robo-Advisors

From Ellevest, designed for women investors to M1 Finance, the free robo-advisor with thousands of investment options, there’s a wide range of choices.

Blooom is a robo-advisor that only manages your 401(k) investments. You pay $10 per month and Blooom chooses the lowest cost funds from the available choices.

While Titan Invest is a hedge-fund inspired robo advisor with much lower fees and investment minimums.

If you’re interested in socially conscious investing, there are several robo-advisors that offer impact investing portfolios; Betterment, M1 Finance, Grow App and Wealthsimple.

Finally, if you’re interested in more specialty robo-advisors, I recently wrote an article at U.S. News and World Report about “The Ways Robo-Advisors Stand Apart”.

Robo-Advisor Fees and Investment Minimums

Robo-advisor fees are typically lower than stand-alone financial advisors, and that’s part of their allure. Robo advisory management fees start with free platforms at:

After that they range from .15% of assets under management on up to approximately  .87%. The higher fee robo-advisors typically offer more features.

The investment minimums also vary from zero at Betterment, Ellevest, Axos Invest and others to $50,000 at Vanguard Personal Advisor Services. Check out our Robo-Advisor Comparison chart (sign up at the bottom) to review the range of management fees and minimums.

Financial Tools and Resources

In addition to investment management, many robo-advisors offer a slew of budgeting, retirement planning, and financial management tools. In fact, Personal Capital is known for it’s free suite of money, budgeting, investing and retirement planning tools. These are available to all investors, whether you sign up for the Personal Capital Advisors paid services or not.

FAQ

Can You Trust Robo Advisors and are They Safe?

Most of our money is handled electronically even if you walk into a bank and make a cash deposit. The bank rarely keeps your cash in the building. The money is translated into a series of numbers in your account, and the physical cash gets transported somewhere much safer.

If you’re comfortable banking and investing online, then you can trust robo-advisors. Robo-advisors are as safe as online banking with many safeguards including encryption and two-factor authentication.

Check out the security page on each robo-advisor to review how your data and personal information will be protected. Of course, it’s also your responsibility to choose complex passwords and change them regularly.

How are Robo-Advisors Taxed?

If you open a retirement account like a robo-advisor IRA or Roth IRA then you won’t pay taxes on the income earned within the account, like dividends and capital gains.

Rollover IRAs typically won’t be taxed while the money is in the account. As long as the rollover is completed within the 60-day window, you won’t be taxed on the “withdrawal” from the original account.
Income taxes will be due on withdrawals from traditional and rollover IRAs that were funded with pre-tax dollars. Since Roth IRA contributions were already taxed, their withdrawals are tax-free.

Robo-advisors owned within typical brokerage, trust, business and other types of taxable accounts will receive a 1099 with the taxable income listed. These dividends, interest and capital gains payments are taxed in the same way as any other income from investment and bank accounts.

Can you lose money with robo-advisors?

Of course. Like any financial asset, with the exception a bank savings, checking or CD account, your investment values will go up and down. Although over the long term, stock and bond fund investments have offered good long term returns.

Should I Use a Robo-Advisor – Wrap up?

Are you wondering, Is investing with a robo-advisor worth it? The answer is yes, if you are seeking low-cost, research supported investment management, then a robo-advisor makes sense.

As a final wrap-up here’s who benefits from investing with a robo-advisor:

  • The new investor, that wants to get started in the financial markets.
  • The seasoned investor who wants a portion or all of their money on auto-pilot and invested using a sound, researched-based investment approach.
  • Retirees who want special guidance or an income stream like the one available at Schwab Intelligent Income.
  • The investor who wants rebalancing plus the opportunity to pick stocks and funds themselves. This customization is available at M1 Finance as well as at the robos from major brokerages like Fidelity Go and Merrill Lynch Guided Investing.
  • Fee-conscious investors who want financial advice for a reasonable fee along with well-managed investment portfolios.

For help wading through the vast pool of robo-advisors, check out our free Robo-Advisor Comparison chart:

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Disclosure: Please note that this article may contain affiliate links which means that – at zero cost to you – I might earn a commission if you sign up or buy through the affiliate link. That said, I never recommend anything I don’t believe is valuable.

2 thoughts on “How Do Robo-Advisors Work?”

    1. Barbara A. Friedberg, MBA, MS

      Hi D, The best way to uncover that information is to visit a specific robo-advisor website and read their “legal” and “disclosures” section. For example, most robo advisors are registered investment advisors and subject to strict laws that govern the entire investment industry. Most will complete an ADV form which isthe uniform form used by investment advisers to register with both the Securities and Exchange Commission (SEC) and state securities authorities.

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