What is a robo-advisor? Definition and how they work (2024)

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• Robo-advisors uses computer algorithms to create and manage investment portfolios with little human involvement.
• Robo-advisors rely on preexisting model portfolios that are adjusted based on your risk tolerance, time horizon, and goals.
• Automated investing platforms are best suited for fee-conscious novices and hands-off investors.

Robo-advisors have grown in popularity due to their simple, cost-effective way of investing that avoids the need to deal with — and pay — human professionals. With their low fees and deposit minimums, robo-advisors have opened up savings and investments to a new demographic of investors.

However, trust in these automated portfolios is split across generational lines. Millennials and Gen Z investors are far more likely to trust the best robo-advisors than Boomers and Gen X.

Here's everything you need to know about robo-advisors.

What is a robo-advisor?

Robo-advisors are automated investing platforms that use AI to build and maintain investment portfolios. These AI algorithms pull from various economists' research, such as Harry Markowitz's modern portfolio theory (MPT), which outlines a method for selecting investments that maximize returns while keeping risk at tolerable levels.

Investment managers and brokers have actually been using robo-advisor technology since the 1980s. In recent years, automated investing started to be directly marketed to consumers. In 2008, Betterment Investing launched the first robo-advisor available to the general public.

Since then, robo-advisors have continued to grow in popularity among investing novices and passive investors. While not as personalized as self-directed brokerage accounts, automated investing offered a more accessible and low-cost method of investing.

"Over the past few years, the 'catch-all' term 'robo-advisor' has become increasingly obsolete, with firms preferring more specific terms such as Digital Wealth Service, Automated Advice, Hybrid Advisor or even Bionic Advisor to describe better what they actually do," says Simon Bussy, consulting director at Behavior Consulting Limited.

Today, robo-advisors fall into two basic categories: those that are exclusively online — like Acorns Invest — and those offered by brick-and-mortar brokerages and financial service firms, like Charles Schwab automated investing.

Traditional brokerage firms tend to cater to investors with a bit more capital, often requiring higher minimum deposits and charging higher fees — but also the option of live interaction.

How does a robo-advisor work?

Robo-advisors require you to complete a questionnaire regarding relevant personal information pertaining to investing. While some platforms will only ask basic questions, others will pose a more detailed range of queries intended to identify the client's specific financial needs and provide regulated advice.

"An investor typically provides information about his or her risk tolerance, time horizon, and investing goals, and based upon that information, a portfolio is recommended, usually comprised of low-cost ETFs, that are managed and rebalanced as needed," says Keith Denerstein, head of wealth management product at Empower.

Robo-advisors commonly offer features like:

• Socially responsible investing (SRI) portfolios
• Tax-loss harvesting
• Automatic rebalancing
• Goal-based investing strategies
• Mobile access

Automated platforms manage investment portfolios by keeping each asset within a range of certain percentages. For example, let's say that your robo-advisor has allocated 20% of your portfolio toward the . The robo-advisor will give it a little wiggle room, plus or minus 5%. If the Vanguard drops below 15% or exceeds 25%, it will rebalance your portfolio.

How much do robo-advisors cost?

Robo-advisors generally have a low expense ratio. "The average robo advisory platform charges a management fee for its services, typically less than 0.50% per year," says Denerstein.

For example, TD Ameritrade's robo-advisor carries a 0.30% advisory fee. Vanguard Digital Advisor charges a 0.20% advisory fee. These fees often vary depending on the size of your portfolio.

Vanguard Personal Advisor Services, which combines robo-management with human advisors, charges fees on a sliding scale:

• 0.30% for portfolios under $5 million
• 0.20% for portfolios between $5 million and $10 million
• 0.10% for portfolios between $10 million to $25 million
• 0.05% for portfolios $25+ million

Other robo-advisors may charge an 'expense' or trading fee on each transaction. You may also be charged an expense ratio fee, which is charged based on the funds the robo-advisor invests.

Overall, the cost of using a robo-advisor generally amounts to less than 1% of assets under management (AUM).

Benefits of robo-advisors

Comparatively inexpensive to human advisors

Robo-advisors generally cost less than human financial advisors and investment managers. For example, automated investing apps charge between 0.00% and 1% of investment portfolios annually. Traditional wealth managers typically charge over 1% of AUM.

Lower account minimums and fees

Robo-advisors usually have lower account requirements than traditional brokerages and investment managers. For example, Betterment has a minimum account requirement of $0, while Wealthfront Investing's robo-advisor has a minimum of $500. By comparison, Charles Schwab Intelligent Portfolios has a minimum of $5,000.

"The typical retail investor using a robo-advisor can potentially benefit from professional portfolio management at a cost far lower than that traditionally charged by a live advisor," says Denerstein.

Beginner-friendly investing strategies

Because they do all the choosing and investing, robo-advisor platforms don't require much on the part of investors. You need no specialized knowledge of stock markets, P/E ratios, balance sheets, or anything else. Automated investing platform truly geared toward the novice or the invest-it-and-forget-it client.

Drawbacks of robo-advisors

Limited control

Robo-advisors mainly invest in inexpensive exchange-traded funds (ETFs) and index mutual funds (one way they keep costs low). But the majority of services don't let users select which funds are included in their portfolios. Nor do they invest in individual stocks, bonds, or exotic, alternate investments.

Some online brokerages, like Acorns Invest, offer DIY investing of certain assets like individual stocks and cryptocurrencies when you pay an additional monthly fee.

Limited flexibility beyond pre-built portfolios

Robo-advisors usually apply general criteria when selecting or recommending portfolios to customers. In many cases, they shoehorn customers into one of their preexisting model portfolios (i.e., growth, income, growth + income) based on the basic risk tolerance, income profile, and rudimentary investment goals indicated in your questionnaire.

That's why human wealth managers and "financial planners argue that 'robos' cannot replace them — they are not sophisticated enough to understand the whole picture or provide fully-rounded advice," says Bussy.

While automated investing platforms may offer general financial planning tools, like retirement calculators, robo-advisors aren't financial planners. They just invest money. That means they can't counsel you on long-term financial plans and goals, such as saving for retirement or college, or when unexpected financial needs arise.

Lack of personalized advice and human assistance

Many robo-advisors, especially the online-only variety, don't provide clients with a direct line to any human help. The customer service reps, if any, are mainly there for logistical questions or platform errors. Robo-advisors are incapable of providing investors with financial counseling or explaining investment strategies.

That said, investing through a robo-advisor doesn't prevent you from seeking financial consultation from another brokerage or broker firm. But you will have to pay the additional cost for this service.

Robo-advisors — Frequently asked questions (FAQs)

How do robo-advisors make money?

Because fees are so low, robo-advisors are increasingly making money via other revenue streams. Some, such as UK-based Wealthify and Munich's Scalable, sell their technology to other money managers or financial professionals.

Others are looking to move beyond portfolio management, offering banking services such as high-yield savings accounts. The idea is to encourage customers to keep excess cash with the service or attract new clients. AI investing platforms have also adopted a hybrid model, mixing automation with humans. The more personal the advice, the higher the cost.

For example, offers a tiered investment management service. It has a basic self-directed brokerage account option and a completely automated platform. Merrill Edge's robo-advisor has no minimum investment requirement.

In addition, Merrill Edge offers an online Guided Investing account with a $1,000 minimum. And finally, there's the top-of-the-line Guided Investing, starting at $20,000, which combines a robo-advisor with one-on-one human portfolio management and advice.

Are robo-advisors worth it?

Whether they are right for you or not, robo-advisors could spell the future of investing. Automated investing apps serve portfolios large and small and a variety of investor types. "A low-cost 'robo' can help someone get their foot on the investment ladder, or for more experienced investors, can help save them costs," as Bussy puts it.

One of the main selling points for robo-advisors is that they're completely automated, which means you don't have to think about that investment actively. On the other side of that coin, if you're looking to choose certain shares, you may be disappointed with the level of freedom a robo-advisor will give you.

Still, robo-advisors remain primarily of best use for hands-off investors or those needing to start out small on their investment journey. Automated investing isn't for everyone, especially folks wanting a more personal touch or customized approach.