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What is a Robo Advisor?

Would you hire a robot to manage your investments?

Perhaps surprisingly, many people do, although the "robot" in this case isn't an animated or human-like machine from a sci-fi movie. It's a digital investment service that uses computer software and algorithms to recommend investments and execute trades without a human being involved.

Commonly called "robo-advisors," these investment services can be easy to use and affordable, making them especially attractive for small or beginning investors. Robo-advisors are also known as automated investment advisors, digital investment advisors, digital investment advice platforms, and automated investing services, among other names.

What is a robo-advisor and what do they do?

A robo-advisor typically uses a three-step process to invest your funds:

Step 1: The system collects basic financial information about you and your situation. This information may include how much you want to invest, your timeframe for your investment, how comfortable you feel with investment risk, any preferences you may have for your investments and your investment goals. Examples of investment goals include buying a home or retiring from your career.
Robo-advisors typically collect this information through an online questionnaire.

Step 2: The robo-advisor processes the information you provided and recommends an investment strategy that may be appropriate for you. The strategy may be aggressive, moderate, or conservative, depending on your timeframe, goals, investment risk tolerance, and other factors. Investing always involves some degree of risk.

Step 3: After you approve the recommended strategy, the robo-advisor automatically invests your funds in a portfolio of investments that fit that strategy. The investments robo-advisors select are typically index funds or exchange-traded funds (ETFs) that have been chosen by the company that manages the robo-advisor. Index funds and ETFs are "baskets" of multiple assets that may be intended to track a specific market index, such as the S&P 500.

What are the pros and cons of robo-advisors?

The pros and cons of robo-advisors can be challenging to identify because they involve some degree of subjectivity. One investor's pro may be another investor's con. With that in mind, there are some factors to consider.

Robo-advisors are generally fast, easy to use, and less costly than human financial advisors. They typically allow very low or even no minimum balance to invest. For those willing to do their homework, a robo-advisor may include basic financial education and online financial planning tools, such as retirement savings calculators.

Some robo-advisors can execute complex investment strategies, such as selling certain investments to realize losses for income tax purposes. This strategy is known as "tax-loss harvesting." And most robo-advisors will periodically rebalance your portfolio to bring it back into alignment with your investment strategy.

However, robo-advisors generally don't offer much, if any, personalization or flexibility. If you find yourself in a stressful investment situation, like a market downturn, it might be difficult to find a person to speak to.

And while some robo-advisors offer high-quality investment portfolios, others are not well-designed in terms of their investment diversity or the way their portfolios are structured. They may include cash as a significant percentage of your investment portfolio. This strategy leaves a portion of your funds uninvested and could affect your investment returns.

Should you use a robo-advisor?

If you're unsure whether to use a robo-advisor, remember that it doesn't have to be an all-in proposition. You can divide your funds and only invest a portion of them with a robo-advisor. There are also some specific issues that may influence your thinking one way or the other.

A robo-advisor may be appropriate for you if:

  • You're well-educated or willing to educate yourself about investing, but you don't have a lot of money to invest, or you don't feel comfortable making investment decisions on your own.
  • You have a limited budget to pay for investment advice or you don't have time to meet with a human investment advisor, and you feel comfortable allowing an algorithm to make investment decisions for you.
  • You want to use an investment strategy that requires a lot of technical analysis, or you want to commit to an automated investment approach that may help you curb impulsive or emotionally reactive investment decision-making.

A robo-advisor may not be a good fit for you if:

  • Your investment needs are relatively complex, you're interested in uncommon, esoteric or novel investment strategies, or you want personalized investment advice.
  • You want to select specific investments rather than invest in index funds or ETFs.
  • You need help with invested-related issues, such as insurance, estate planning, or timing withdrawals from your retirement accounts after you stop working.

Still not sure? A human investment advisor can answer your questions and help you make a smart choice for your personal situation.

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