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Some days it can feel like the robots are taking over. Automation touches nearly every aspect of our daily life: Homes, cars and even our bank accounts often come with automated features designed to help make our lives a little easier.
Automation has also made the leap to the investment world. Robo-advisors, or automated investment platforms, first marched onto the scene in 2008 and have grown in popularity. Many investors, both newbies and experts, have turned to robo-advisors to help manage their investments.
That’s because on top of their typical lower fees, robo-advisors can be a huge time-saver for investors. You don’t have to carve out a chunk of time to do research on which individual assets to hold, buy or sell. Based on the information you plug in when you open the account, robo-advisors can recommend an investment portfolio that fits your needs. And they’ll help you manage it over time, too.
As robo-advisors continue to grow in popularity, it’s important to understand how they work. In this article, we’ll pull back the curtain (or should we say, panel?) and take a closer look at these digital investment platforms.
If you’ve ever shopped for a robo-advisor, you’ve probably come across products that market themselves as “robo-investing,” “digital advisors” or “smart portfolios.” The names may differ, but the idea behind them is generally the same.
Robo-advisors are digital platforms that provide various automated investment services based on your personal goals and preferences. Instead of relying on human advisors to make every little decision or recommendation, robo-advisors use algorithms for portfolio selection and management.
Let’s say you’re interested in building up a nest egg for retirement. A robo-advisor program may ask you a few questions about when you’re planning to retire, how much you want to save, and your risk tolerance. Based on your answers, the program will recommend a portfolio that can help you achieve your investment goal.
Each robo-advisory provider has their own philosophy and approach when it comes to automated investing, which can impact their recommendations and offerings. That being said, no matter which firm you go with, here’s what you can generally expect when opening an investment account. (Note: It’s a good idea to check specific terms and conditions before choosing a robo advisor.)
First, the robo-advisory platform or app will usually walk you through a series of questions about you and your financial situation. For example, what are your spending habits, what are your investing objectives? Your answers can help the robo-advisor better understand your investment needs, time horizon, goals and appetite for risk.
Next, the robo-advisor uses the information you provided to recommend a particular portfolio of investments.
When you’re all set up, the robo-advisor can help monitor the markets and make adjustments to your account as needed to help ensure your allocations stay in line with your goals and risk preferences.
Want to open up an account without having to talk to an actual person? (We see you, introverts.)
With robo-advisors, you don’t have to wait to talk to a financial advisor to open an account, withdraw funds or update your portfolio. Many account services are just a few clicks away, and you can access your account online 24/7.
Lower opening deposit requirements are another common feature of robo-advisors. On top of this, you can generally expect lower fees, too, (compared to traditional advisory services) due to the digital nature of robo-investing.
For instance, rather than relying on financial advisors for day-to-day portfolio management, robo-advisory platforms use algorithms (more on this later) to automate many investing activities. Generally speaking, the fewer people you have actively managing your account means lower costs.
While robo-advisors could save you time and money, keep in mind that your investment choices may be limited when compared to a traditional advisory service. You usually can’t handpick individual stocks, bonds or funds.
Many robo-advisors focus on passive investing to help you build wealth over time. They typically invest in low-cost ETFs or index funds that track major indices like the S&P 500.
The robo platform automatically recommends a portfolio of funds for you based on the investment goals, time horizon and risk tolerance you provide. The funds/ETFs in these portfolios are usually pre-selected by a team of investment advisors.
When someone says algorithms, you may only hear beep-boop-beep. You’re not that far off! They’re basically a set of computer instructions (or computer program) written to solve a particular problem.
Algorithms can be simple and designed to do one thing, like build a basic portfolio. With the help of proprietary algorithms, robo-advisors can recommend a diversified investment portfolio that’s in line with the financial goals and risk tolerance you’ve shared with it.
Algorithms can also be mind-bogglingly complex – set to execute a series of actions or calculations. Automated portfolio management services like rebalancing and tax-loss harvesting are good examples.
Keep in mind that even though robo-advisors run on algorithms, there’s still a person(s) involved in some capacity behind the scenes. For instance, advisory personnel have the ability to make adjustments to the account as necessary in response to what’s going on in the financial markets.
Good to know: If you’re shopping for a robo-advisor, you’ve probably noticed there are many providers out there to choose from. It’s important to do some research and be thoughtful about where you open an account.
Not all robo-advisors can provide the same level of financial expertise. At the end of the day, you want to be able to feel confident that your provider – or the advisors powering the algorithms – can manage your money with experience and diligence.
The types of services you get from a robo-advisor can vary from firm to firm. But two common ones you may have seen are portfolio rebalancing and tax-loss harvesting.
Portfolio rebalancing. So what is automated rebalancing? Once you’ve set up and fund an account, your robo-advisor stays busy in the background monitoring your investments to make sure they don’t move too far outside of your original asset allocations.
Wait, remind me – what’s asset allocation? This is how you divvy up your money across assets in your portfolio based on your risk tolerance. Remember, changes in the market can cause your asset allocations to shift over time.
In short, rebalancing can help you stay on track of your goals. Automated rebalancing can be a real time (and money) saver, as you don’t have to burn the midnight oil trying to figure out how to move around your investments on your own.
Good to know: It’s important to keep your account profile updated. Sometimes, certain life changes could affect your risk tolerance or time horizon (for instance, maybe you’re thinking of retiring early). This helps ensure you’re in the appropriate asset allocation and that the robo-advisor continues to rebalance in line with your investment objectives.
Interested in learning more? Check out our article on “What Is an Asset Allocation and What is Rebalancing?”
Tax-loss harvesting. Some robo-advisors also provide tax management services like tax-loss harvesting. In the simplest terms, tax-loss harvesting is a strategy where you sell certain securities at a loss to offset capital gains elsewhere in your portfolio. Using losses to offset gains could help reduce your tax bill. Again, thanks to the help of algorithms, robo-advisors can automate this process.
Good to know: In certain cases, automated tax-loss harvesting can have its limitations and drawbacks, so it may not be right for every investor in every scenario. Investment taxes are generally a complicated matter. If you have any questions about this feature, it’s a good idea to consult with your personal tax advisor.
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