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What Is a Robo Advisor and How Do They Work?

| MoneyRates.com Senior Financial Analyst, CFA
min read

human_and_robot_handshakeAre you ready to join the rush towards robo-advisors?

If so you have a lot of company. This segment of the investment business has grown to represent more than $200 billion in assets under management, and this is expected to expand rapidly in the years ahead. Many online brokers now offer robo-advisor programs, as do some mutual fund companies and investment managers.

If you are looking to have an investment portfolio managed for you but you don't have a huge amount of money yet, robo-advisors are worth considering. Before choosing a robo-advisor though, it is important to understand not just what they are, but also what they can and cannot do for you.

What is a robo-advisor?

So what is a robo-advisor exactly?

A robo-advisor is an automated investment management platform that uses mathematical formulas based on your age, goals, and risk tolerance to set an asset allocation target for you. It will typically invest via exchange-traded-funds (ETFs), which are able to capture a broad range of market representation cost effectively. A robo-advisor will then use automation to adjust for cash flow and fluctuations in the value of different assets, to maintain the desired asset mix for you.

In short, a robo-advisor uses automation to take the human element out of applying fundamental portfolio management techniques to your investments. That is both the strength and the weakness of this approach - it takes human error out of the equation, but also eliminates the opportunity for human judgment.

That trade-off largely defines the things a robo-advisor can and cannot do for you.

5 things a robo-advisor can do for you

Here are five useful things a robo-advisor can do for you:

  • Define your asset allocation approach.

    Setting the right mix of stocks, bonds and other asset classes is a vitally important investment decision. Robo-advisors do this for you automatically, typically based on a Modern Portfolio Theory analysis of historical risk/reward characteristics of various types of investments.
  • Keep your portfolio in balance.

    Once you set an asset allocation, that allocation can get out of whack with every contribution to or withdrawal from the portfolio, every dividend or interest payment, and every price fluctuation. Robo-advisors automatically adjust your portfolio back to the target asset mix.
  • Lower costs.

    Having these fundamental portfolio management tasks handled by automation rather than by a human portfolio manager is much cheaper. Also, ETFs can give you a broadly-diversified portfolio at low costs and with efficient trading.
  • Apply tax optimization techniques.

    Concerned that realized gains might boost your tax bill? Robo-advisors can automatically scour your holdings for potential losses to realize as an offset against some of those gains.
  • Reduce human error.

    People make mistakes - they make bad judgments, or act emotionally rather than rationally in times of stress. While there is still a human element in how robo-advisors are designed and implemented, their automation greatly reduces the opportunities for human error.

5 things a robo-advisor cannot do for you

Nobody's perfect - not even a robot. Here are five things a robo-advisor cannot do for you:

  • Spot emerging themes.

    Since Modern Portfolio Theory analysis is based on historic performance characteristics of assets, it is backward-looking. It's good for basing judgments on how things have behaved in the past, but not for spotting new individual opportunities or anticipating broad changes in market characteristics.
  • Make valuation judgments.

    For the most part, robo-advisors assume stocks will perform as they have historically, without taking price into account. They don't make valuation judgments based on things like how expensive a stock is relative to earnings, where earnings are in the economic cycle, or interest rate levels relative to earnings yield.
  • Take the long view of risk.

    Common portfolio optimization techniques define risk as the quarterly fluctuation of returns. That's handy for calculation purposes, but not especially relevant to the average investor. People are not so much concerned about quarterly ups-and-downs as they are for the possibility of severe or sustained losses.
  • Hold your hand.

    Perhaps the greatest value a good investment professional can provide is keeping people on course so they don't get too fearful during bear markets or too greedy during bull markets. While robo-advisors are designed to take this kind of emotion out of day-to-day decision-making, they can't do much to calm an investor who wants to completely change course in reaction to market events.
  • Make success automatic.

    A complex algorithm and cutting-edge implementation technology does not guarantee success. Studies have begun to identify differences in how robo-advisors perform. Apparently, some robots may be more talented than others.

When choosing a robo-advisor, it is important to recognize both the strengths and the limitations of this approach. Robo-advisors are a good way for relatively inexperienced investors to apply widely-accepted investment techniques that should work decently under most circumstances. When it comes to accounting for more extreme circumstances though - whether unusual risks or extraordinary opportunities - the backward-looking methodology of robo-advisors may give them some blind spots.

More resources on robo-advisors:

How to Find the Best Robo-Advisor

How to Choose an Online Broker for Your Retirement

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