What is a robo-advisor?

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We’ve all heard of robot lawn mowers and robot vacuum cleaners. But how exactly can robots help in the investing world? Is using a robo-advisor like getting R2-D2 to manage your investments?

Let’s take a look at everything you need to know about robo-advisors so you can determine whether they’re the right choice for you and your investments.

What is a robo-advisor?

A robo-advisor is an automated investment tool that helps you invest according to your future goals and financial situation. You create an online account and answer questions about your current financial position, your future goals and your attitude to risk. The robo-advisor then uses an algorithm to suggest a ready-made portfolio that’s suitable for you.

Key features of robo-advisors

Here are some key features of a typical robo-advisor:

  • Easy account setup
  • Responsible customer service
  • Lots of information about investing to help you learn more
  • Robust account security
  • Low fees
  • Low minimum investment levels, making them accessible for new investors

It’s important to remember that the simple options offered by a robo-advisor may not be suitable for people with complicated financial situations or investors who need tailored estate planning advice.

How do robo-advisors work?

Robo-advisors work a bit like human financial advisors. They start by asking you a series of questions to find out more about your situation. Typical questions focus on:

  • Your personal details and age
  • The time horizon of your investing (how long you plan to invest)
  • Your earnings, savings and financial commitments
  • How and why you want to invest
  • Your attitude to risk

Once you’ve finished the survey, the robo-advisor will use its algorithm to suggest a suitable ready-made portfolio for you. It will take into account the length of your investment and your attitude to risk.

If you’re a cautious investor and investing for a shorter time period, then the robo-advisor might pick a portfolio with a large proportion of cash and bonds. If you want to take some investment risks, then it will probably pick a portfolio with a higher proportion of stocks.

When you confirm you’re happy with your suggested portfolio, the robo-advisor will start investing your money.  Most robo-advisors use exchange-traded funds (ETFs) and passive trackers. These are also known as passive investment funds and they invest in a whole share index. This means your investment is diversified across many companies.

Some robo-advisors offer additional options, allowing you to specify sustainable investing funds or halal investing.

How many types of robo-advisors are there?

There are several types of robo-advisors that differ depending on how they evaluate customers, how they raise revenue and the range of investments they recommend.

Here is a summary of the main areas where robo-advisors vary:

  • Depth of evaluation – simple advisors use a brief questionnaire to assess an investor’s attitude to risk and their investing goals. In contrast, more comprehensive robo-advisors have an in-depth assessment procedure, assessing an investor’s net worth, debt levels and spending habits to create a personalised profile. Robo-advisors can also include services such as retirement planning, tax planning and rebalancing your portfolio.
  • How they raise revenue – some robo-advisors earn commission when they sell a product, while others charge investors a fee for their advice and recommendations.
  • The scope of investments they recommend – some robo-advisors only offer advice on equities, whereas others provide guidance on a wider class of assets and financial products.

How much are robo-advisor fees?

Robo-advisor fees vary between providers but start at a very reasonable 0.25% per year. You’ll also have to pay fund charges, which can vary depending on the types of funds you invest in. They are generally around 0.2% if you’re invested in lowcost index tracker funds.

What are the pros and cons of robo-investing?

As with all methods of investing, robo-advisors have pros and cons. Here are the main pros and cons to consider.

Pros

  • Low cost – robo-advisors can afford to charge less than human financial advisors. They often have flat annual fees of less than 0.5% per year rather than the 1% to 2% for a traditional advisor. A robo-advisor could cost as little as £25 for initial guidance on where to invest £10,000, compared with anywhere between £100 and £300 for a traditional advisor.
  • Easy access – robo-advisors are available 24 hours a day rather than having to book an appointment.
  • Quick service – if you want to buy or sell something quickly, then you’ll have immediate access to your account.
  • Better value for smaller investment amounts – traditional advisors often have minimum charges that make them unaffordable for smaller investment balances.
  • Lack of emotion – robo-advisors take the emotion out of investing, meaning you’re less likely to make common mistakes associated with the psychology of investing. For example, many investors panic and sell their shares when the stock market drops in value, meaning they crystallise a loss.
  • Regulated investing – robo-advisors are regulated by the Financial Conduct Authority (FCA) for investments worth up to £85,000. This means you’ll be protected if something goes wrong due to advice you’ve been given.

Cons

  • Limited investment options – you can’t choose where you invest or buy individual shares.
  • Lack of complexity – robo-advisors can’t take into account every type of financial circumstance and some are simplistic in their planning. They may not offer advanced services like complicated tax planning or trust management. They also can’t advise on unexpected changes in circumstances, like a job loss or an unexpected large expense.
  • No human help setting investing goals – robo-advisors assume that you already know your financial goals and attitude to investing risk. But you may need some help working out your investing goals and risk tolerance.

How do robo-advisors make money?

Robo-advisors often earn money by charging percentage fees on the investments they manage. Typical fees are around 0.25% per year, compared to 1% to 2% for a traditional advisor.

Robo-advisors also have several other revenue streams. They can earn money through accruing interest on cash deposits. They can also earn commission through targeted marketing of other financial products to their customers.

How should you choose a robo-advisor?

Here are a few key questions you should ask when assessing the suitability of a robo-advisor:

  • Is it regulated by the FCA?
  • What fees are involved?
  • What investment options does it offer?
  • Can you speak to a human advisor if you need some extra help?
  • Does it have good reviews?
  • Is there a minimum investment level?

Is a robo-advisor right for you?

Whether a robo advisor is right for you depends on your circumstances and investing goals. If you need basic guidance to help you choose investments and have a modest investment portfolio, then a robo-advisor may work well for you. If you have significant investments and need help with more complex matters like tax or estate planning, then a robo-advisor may not offer enough complexity and you might prefer a traditional advisor.

If a robo-advisor is right for you, check out our top robo-advisors, where we compare their features and highlight our top picks on the market.