What is a robo-advisor and how does it manage your money?

#What is a robo-advisor, in plain English?

Imagine a personal trainer app for your savings. Instead of a person in an office, a computer program decides how to split your money between different investments and keeps checking that the split stays where it should. The US Securities and Exchange Commission (SEC), the country's main markets regulator, describes the term as referring generally to "an automated digital investment advisory program"⁠^[1]. US regulators spell it robo-adviser; most people and companies write robo-advisor. Both mean the same thing.

Robo-advisors are part of wealthtech, the slice of fintech that deals with investing and saving. They are not a new kind of investment. They usually buy ordinary products such as exchange-traded funds (ETFs), which are baskets of shares or bonds that trade on a stock exchange. What is new is that software does the picking and the upkeep. For a one-paragraph definition you can come back to, see our glossary entry on robo-advisor.

#How does a robo-advisor build your portfolio?

It starts with a questionnaire. The SEC says these services collect information such as your financial goals, investment horizon, income and other assets, and risk tolerance, and then create and manage a portfolio based on the answers⁠^[1]. A 2016 report by FINRA, the self-regulatory body that oversees US brokerage firms, found that client-facing digital tools asked between four and twelve questions, generally in five areas: personal information, financial information, investment objective, time horizon and risk tolerance⁠^[2].

The most important output is the asset allocation: how much goes into shares (higher expected growth, bigger swings) versus bonds and cash (usually steadier, usually lower growth). A younger saver with a long time horizon might be given more shares; someone who needs the money in two years might be given more bonds. The exact formula differs from firm to firm and is part of what you should read about before signing up.

#What does a robo-advisor actually do after you sign up?

FINRA lists the jobs that digital advice tools can support as "customer profiling, asset allocation, portfolio selection, trade execution, portfolio rebalancing, tax-loss harvesting and portfolio analysis"⁠^[2]. Not every service does all of them. The table below translates each job into plain English.

#How does automatic rebalancing work?

Markets move, so your mix drifts. If shares rise and bonds stay flat, shares become a bigger part of the pot than you planned, and your risk quietly goes up. FINRA found two common approaches: rebalancing on a calendar (for example monthly, quarterly or yearly) or when the portfolio drifts past a set limit; one firm it studied used "a bright line threshold of 3 percent portfolio drift"⁠^[2]. The example below uses that 3-point idea with made-up numbers.

Rebalancing does not make you money by itself. It keeps your risk where you said you wanted it. Selling can also create a tax bill in a taxable account, which is one reason some services combine rebalancing with tax-loss harvesting.

#Who regulates robo-advisors, and what duties do they have?

In the United States, the SEC's Division of Investment Management says robo-advisers are "typically registered investment advisers" and that they "are subject to the substantive and fiduciary obligations of the Advisers Act"⁠^[3]. A fiduciary duty means the firm must put your interests first. The SEC has explained that an adviser's fiduciary duty is made up of a duty of care and a duty of loyalty, and that it applies to the entire relationship⁠^[4].

The same SEC guidance highlights three areas for robo-advisers: clear disclosure of how the algorithm and service work, a questionnaire good enough to gather the information needed to give suitable advice, and a compliance programme that covers things like testing the algorithm and overseeing outside providers⁠^[3]. Before you sign up, you can look a firm up on the SEC's Investment Adviser Public Disclosure (IAPD) site and read its Form ADV, the disclosure document advisers file⁠^[1]. Checking who you are dealing with is the same habit we recommend in is a fintech app a bank?.

#What does a robo-advisor cost?

Most charge an ongoing yearly fee worked out as a percentage of the money they manage, and the funds inside your portfolio have their own costs on top. The SEC warns that "fees and other costs can greatly impact your return on investment" and suggests looking at the full picture, including brokerage fees and fund management fees⁠^[1]. Small percentages add up: in a separate bulletin, the SEC shows that $100,000 growing at 4% a year for 20 years ends at roughly $208,000 with a 0.25% yearly fee but roughly $179,000 with a 1% fee⁠^[5]. Our comparison robo-advisor vs financial advisor walks through that maths step by step.

#What are the limits of a robo-advisor?

The SEC points out that a robo-advisor's recommendation depends on the information you give, which may be limited, and that you are usually responsible for updating it when your life changes⁠^[1]. An older SEC alert on automated investment tools adds that such tools may rely on assumptions that do not fit your situation, may consider only limited options, sometimes only products of an affiliated firm, and may not weigh things like your tax position or other holdings⁠^[6]. Human contact also varies widely: some services offer access to a human professional, others only technical support⁠^[1].

#Where do robo-advisors fit in the wider fintech picture?

Robo-advisors sit next to other wealthtech ideas such as fractional shares, which let small portfolios hold slices of expensive shares. Behind the app there is always a regulated firm that holds your assets, often called a custodian, and a broker that places trades. Knowing those layers helps you ask better questions, whether you use a robo-advisor, a human adviser or both.