"Robo-advisor" is a term that refers to companies that provide financial advice online, using software to calculate how investors should allocate their assets. Most robo-advisors provide portfolio management rather than just advice. That is, they execute the trades needed to balance their clients' investments: they buy and sell stocks and bonds for you. In that sense, they perform one of the many tasks of a conventional human financial advisor.
Robo-advisors tend to rely on several well-established algorithms to maximize the chance of growing investments long term while minimizing risk. Their approaches may vary, but they are influenced by Nobel-Prize-winning strategies such Modern Portfolio Theory, the Black Litterman Model and Fama-French's observation that small-cap and value stocks outperform other securities.
How It Works
Robo-advisors can manage assets in two ways:
1. The investor allows the robo-advisor to operate within their pre-existing accounts.
- This involves giving them permissions to make certain changes to your investments on your behalf. Those permissions can be withdrawn at any time. This is often more tax- and time-efficient
- Examples: FutureAdvisor
2. The advisor opens up a new account into which investors place their assets, and manage it for them. This involves several steps:
- Cashing out and closing your pre-existing brokerage and retirement accounts
- Moving your cash to a new custodian
- Examples: Betterment, Wealthfront
Once investor assets are held in an account the robo-advisor controls, the company can begin to buy and sell assets in order to balance its clients portfolio. While precise definitions of "balance" vary, they are usually determined by the investor's risk appetite, current age and the year when they plan to retire.
Rebalancing happens as market shifts move the accounts away from their ideal asset allocation. For example, let's the ideal asset allocation for one investor's portfolio was 50% stocks and 50% bonds. If the stock market rose and all stocks appreciated in value, they might make up 60% of the investments' total value. Modern Portfolio Theory would dictate that the portfolio be rebalance by selling the stocks (cashing in on their rise) and buying bonds with the gains.
The closer an investor comes to their retirement date, the more their assets are shifted from stocks to bonds. That lessens the risk that a stock market crash will destroy their wealth in the few years before they'll stop earning income and start living off their investments.
This is a strategy also employed by target-date, or life-cycle, funds, which allocate assets according to a "target" or end date the investor specifies — usually their expected retirement date.
Before robo-advisors, financial advice was given by solely by human financial advisors. Around 2005, many of those human advisors began to use software to calculate how clients should allocate their assets. But that software wasn't distributed directly to their clients. It was reserved for the professionals.
Robo-advisors like Betterment, FutureAdvisor and Wealthfront essentially made an end run around human advisors to provide portfolio management software directly to consumers. By circumventing the scarce human expertise of financial advisors, robo-advisor have vastly expanded the number of investors who can be served.
Most human advisors serve between 75-125 customers per year. So-called flat-fee advisors make their living by charging a percentage of investable assets. Robo-advisors, like conventional human advisors, charge a flat fee. Because human advisors are limited in the number of clients they can serve, they are only able to increase their income by maximizing the net worth of their few clients. That's the primary reason why financial advice was the exclusive domain of high net-worth families, until robo-advisors came along.