How do Robo Advisors Work?

Updated November 01, 2021

Investing for your future financial goals is essential. But the thought of planning out a balanced investment portfolio that aligns with your plans and your values can be overwhelming. That’s when a robo advisor can step in to save the day and make the process easier.

Let’s explore how robo advisors work so you can decide if this financial tool is right for you. 

What is a Robo Advisor?

A robo advisor is a digital tool that manages your investment portfolio based on an algorithm designed to automatically help you meet your financial goals. The process of managing your investment portfolio is completed without consulting a human financial advisor, and the automation helps you save time and focus on other things in life.

You may also hear robo advisors referred to as a roboadvisor or robo-advisor. But for each spelling variation of robo advisor, the same principles apply. Robo advisors seek to automate as much of the financial planning process as possible with as little human interaction as possible.

In general, robo advisors are known to offer lower fees than traditional financial advisors. The lower cost is possible thanks to the automation a robo advisor uses. However, you will lose some personalization that a human financial advisor can offer. 

Depending on the robo advisor, you may be able to save and invest for multiple goals through different portfolios included within a single account. For example, you might choose to invest with a long-term mindset for your retirement goals, but decide you want a different approach for a short-term savings goal. 

With your specific goals in mind, a robo advisor will create a portfolio designed to achieve them within your timeline. As you continue to grow your portfolio, the robo advisor will take care of rebalancing along the way to make sure you stay on target. 

Types of Robo Advisors

Robo advisors come with a variety of different investing styles to complement the wide range of investors seeking assistance. But three factors can allow you to distinguish different types of robo advisors from one another.

First, robo advisors vary in their technical abilities. You’ll find either simplistic or comprehensive robo advisors on the market. With a simplistic robo advisor, your portfolio will be created based on standard questions that focus on your goals and risk tolerance. 

Comprehensive robo advisors take things a step further to gain a better understanding of your complete financial picture. With an increased intake of data about your net worth and spending habits, a comprehensive robo advisor takes steps as needed to adapt your portfolio based on your financial choices. 

Another way to distinguish between different types of robo advisors is to determine the scope of the services offered. In many cases, these tools will stick to offering basic access to mutual funds and ETFs. But some offer a wider scope to include other assets in your portfolio and access to an array of financial products.

How Robo Advisors Choose Your Investments

A robo advisor starts the process of choosing your investments with a series of questions designed to understand your investment goals. In addition to determining what you hope to gain from your investments, a robo advisor will gauge your level of risk tolerance and current financial state.

With that information, your robo advisor will begin to craft an investment plan for you. The first step will be to recommend which type of investment account may best suit your interests. For example, if you identified saving for retirement as a major long-term goal, a robo advisor may point you in the direction of a tax-advantaged vehicle like an individual retirement account (IRA). But if you have a short-term investment goal, then it may recommend a different account for your goals. 

Once the type of investment account is nailed down, the robo advisor will craft a portfolio that aligns with your goals. Essentially, the questions you answered will guide the robo advisor to determine an appropriate asset allocation

Most robo advisors will use Modern Portfolio Theory. Modern Portfolio Theory uses diversification to optimize portfolio returns while an acceptable level of risk. The diversity of assets should help keep your portfolio growing steadily over time. 

Once your initial investments are set up, the robo advisor will take steps to rebalance your portfolio regularly. Rebalancing will ensure your asset allocations continue to reflect a portfolio designed to reach your goals. 

Is a Robo Advisor Safe?

Like other investment opportunities, robo advisors are not free from risk. 

Anytime you build an investment portfolio, you’ll encounter some risks along the way. Although the hope is that your money will grow within the portfolio, it is possible you’ll experience volatility along the way. 

But these tools can be an effective way to build an investment portfolio. Robo advisors are regulated by the Securities and Exchange Commission as Registered Investment Advisors. Basically, that means most robo advisors are charged with a fiduciary responsibility that requires them to make investment choices that are in your best interests. 

Additionally, most robo advisors protect your assets through the Securities Investor Protection Corporation (SIPC). SIPC coverage provides protection for up to $500,000 in assets for each account type. This includes a $250,000 cash account limit.  

However, SIPC insurance is not intended to protect against loss if the market value of your investment falls, as this is a normal part of investing. Instead, it protects customers if the firm fails financially. 

Look for a well-established robo advisor that is both a fiduciary and is a SIPC member firm. As with any investment there is always risk, though these safeguards can help ensure you are investing with a reputable robo advisor. 

Benefits of Robo Advisors

Working with a robo advisor can help you dive into the world of investing without spending a lot of time learning the ins and outs. Robo advisors can serve as a tool to help you achieve your investment goals.

Plus, you won’t have to come up with a large initial investment to get started. Although many human financial advisors require hundreds of thousands of dollars to open an account, many robo advisors can help you get started with hundreds of dollars. Or you may not need any opening deposit if you choose Betterment as your robo advisor. 

Since these are not human financial planners, it’s relatively quick to open an account with a streamlined process, and your portfolio can be managed efficiently to meet your needs. 

Finally, robo advisors are known for offering an affordable option. As compared with human financial planners, robo advisors are significantly less expensive to use.

Limitations of Robo Advisors

Of course, there is a downside to using a robo advisor. 

The major drawback is that you won’t have regular access to a human financial advisor to field your personalized money questions. Although not everyone wants to chat with a real human, some do. And that’s completely understandable. If your financial planning needs are more complex and you want more personal service, then a robo advisor is not a good fit. 

What Robo Advisors Cost

In general, robo advisors are more affordable than human financial advisors. But these tools certainly aren’t free. 

You can find robo advisors with assets under management fees that range from 0.00% to 0.89%. However, most robo advisors start their pricing with at least a 0.25% fee. 

Schwab Intelligent Portfolios is the exception at 0.00%. However, the company has a catch in the fine print that requires you to keep some of your portfolio in cash so Schwab can earn interest on the balance. 

You’ll have to pay something to work with a robo advisor. But the cost may seem more reasonable when compared to the average 1% assets under management fees charged by many financial advisors. 

How Do You Get Started With a Robo Advisor?

Have you decided that a robo advisor is the right fit for your financial goals? The next step is to pick the right robo advisor for you. 

Luckily, InvestingAnswers has created a list of the best robo advisors out there to help narrow your search. Take some time to review your options before moving forward with the perfect match.

RELATED: Betterment RoboAdvisor Review: Pros and Cons

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All of our content is verified for accuracy by Mark Herman, CFP and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about How do Robo Advisors Work?.

Are robo advisors good for beginners?

If you are just diving into the world of investing and have a small amount to start investing, then a robo advisor is a great way to get your feet wet. A robo advisor can set up your accounts and tailor your portfolio in a relatively efficient way. Even if you are new to investing though, it’s important to understand your goals and risk tolerance before you commit to a strategy. Most robo advisors will offer tools to help you further define these as part of the account opening process.  

Taking some time to learn a few investment basics could help make the transition a bit less scary. Learn more about investing for beginners here

Which robo advisor is best for beginners?

The right robo advisor will vary based on your unique financial situation and goals. If you aren’t sure where to get started, check out our favorite robo advisors out there. The guide should help you narrow down your options to the absolute best choice for your situation. 

Mark Herman has been helping friends with financial questions since serving as an Army helicopter pilot. Since then, he’s gained valuable experience in the corporate world before moving on to become a Certified Financial Planner™.

If you have a question about How do Robo Advisors Work?, then please ask Mark.

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