What is a robo-advisor? An introduction to automated investment tools

One of the joys of writing a money blog like Get Rich Slowly is the continuing self-education. I’m always reading and learning about personal finance. A lot of the times — as in the past month — this education is about esoteric topics. I’m currently diving deep into the history of personal finance, a subject that’s interesting to me but admittedly not of much practical use in the modern world. (Today in the mail, I got a book about advertising and the use of credit during the 1920s. How’s that for esoteric?)

But sometimes, this self-education does have practical uses, and it’s stuff that I can share with you folks so that you too can become better educated.

For instance, I have a huge blind spot when it comes to so-called “robo-advisors”. When I stopped writing here in 2012, robo-advisors existed but they hadn’t yet become a Big Deal. By the time I re-purchased this site in 2017, things had changed. Robo-advisors had become a major force in the investment industry — and I was clueless about what they were.

I’ve remained (mostly) clueless for almost three years now. I have a general idea of what robo-advisors are and how they operate, but only in the broadest sense. During our weekly planning call on Monday, I mentioned this blind spot to my business partner, Tom.

“You should write about robo-advisors,” Tom said. “If you don’t know what they are, I’ll bet there are plenty of readers who don’t know either. Do some research, write it up, and then everybody benefits.”

Tom is a smart man.

Here then is my research into the world of robo-advisors. What are they? How do they work? And who should use them? Let’s find out.

What is a Robo-Advisor?

Simply put, a robo-advisor is a company (or service) that offers investment management with a minimum of human input. Traditional financial advisors are all about human interaction. Robo-advisors are not. Let’s look at an example.

Before 2020 descended into chaos, Kim and I were having bi-weekly meetings with Luna Jaffe, a local Portland financial advisor.

Once every two weeks, we’d drive to Luna’s office. For an hour, Luna would ask us about our plans. She’d then offer advice and suggestions about how we should handle our money. If we were actual clients — instead of colleagues and friends wanting to learn about how this process works — we might then allow Luna to manage our investment accounts. (And, in fact, Kim may still do this in the future.)

A traditional financial advisor helps her clients get clear on their goals, then offers advice about how the clients can best manage their money to achieve those goals. Plus, the advisor acts as a sort of voice of reasons as the market rises and falls.

A robo-advisor, on the other hand, does none of this. In fact, I’d argue that the “advisor” portion of the term “robo-advisor” is a complete misnomer. Robo-advisors offer no advice. None. Zip. Nada. Sure, they might have blogs on their websites, but they deliberately steer clear of giving specific recommendations to clients. Robo-advisors are not financial advisors.

And, in fact, if you visit the website of any robo-advisor, you’ll see they never ever use that term. Nor do they ever claim to be financial advisors. (And they specifically disclaim that they’re offering financial advice.)

Well then, what do robo-advisors actually do?

Because I’m a nerd, I always want to know how and why and when. Why do we call these companies robo-advisors? And when did the term first come into use?

The short answer: Nobody knows.

The long answer: According to Business Insider, the first use of the term “robo-advisor” actually was “robo-adviser” (with an “e” instead of an “o”) and occurred in the title of a 2002 journal article. But the term didn’t appear in the article itself.

After that, the term wasn’t used again until 2011 (when it appeared again in the same journal as the first use). Then, in 2012, the name exploded in use and popularity. And that explains why I don’t know anything about robo-advisors. They became a thing exactly at the time I “retired” from the world of personal finance.

For more info, check out this short article that offers a brief history of robo-advisors.

What Do Robo-Advisors Do?

Robo-advisors might be more accurately described as automated investment-management tools.

Let’s use Betterment as an example. Betterment was founded in 2008, and the company launched its investment service in 2010. Today, a decade later, Betterment also offers tools to help people manage spending and start saving.

Here’s how Betterment describes itself:

Betterment helps you manage your money through cash management, guided investing, and retirement planning. We are a fiduciary, which means we act in your best interest.

We’ll ask a bit about you when you sign up. We’ll also gather information when you sync your outside accounts. Then, we’ll help you set financial goals and set you up with investment portfolios for each goal.

For your long-term financial needs (like retirement, next year’s vacation, or a down payment), our investment strategy is built on low-cost ETFs (exchange-traded funds) and a risk profile based on how long you plan to invest.

So, Betterment offers investment portfolios built on exchange-traded funds — index funds that you can trade like a stock. It appears that the company offers several pre-constructed portfolios, or allows individual investors to build their own from a small universe of ETFs. Here’s a screenshot that I pulled directly from the Betterment page on how their portfolios work.

Betterment portfolio manager

I can’t tell exactly, but it seems like Betterment offers maybe four primary pre-built portfolios, plus allows customers to build their own. (Maybe an actual customer can chime in with a comment about how this works?)

Other robo-advisors offer similar services. Here, for instance, is a screencap from the Wealthsimple website that describes how its product works.

Wealthsimple investing

Most robo-advisors offer a variety of accounts. You can start a regular, taxable investment account. You can contribute to your IRA. And a few allow you to contribute to your 401(k). I think Vanguard Digital Advisor is set up for this. I know that Blooom was specifically created to be a 401(k) robo-advisor.

So, the bottom line is this: Robo-advisors are not advisors. They’re simply platforms that make it easier for people to get started investing. (Note that unlike some robo-advisors, Betterment does offer actual financial advice if you’re willing to pay an additional fee.)

Note: I often hear Robinhood mentioned as a robo-advisor. It’s not. Robinhood is a DIY investment platform, much the same as Sharebuilder was fifteen years ago, but it’s decidedly not a robo-advisor.

I think it’s important to note that traditional investment companies have begun to launch their own products to compete with the robo-advisor industry. In fact, currently the largest robo-advisor of all is from The Vanguard Group, the mutual-fund company so popular (and justifiably so) with the early retirement community. Charles Schwab has the second-largest robo-advisor.

The Pros and Cons of Robo-Advisors

The biggest advantage of robo-advisors is that they take care of portfolio maintenance for you. Once you’ve selected an investment strategy, the robo-advisor will take care of everything else.

Whenever you make a contribution, the robo-advisor allocates the funds according to your plan. When you sell, the robo-advisor sells according to your plan. And, perhaps best of all, the robo-advisor will monitor your asset allocation and make adjustments, if needed.

Rebalancing your investment portfolio — the process of shifting your money around so that you maintain your target asset allocation — can be tedious and complicated. (It’s so annoying, in fact, that I don’t do it at all. It helps that John Bogle, one of my investing heroes, believed that rebalancing is optional.)

Another advantage of robo-advisors is that they’re a “good enough” solution.

Too many people are paralyzed by indecision. They fail to invest because they don’t want to make a mistake. Or they want to make the best possible choice.

Well, robo-advisors aren’t the best possible choice, but they’re fine. They’re good enough. Investing with Betterment or M1 Finance or Wealthfront will give you smart, affordable options.

The biggest downside to robo-advisors that I can see is cost.

As you probably know, costs are the second-largest drag on investment performance for the average person. Study after study has shown that the best predictor of long-term investment growth are the total fees for any given investment vehicle. So, adding fees to your investing doesn’t make much sense.

That said, there are a couple of reasons you might not mind paying these fees.

  • First, robo-advisor fees are typically much less than what you’d pay a traditional financial advisor. (That said, you pay more for a traditional advisor because she, well, actually provides advice.)
  • Second, while fees are the second-largest drag on investment performance, the number-one barrier to performance is investor behavior. Generally speaking, you are your own worst enemy when it comes to making your money grow. And if paying a fee will help prevent you from sabotaging your future, then it’s probably worth the cost.

If you’re already set up and running and managing your own investments, keep doing what you’re doing. You don’t need a robo-advisor. And if you’re self-motivated and willing to spend some time on self-education, it’s perfectly possible to replicate the services a robo-advisor provides without using one. Nowadays, the major mutual fund companies allow you to buy and sell ETFs (or, better yet, index funds) via an easy-to-understand web interface. That’s what I do at Fidelity!

But not everyone learns to ride a bike without assistance. Some kids need training wheels, and there’s absolutely nothing wrong with that. In my mind, robo-advisors are like training wheels for people learning to invest. They serve a purpose.

That sounds a bit condescending, I know, but I don’t mean it to be. On our call Monday morning, Tom admitted that even he might make the move.

“I’m almost considering a robo-advisor,” he said. “I’m ready to outsource this stuff. I just don’t want to think about it anymore. I don’t want to rebalance. I don’t want to watch the market.”

He paused for a moment, then added: “I do still have a problem with the fees, though.”

A Final Word of Warning

A chat about robo-advisors When reading online reviews of robo-advisors, take them with a grain of salt. This is a growing industry that’s advertising heavily. People are paid to promote these companies. (And, in fact, when I link to certain platforms from this article, I’m using affiliate links too.)

So, if you go to a popular site and see that every robo-advisor earns 4.5 stars, that should make you skeptical. It makes me skeptical, anyhow. And note that nobody talks about Vanguard Digital Advisor, the largest robo-advisor out there. Why not? Because Vanguard doesn’t pay commissions for sending people their way. Ah, that thin green line makes it so difficult to trust financial websites sometimes!

After I wrote this article, Tom and I chatted. We’ve agreed that as we bring on staff writers here at Get Rich Slowly, it’d probably be a good idea to have them review various robo-advisors. We get a lot of questions about them in the Facebook group, but I personally don’t want to take the time to investigate all of them. I just don’t care. (Plus, I think most readers are best served by managing their money themselves.)

As we do this, though, I don’t want to take the same approach as everybody else. Sure, the our reviews will probably be cursory, the same as everyone else. They’ll provide the basics of each product and not much more. But we won’t patronize you by rating every service 4.5 stars. (I doubt that we’ll provide ratings at all!) And if we ever do a round-up of “best robo-advisors”, we’re not going to simply recommend those that pay us. That’s a bunch of bullshit.

Bonus! Although I didn’t know much about robo-advisors before researching this article, I am a huge huge fan of the Wealthsimple magazine. It’s outstanding. The magazine’s money diaries are great. So are the how-to pieces and the customer questions. And relevant for me and Tom is this recent piece on the in-game economy for Nintendo’s Animal Crossing: New Horizons. (Both Tom and I are playing the game at the moment. Our Monday calls often start with a discussion of turnip prices.)

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There are 13 comments to "What is a robo-advisor? An introduction to automated investment tools".

  1. Bryan says 10 June 2020 at 15:32

    Great article, though I’m afraid it misses the elephant in the room with respect to robo-advisors: Mutual funds already do all this. There are a bazillion mutual funds out there with risk levels specifically targeted to what you want, some with glide paths to automatically readjust as time goes on. Typically, an index-driven passive mutual fund is going to cost less than a robo-advisor. I’ve yet to meet someone who really needs the extra customization that a robo-advisor could offer.

    So what can robo-advisors offer that mutual funds can’t? Automated Tax Loss Harvesting. One whitepaper (I believe it was Betterment) estimated that this process could provide 50 basis points (half a percent) increased growth year-over-year. If it’s true, that’s something, but it’s significantly offset by the cost. And it 100% does not apply to investments in tax-advantaged accounts, which is the majority of retirement funds in the US.

    • J.D. says 10 June 2020 at 16:03

      Awesome comment, Bryan. Thanks. I have high hopes that the responses to this article will help educate me — and GRS readers — even more. This is a terrific start.

      For those who are interested, here’s the white paper that Bryan mentioned: Betterment’s tax-loss harvesting methodology.

  2. Natalie says 11 June 2020 at 06:25

    Going to share a personal experience here: I used Wealthfront for about a year while I was learning more about investing. You are right to call it “training wheels”. When I was ready I transferred everything to Vanguard and began managing on my own. The process was not difficult.

    Pros: fees were not too bad, the app was easy to use, and the investment selection was reasonable. The transfer process to Vanguard wasn’t a hassle (I have heard that transfers from Betterment can be). I actually kept most of the ETFs that Wealthfront had selected after the transfer, and just put new funds into VTSAX.

    Cons: Wealthfront heavily touts their tax loss harvesting and even their app showed how much I “saved” from this service. As I learned more I realized that I was in the zero percent bracket for long term capital gains and I actually should have been doing tax gain harvesting. (Wealthfront didn’t ask about children, marital status, etc.)

    Overall I made more gains with Wealthfront than I would have if I’d just left the money in a savings account for another year while I figured things out.

  3. JC Webber III says 11 June 2020 at 07:57

    Yea, I don’t see the advantage. Not even of the Vanguard robo advisor service. Tax loss harvesting? What’s so complicated about that? Sell your losers if you’ve lost confidence that they will recover (personally, I have never experienced a tax-loss opportunity with any of my index mutual funds). And what about Tax GAIN harvesting? That’s a thing (which I *have* taken advantage of with my AAPL shares acquired while employed at Apple in order to raise my cost basis). They don’t offer that service. And rebalancing? You have the option of going with Target Fund funds that will do that automatically for you. But, really, how hard is it? I set up a spreadsheet where I occasionally update the value of each of my dozen funds and it automatically calculates my AA. If I find that I’m more than 5 points off my desired 65/35 AA, I rebalance. I do so within my tax sheltered/prepaid accounts so there are no tax implications for this rebalancing. There are other ways to rebalance. If you are in the accumulation phase you just direct new contributions towards the underperforming portion of your portfolio. If you are in the decumulation phase (as I am), you can rebalance by withdrawing living expenses from the over-performing portion of your portfolio. If the out-of-balance exceeds the ability to correct by the above methods, then sell the winners and buy the losers. Easy peasy. It’s just math.

  4. Amy says 11 June 2020 at 10:13

    ooooh I am so guilty of using a service like this (via schwab) and not fully understanding the fee structure. Also enjoying it because I just send money to the account and viola, I’m done. About the only thing I can remember about the fees was what you mentioned: FAR lower than a real life person (I have friends paying out the nose for their advisor) and I was grandfathered into a fee structure that’s actually better than what Schwab offers now.

    Something something I should be more knowledgeable about how I’m handling my investing… I’ll be the ‘bad’ example for the group today! I’ll spend some more time with this article and try to get a handle on what I have going on soon.Thanks for this!

    • J.D. says 11 June 2020 at 10:26

      Amy, I don’t think you’re a bad example at all! As I said in the article, I think there are a lot of people for whom robo-advisors are a smart choice. Sounds like you’re one of them. And again, look at my business partner, Tom. He knows what he’s doing, but he’s still considering using a robo-advisor because it would off-load some stuff from his plate.

      Here’s an analogy I should have used in the piece maybe: It’s like hiring a housekeeper. Right now, Kim and I pay $120 every two weeks for somebody to clean the house. We could absolutely be doing this ourselves, but we choose not to. We’d rather use our time on other things. This is the same reason that Tom is considering a robo-advisor. There’s nothing wrong with using one. But I think it’s important that you’re aware of the costs. If you choose to use one despite the costs, that’s perfectly fine.

    • Big-D says 11 June 2020 at 13:02

      Amy, if you are using the Schwab Intelligent Portfolios (SIP), they are free to you in terms of fees (The individual investments/funds may have fees). They make money by having somewhere from 8-20% of your investments in cash so they can make interest on that in other places in the organization. If you are using Schwab Intelligent Advisory services (which are an add on to SIP), I don’t know the fees but I know there is one based on previous discussions.

      Like you, I have an advisor for my taxable account, and have my IRAs (Roth and Rollover) in SIP. I pay nothing for my yearly talk with my advisor, and the SIP is free to me. I am looking at how well the SIP has done (vs the market) and wondering if I want to keep it in there because it is really hard to tell how much my return is (since I put money in my Roth yearly).

      • Amy says 12 June 2020 at 08:29

        Thanks!! I will see what I have. I have talked to an advisor before but lately haven’t made an appt because nothing has really changed in my financial life.

        I appreciate your feedback JD and Big-D!

  5. Kristen says 11 June 2020 at 13:08

    I didn’t realize that Vanguard had one, and I excitedly went to the site to look it up to be disappointed to find a $3,000 minimum. While my husband and I diligently save, his sister has yet to open a retirement account (age 44). The barrier is the $1,000 minimum to open an account. If we could get her to save that $1000, I believe we could get her to start saving a little bit each month afterward. But that initial thousand bucks is a big barrier to entry.

  6. Adam says 14 June 2020 at 08:58

    The best use case for roboadvisors might be for novice investors. Services like Acorns and Betterment get your feet in the water and expose you to having a dog in the fight. This type of exposure will build momentum and future interest in having additional funds in the market and creating more sophisticated diversification. Great post!

  7. David Jacobs says 16 June 2020 at 13:39

    Great article, We think there are a lot of people for whom robo-advisors are a smart choice.

  8. Chris says 16 June 2020 at 20:44

    One of the benefits that interest me would be tax loss harvesting for the rebalancing in the portfolio. I wonder if this would cover the added fees.

    • Mark Kelly says 25 June 2020 at 13:34

      The tax loss harvesting alone has more than covered the fees I have with Betterment. Personally, I’ve tried Ally, Acorns, Stash, & Betterment. I just started with Ally robo advisor so can’t comment on it yet. Acorns is the weakest of the bunch in my mind. I love the concept of putting spare change away and not noticing it, but their returns have left me very underwhelmed. I’ve been with Betterment for several years and have grown to love it. Stash is new one in my arsenal and so far I like it as well as you can buy whatever you want commission free and the $1 a month fee for the basic service is pretty easy to absorb.

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