What is a Robo Advisor and Should You Use One?

A robo advisor is a digital financial advisor that uses complex algorithms to build and manage an investing portfolio based upon your goals and risk tolerance.

Although the automated portfolio technology behind robo advisors has been around since the early 2000s, robo advisors became available to the general public between 2008 and 2010 with the launch of companies like BettermentBetterment and Wealthfront. Historically, personalized investment advice was only available to high net worth clients as advisor fees were expensive and minimum deposits were greater than the typical investor could afford.

When major financial institutions were struggling during the financial crisis of 2008, financial startups had an edge by leveraging technology to offer financial services to the every day investor. Robo advisors have evolved since then and continue to offer an affordable investing opportunity to everyone by using technology to offer low fees, low account minimums, and personalized investing portfolios.

Step 1: When you first sign up for a robo advisor, you will be asked a series of questions related to your investing goals, your time horizon, your risk tolerance and more.

Step 2: Based upon the information you provided in Step 1, the robo advisor will use a series of financial algorithms to build a tailored investing portfolio that aligns with both your financial goals and risk tolerance.

Step 3: Once your portoflio has been built, you simply make your deposits and your robo advisor will automatically invest into the assets within your portfolio. Over time, investments within your account are rebalanced. This simply means that your robo advisor will buy and sell certain investments automatically to keep your portoflio optimally balanced to reach your goals.

Most robo advisors offer a mix between standard brokerage accounts and retirement accounts. After your robo advisor builds your portfolio that contains your investments, you can select what account type you want to place your portfolio within. These are some common account types offered by robo advisors.

Individual or joint brokerage account: A brokerage account simply allows you to deposit funds and start investing. You can own this account as an individual or jointly with another person.

Traditional IRA: IRAs are individual retirement accounts. A traditional IRA allows you to contribute pre-tax dollars to the account to save for retirement. In general, the amounts in your traditional IRA, as well as earnings and gains are not taxed until you take a withdrawal.

Roth IRA: A roth IRA is just the opposite of a traditional IRA. You pay taxes up front on the money you contribute to this account, but when you make a withdrawal you don't pay taxes.  

SEP IRA: Simplified employee pension (SEP) IRAs are retirement accounts for business owners in which the contributions are tax deductible. Investments grow tax deferred, and are taxed as income upon withdrawal in retirement.

401k Rollover IRA: A rollover IRA allows you to transfer funds from an old employer sponsored plan to an IRA.

Please note: You must qualify for an IRA and there are limits to these accounts. Consult a licensed financial advisor or visit the IRS website below to learn more.  

The short answer is no. Most robo advisors use what is called a passive investing strategy. The idea here is to buy and hold a diverse range of assets over a long period of time to minimize risk and maximize the possibility of a positive return. With this in mind, most robo advisors build your portfolio with a mix of low cost ETFs and index funds which can be thought of as baskets of stocks.

If you do want more control of your investments within your portfolio, you could consider a hybrid robo advisor. A hybrid robo advisor still primarily uses a passive investing strategy, but does allow for a bit of portolio customization. M1 Finance would be an example of a hybrid robo advisor.

In general most robo advisors are farily affordable and are typically cheaper than a traditional financial advisor. Typical annual fees can range from 0.25% to 0.50% and there are even some robo advisors that don't charge a fee at all such as Sofi Automated Investing. Minimum deposits can range anywhere from $0 to $500 depending upon the robo advisor.

Limited control over your investments: In general, robo advisors don't let you choose the investments within your portfolio. You are relying on the algorithms operating the robo advisor to choose investments that are in your best interest based upon your goals and risk tolerance.  

Not a complete financial advisor: Although robo advisors are called "advisors" they really don't fit that description. A robo advisor helps build a portfolio and manage the assets within it, but they don't always offer full fledged financial planning such as building a budget, looking at accounts outside of your investments, paying off bad debt, and more.

Stock brokers: If you want more control over your investments, a stock broker is a good option. Stock brokers allow you to buy both individual stocks, as well as ETFs and index funds so you can take advantage of both passive and active investing strategies. Many stock brokers are also using technology to offer commission free investing so they can be an affordable option.

Financial advisors: If you want a comprehensive financial plan, having a financial advisor is your best bet. An advisor can help with large picture financial problems and solutions that robo advisors can't solve. It should be noted that several robo advisors do offer financial advisors in addition to their automated investing advice. Sofi Automated Investing offers access to a free advisor and Betterment offers an advisor for an increased cost once your account balance reaches $100,000.