What Is a Robo-Advisor?
A robo-advisor is an automated digital investment advisory program that builds and manages an investment portfolio for you from your answers to an online questionnaire. The U.S. Securities and Exchange Commission (SEC) explains the model in an Investor Bulletin on robo-advisers, and the Investor.gov glossary defines the term.
The questionnaire asks about your financial goals, investment horizon, income, other assets and risk tolerance. Robo-advisors often aim to charge lower costs and fees than traditional advisory programs. Some require lower account minimums.
In exchange, some robo-advisors offer little or no contact with a person, and the advice can only use what the questionnaire collects.
What a Robo-Advisor Is and Who It Fits
A robo-advisor fits you if you are comfortable answering an online questionnaire, reading its disclosures online and working with limited human contact. It does not fit you if you want to speak with a person during a market downturn, or if your finances include debts and assets its questionnaire does not ask about.
Investor.gov spells the term "robo-adviser" and describes it as an automated digital investment advisory program. In most cases it collects your financial goals, investment horizon, income, other assets and risk tolerance through an online questionnaire. "Based on that information, it creates and manages an investment portfolio for you," the Investor.gov glossary entry says.
The same entry says services, approaches and features vary widely. Two robo-advisors can differ in what they ask you, what they invest in and how much human help they offer. The SEC Investor Bulletin on robo-advisers, published February 23, 2017, asks readers to weigh how much human interaction matters to them and to consider their own level of financial literacy.
How a Robo-Advisor Works
A robo-advisor lets you create and manage your investment account through a web portal or mobile application, sometimes with little or no interaction with a human being. You answer the questionnaire. The robo-advisor uses those answers to build and manage your portfolio. The SEC bulletin names lower costs than traditional advisory programs as the potential benefit of that setup.
The SEC bulletin says a robo-advisor's recommendation is limited by the information it requests and receives from you. Some robo-advisors obtain and consider only limited information. In many cases the burden to update that information falls on you.
Investing approaches differ from one robo-advisor to the next. Some offer several pre-determined portfolios that you may or may not be able to customize. Others use a limited range of products, such as broad-based exchange-traded funds (ETFs).
The SEC bulletin says a robo-advisor's services, approaches and features are described in its Form ADV Part 1 and Part 2 brochure.
Hybrid, Limited or No Human Contact
The amount of human contact varies from one robo-advisor to the next, and the SEC bulletin describes three arrangements.
- Hybrid advice, sometimes called "bionic" advice, where you can contact an investment professional in addition to using the automated service.
- Access to a person only for accounts that meet a minimum size.
- Technical support staff only, with no investment professional to contact.
Unlike a traditional adviser, a robo-advisor may have no initial or later conversation with you to gather information about your needs. The SEC bulletin asks whether you would like to speak with a person during market events such as downturns.
If your answer is yes, put hybrid access on your list of requirements and ask what account size it needs. If you would rather work with a person from the start, our guide on how to choose a financial advisor walks through that search.
What to Check Before You Open an Account
The SEC bulletin poses questions to ask before you open a robo-advisor account, and they fit into six checks.
- What information it uses. The bulletin suggests asking whether the questionnaire covers high-interest credit card debt or student loans, bank and savings accounts, real estate holdings, retirement accounts and other assets. Anything it does not ask about stays outside the advice.
- How it handles risk and rebalancing. The bulletin suggests asking how the robo-advisor takes your risk tolerance into account, including when it rebalances after a market decline, and how often it rebalances your account. Rebalancing can have tax implications, and some robo-advisors may be able to freeze sales during market volatility.
- Which account types it manages. The bulletin lists individual retirement accounts (IRAs), taxable accounts, 401(k) plans and college savings accounts as types to ask about.
- Whether it uses tax loss harvesting. The bulletin says its value depends on your tax situation and that it may implicate wash-sale rules, so it suggests considering a tax adviser.
- Your total costs. The bulletin says fees and other costs can greatly impact your return. A robo-advisor may offer lower-cost advice, but if it uses high-cost investment products, your total costs could still be high.
- Its registration. Investor.gov calls registration with the SEC or a state securities regulator the most important question before hiring an investment professional, and robo-advisers are investment advisers. Search the firm at adviserinfo.sec.gov before you open an account.
The bulletin adds that in some cases a robo-advisor may offer services that are not much different from a traditional advisory program or from a single product such as a target date retirement fund. Investor.gov warns that investing with someone who isn't licensed is "really risky" and offers a free search tool that shows whether an investment professional is licensed and registered.
Who a Robo-Advisor Does Not Fit
Our guide on whether a financial advisor is worth it compares a robo-advisor with a human advisor.
The SEC bulletin also notes that in some cases robo-advisers may not have been tested under stressed market conditions. If you want a person to talk to during a downturn, a robo-advisor that offers only technical support leaves you without one.
| Your situation | Robo-advisor fit | Source |
|---|---|---|
| Comfortable with a questionnaire, online disclosures and limited human contact | Fits | SEC bulletin |
| Want a person to talk to during downturns | Fits only with hybrid access | SEC bulletin |
| Debts, real estate or retirement accounts the questionnaire skips | The advice leaves them out | SEC bulletin |
| Want lower fees and lower minimums | Often fits. Add up total costs first | Investor.gov glossary, SEC bulletin |
Our answer changes in two cases. If a robo-advisor's questionnaire asks about your debts, real estate and outside retirement accounts, the information objection shrinks. If it offers a hybrid human adviser, or a person for accounts above a minimum size you meet, the downturn objection shrinks. Our best robo-advisors roundup ranks individual providers.
If you want the head-to-head, see our robo-advisor vs financial advisor comparison.
Our Takeaway
A robo-advisor fits an investor who is comfortable with an online questionnaire, online disclosures and limited human contact. It does not fit someone who wants a person during market stress, or whose finances a questionnaire cannot capture, unless the provider offers a hybrid human adviser. This read rests on the Investor.gov glossary and the SEC's 2017 investor bulletin.
Once you know what a robo-advisor is, run the six checks above on each provider you are considering. Start by searching the firm at adviserinfo.sec.gov, then ask for its Form ADV Part 2 brochure and compare providers in our best robo-advisors list.
Frequently asked questions
Are robo advisors good?
A robo-advisor can be a good fit when you are comfortable with an online questionnaire, online disclosures and limited human contact. Investor.gov names the benefits: advice that often costs less than traditional advisory programs and, in some cases, lower account minimums. The SEC bulletin names the limits: advice bounded by what the questionnaire asks, human contact that varies by provider and, in some cases, no testing under stressed market conditions.
Is a robo advisor worth it?
A robo-advisor is worth it when its lower cost holds up after you add the advice fee to the cost of the investment products it uses, and when you do not need a person to talk to. The SEC bulletin warns that total costs can still be high if a robo-advisor uses high-cost products. It also says some robo-advisors offer services not much different from a traditional advisory program or a target date retirement fund.
Why do some people say robo advisors are bad?
The SEC bulletin lists three limits behind that view. A robo-advisor's recommendation is limited by the information its questionnaire collects, and keeping that information current is often up to you. Some offer only technical support staff, with no investment professional to call during a downturn. In some cases, robo-advisers may not have been tested under stressed market conditions.
Is a robo-advisor a fiduciary?
A robo-advisor is an investment adviser, and Investor.gov says investment advisers are required to act in your best interest and not put their interest ahead of yours. Investor.gov also says the way advisers make money creates some conflicts with your interests, so ask any robo-advisor about those conflicts. Our guide on what a fiduciary is explains the term.
Sources
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