How Do Robo Advisors Work?
A Robo Advisors’ main function is automating the work of a human financial advisor. This reduces your cost of investing and provides you more accessibility and transparency into your portfolio’s performance. They build your portfolio, buy and sell your stocks, and finally perform routine tasks such as tax-loss harvesting.
We explain how Robo Advisors actually work…
1. The Program – Software Running On Servers In Datacenters
A Robo Advisor is simply a software program running on computers in a data center. These applications are usually accessed via a secure website or smartphone app. The program is designed by software programmers based on the fund managers’ requirements and the way the fund will operate. For example, many Robo Advisors simply buy and sell a selection of Exchange Traded Funds on your behalf.
2. You Register An Account & Transfer Money
When you register with a Robo Advisor, you will need to transfer at least the minimum required amount to an account in your name. You will also need to provide your Tax Identification Number (TIN) and valid proof of identity. This will be used to ensure you pay the correct taxes.
3. You Provide Your Risk & Investment Preferences
You will then answer a series of questions design to understand your tolerance for risk and your preferences for investment types. The types of questions you are asked are:
- Personal Status: Age, Job, Income, Marital Status, Dependents
- Your Goals: Target retirement age, saving for children’s college fees, buy a car, buy a house, etc.
- Your Investment Preferences: Do you prefer investing in Technology, Finance/Banks, Real-estate, International Funds, U.S. Funds, or even Developing World funds.
- Your Ethical Preferences: Do you want to invest in clean energy companies, pro-gender equality companies, carbon-neutral companies, etc.
- Your Risk Tolerance: Gauging your tolerance for risk enables the Robo Advisor to suggest how much of your money should be invested in stocks/ETF’s vs. bonds.
4. The Robo Advisor Suggests Investments To Meet Your Needs
The application will then recommend specific portfolios that may meet your previously stated requirements, goals, and preferences. For example, you may be offered a clean energy fund or a technology-centric fund based on your preference.
5. You Select The Funds To Invest In
You can then select one or more portfolios to invest your money in. Perhaps you choose a banking fund, a technology fund, and a Real-Estate fund. You can then confirm your risk biases to determine how your capital is split between stocks and bonds.
Once this is completed, you can launch the investment.
6. The Robo Advisor Makes The Investments
Once launched, the Robo Advisor application will begin to construct your desired portfolio by purchasing the stocks / ETF’s that were targeted. You need to understand that some funds may charge you for the buying and selling of stocks and ETF’s, but for other funds, the transaction fees are included in the fund fees and charges.
7. The Robo Advisor Performs Portfolio Maintenance
The Robo Advisor application will then perform regular portfolio maintenance tasks on your portfolio. Here is where there is a lot of value in Robo Advisors because they take away the burden of managing your own investments.
- Reporting your investment performance
- Reporting the stocks or ETF’s you are invested in
- Providing end of year tax-loss harvesting & reporting
- Collecting and distributing/reinvesting any dividends you may have accrued.
- Portfolio Balancing to ensure that your requested risk tolerances and percentage invested in each fund are maintained.
- Deducting your yearly management fees
Some investors like Robo Advisors because they are faster and charge lower fees than traditional advisors. For instance, there are no bonuses or commissions paid to Robo Advisor algorithms, like that paid to human advisors.