Robo-advisors automate the complex task of creating and managing a portfolio by selecting investments according to your risk profile.
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The best robo-advisors automatically perform time-consuming tasks like purchasing stocks, portfolio rotation, and tax loss harvesting.
Let’s take a close look at how robo-advisors work.
What is a Robo-Advisor?
A robo-advisor is an automated online service that provides investment advice and portfolio management. It uses algorithms to analyze data, such as your risk tolerance, financial goals, time horizon, and more, to create a personalized asset allocation strategy.
Using technology and cutting-edge analytics tools, robo-advisors enable individuals to make smarter investment decisions with less time and effort than traditional methods.
Additionally, robo-advisors typically have lower fees than traditional advisors, making them an attractive option for those looking to invest without breaking the bank. Thanks to their convenience, ease of use, and cost savings, robo-advisors have become increasingly popular in recent years.
How Do Robo-Advisors Work?
A robo-advisor’s main function is automating the work of a human financial advisor. This reduces your cost of investing and gives you more accessibility and transparency into your portfolio’s performance. They build your portfolio, buy and sell your stocks, and perform routine tasks such as tax-loss harvesting.
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 for the fund’s operation. For example, many robo-advisors 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 need to transfer at least the minimum required amount of capital to an account in your name and provide your Tax Identification Number (TIN) and valid proof of identity. This will be used to ensure you pay the correct taxes.
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3. You Provide Your Risk & Investment Preferences
You will then answer a series of questions designed 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 emerging markets?
- Your Ethical Preferences: Do you want to invest in clean energy companies, pro-gender equality companies, carbon-neutral companies, etc.?
- Your Risk Tolerance: Gauging risk tolerance enables the robo-advisor to suggest how much of your money should be invested in stocks, ETFs, or bonds.
4. The Robo-Advisor Suggests Investments To Meet Your Needs
The application will then recommend specific portfolios to meet your stated requirements, goals, and preferences. For example, you may be offered a clean energy 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 in which to invest your money. 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 construct your desired portfolio by purchasing the targeted stocks and ETFs. You need to understand that some funds may charge you for buying and selling stocks and ETFs, but transaction fees are included in the charges for other funds.
7. The Robo-Advisor Performs Portfolio Maintenance
The robo-advisor application will then perform regular portfolio maintenance tasks on your portfolio. There is a lot of value in robo-advisors because they take away the burden of managing your investments.
- Reporting your investment performance
- Reporting the stocks or ETFs 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. With robo-advisors, investors don’t need to worry about staying up-to-date on the latest trends in finance and stock market news. They set their investment goals and let the robo-advisor manage their portfolio according to their preferences.
The bottom line is that with a robo-advisor, you spend less time worrying about your investments and more time focusing on other important areas of your life.
