What Is a Robo-Advisor, and Is One Right for You?

If you’ve ever wished for a robot to clean your house or walk your dog, you’ll likely understand the appeal of a robo-advisor. These services don’t do windows or pet-sit, but what they do offer is a relatively hands-off way to invest.

Robo-advisor definition

A robo-advisor — also known as an automated investing service — is a service that uses algorithms and software to build and manage your investment portfolios. Many robo-advisors also perform automatic rebalancing and tax optimization.

Robo-advisors typically have low or no minimum account balance requirements. This, and the relatively low costs, allow people, especially beginners, to start investing quickly, even in a matter of minutes.

However, robo-advisors provide little to no human interaction. Some robo-advisors have human advisors available for questions, but this access is typically a paid upgrade or available only if you have an account balance over a certain amount.

» Ready to get started? Check out NerdWallet's picks for the year's best robo-advisors

How much does a robo-advisor cost?

Most robo-advisors charge an annual management fee of 0.25% to 0.50% of your account balance. This is usually much cheaper than what human financial advisors charge.

There are four types of robo-advisor fees to consider.

• Asset management fees. Similar to human financial advisors, robo-advisor typically charge a percentage of your assets under management. For example, the typical robo-advisor fee works out to $125 to $250 a year on a $50,000 account balance or $25 to $50 a year for a $10,000 account balance. The fee is usually deducted from your account, prorated and charged monthly or quarterly.

• Trading fees. You won’t usually pay transaction fees to buy or sell investments with a robo-advisor. In a standard brokerage account, you might pay a commission to buy or sell investments. Rebalancing your account, as well as depositing or withdrawing money, also comes with fees at a brokerage but may be waived with a robo-advisor.

• Expense ratios. These are paid on exchange-traded funds (ETFs) and index funds. They’re in addition to the robo-advisor's management fee.

• Account minimums. Some robo-advisors require an initial investment of a few thousand dollars. Others have no account minimum or minimums of a few hundred dollars.

» Read more: How much does a financial advisor cost?

How does a robo-advisor work?

The business strategy for many advisors is the same: automate investment management so it can be done at a lower cost.

When you sign up with a robo-advisor, you'll likely answer a questionnaire designed to learn your risk tolerance, goals and investing preferences.

The algorithm uses the information to build a portfolio out of low-cost exchange-traded funds (ETFs) and index funds. These are baskets of investments that typically aim to mirror the performance of a stock market index, such as the S&P 500.

Robo-advisors generally offer between five and 10 portfolio choices. Risk levels also range from conservative to aggressive. The service’s algorithm will recommend a portfolio based on your answers to the questionnaire, but you can veto that recommendation if you’d prefer something else.

At most robo-advisors, you can expect:

• Regular rebalancing of that portfolio, either upon some sort of trigger or at set intervals (quarterly, for example). This ensures your portfolio maintains its original allocation and is done by algorithm.

• Access to financial planning tools, such as retirement calculators.

• Automated or optional tax-optimization strategies, such as tax-loss harvesting. This involves selling losing investments at a loss to offset capital gains taxes on sales of profitable investments.

Some robo-advisors may manage individual retirement accounts (IRAs) and taxable accounts. Some also manage trusts, and a select few will help manage your 401(k). It comes down to whether you want automated portfolio management.

» Not sure which type of advisor is right for you? Learn how to choose a financial advisor.

Pros and cons of a robo-advisor

Whether a robo-advisor is right for you depends on what you need and how involved you prefer to be in the management of your money.

Alternatives to a robo-advisor

If you don’t want to manage your own portfolio, but want (or need) more comprehensive financial planning, a financial advisor might suit you better.

Many financial advisors have embraced automated portfolio management, which has brought down the cost of their services. It’s common to see financial advisors charge 1% of assets under management, but costs can be even lower:

• Vanguard Personal Advisor offers access to a team of financial advisors for a $50,000 account minimum and an annual fee of 0.30% to 0.31%. You get a customized financial plan, portfolio management and access to financial planning tools.

• Betterment Premium offers unlimited phone access to a team of certified financial planners for a $100,000 account minimum and an annual fee of 0.65% (for balances under $1 million). You get all the features of Betterment’s lower-tier robo offering, plus the financial planning tools of the premium service.

• Empower Personal Strategy offers dedicated advisors for balances of $250,000 or more. Under this amount, clients get access to a team of advisors. Account management fees range from 0.49% to 0.89%, also depending on account balance.