The world is becoming more and more automated. You can use technology to monitor your health, learn new skills, and protect your home. So why not let it manage your investments?
That’s where robo-advisers step in. A robo-adviser is a digital platform that uses advanced algorithms to recommend and manage an investment portfolio on your behalf.
The top robo-advisers come with little to no fees or account minimums. And they offer services such as automatic rebalancing and tax-loss harvesting. Some offer access to human financial advisers.
Nonetheless, robo-advisers may not be the best fit for everyone.
How Does a Robo-Adviser Simplify Investing?
Opening a robo-adviser account typically begins with answering a brief questionnaire. It covers questions about your finances, investment goals, and risk tolerance.
Based on the answers to these questions, the robo-adviser recommends an investment portfolio. These portfolios are usually built with low-fee exchange-traded funds (ETFs). You can think of ETFs as baskets of different stocks and bonds. With that said, robo-advisers offer instant diversification.
Many robo-adviser providers offer a variety of account options, including taxable brokerage accounts, individual retirement accounts (IRAs), Roth IRAs, and health savings accounts (HSAs).
Automated Rebalancing
Most robo-advisers automatically rebalance your portfolio.Rebalancing your portfolio means selling some assets within your portfolio and buying others in order to bring the portfolio back to its target asset allocation. This is the mix of stocks, bonds, and other assets meant to meet your risk tolerance and investment goals.
But market conditions could push that asset allocation out of proportion. Say you originally set your asset allocation to 60 percent stocks and 40 percent bonds. A major stock market rally and downturn in the bond markets can push your bond values to 30 percent and stock holdings to 70 percent—leaving you open to serious risk if there’s a stock market plunge.
So rebalancing would involve selling some of those stocks and buying more bonds to bring your portfolio back to its 60/40 asset allocation.
The process can be complicated. But a robo-adviser can do it for you.
Many robo-advisers ongoingly monitor your portfolio and market movements. And they rebalance your portfolio when your holdings deviate too far from your target asset allocation.
Many robo-advisers do this using balancing bands. For example, the robo-adviser can give each asset class a target weight and deviation range. So say the target weight for stocks is 60 percent with a deviation range of ±10 percent. If the stock holdings move above 70 percent or below 50 percent, the robo-adviser rebalances the entire portfolio.
But one major component to watch out for when rebalancing your portfolio is triggering capital gains when selling assets that have grown in value.
Save on Taxes With Tax-Loss Harvesting
When you sell assets that have grown in value, you pay capital gains taxes on the profit. The tax rate depends on your income and how long you held the asset before selling.For example, let’s say you bought stock XYZ for $20,000 in January and sold it for $25,000 in August. You’d pay a capital gains tax on $5,000 ($25,000 minus $20,000). Because you sold the stocks less than a year after purchasing the assets, the capital gains tax rate would be your 2024 marginal tax rate, which could range from 10 percent to 37 percent.
But tax-loss harvesting could help you minimize the blow. Tax-loss harvesting is the complex strategy of selling assets at a loss in order to offset realized capital gains from selling assets at a profit.
And if your losses are larger than your gains, you can use what’s left to offset up to $3,000 of your ordinary taxable income for 2024.
Consider this example. You buy stock ABC and stock XYZ for $20,000 each in January. In August, you sell stock ABC for $24,000 ($4,000 capital gain). But you sell stock XYZ for $15,000 ($5,000 capital loss).
With tax-loss harvesting, your $5,000 loss offsets your entire $4,000 capital gain. So you’d owe no tax on the capital gain. And you could use the remaining $1,000 to offset your taxable income for 2024.
Low Costs: A Key Advantage of Robo-Advisers
One of robo-advisers’ biggest selling points is low fees.Traditional financial advisers can charge fees around 1 percent of assets under management (AUM). Robo-adviser AUM fees sit around 0.25 percent.
To put that into perspective based on these fees, someone with a $10,000 portfolio could pay a traditional financial adviser $100 a year. The same investor could pay a robo-adviser $25 a year.
Moreover, some robo-advisers charge no fees on small balances. And for slightly higher fees or larger balances, some robo-advisers offer limited access to certified financial planners (CFPs).
The Downsides of Robo-Advisers
While some robo-advisers offer access to CFPs, these interactions are typically limited to video conversations and phone calls.A robo-adviser won’t be there to reassure you when the markets take a plunge or when you’re on the sidelines about a specific investment that’s gaining buzz.
With that said, robo-advisers lack some flexibility when it comes to investment options. You’d typically be limited to a collection of model portfolios built with pre-screened and pre-selected ETFs or mutual funds.
So you may not be able to diversify your portfolio with alternative investments like real estate or precious metals.
And despite being seen as pioneers in low-cost investing, robo-advisers may charge you more in the long run. That’s because many robo-advisers charge management fees on portfolio assets. You could theoretically open a self-directed brokerage account or IRA and build the same portfolio using the same funds, thereby avoiding the robo-adviser management fee—assuming the provider doesn’t charge its own management fee.
And you’d also need to pay attention to the expense ratios or fees of the underlying funds within your portfolio. However, many robo-adviser providers strive to keep these fees as low as possible and some proprietary funds may even be zero percent.
