A robo-advisor is an automated, algorithm-driven financial planning and investment service with little to no human supervision. A typical robo-advisor asks questions about your financial situation and future goals through an online survey. It then uses the data to offer advice and automatically invest for you.

Other common designations for robo-advisors include "automated investment advisor," "automated investment management," and "digital advice platforms."

Thebest robo-advisors offer easy account setup, robust goal planning, account services, and portfolio management. Additionally, they offer security features, comprehensive education, and low fees.

Robo-Advisors: History and Investing Strategy

The first robo-advisors,Betterment andWealthfront, launched in 2008. Wealthfront began as a mutual fund analysis company called kaChing. It planned to assist the tech community, then realized that computer software could make investment advice more accessible. Betterment, on the other hand, began with the initial purpose of rebalancing assets withintarget-date funds (TDFs). It sought to help manage passive, buy-and-hold investments through a simple online interface.

Humanwealth managers have been using automatedportfolio allocation software since the early 2000s. But, until Betterment and Wealthfront launched, wealth managers were the only ones who could buy the technology, so clients had toemploy a financial advisor to benefit from the innovation.

Today, mostrobo-advisors use passive indexing strategies that are optimized using some variant of modern portfolio theory (MPT). Typically, the account holder can't choose which mutual funds or exchange-traded funds (ETFs) to invest in or purchase individual stocks or bonds in their account.

Some robo-advisors offer optimized portfolios for specific strategies such as socially responsible investing (SRI), halal investing, or tactical strategies that mimic hedge funds. They also can handle much more sophisticated tasks, such astax-loss harvesting, investment selection, andretirement planning.

Explosive Growth

The robo-advisor industry has experienced explosive growth. According to Polaris Market Research, the robo-advisory market size was valued at $8.3 billion in 2024 and was projected to grow to $33.6 billion by 2030, according to aCAGR study.

Portfolio Rebalancing

The majority of robo-advisors use modern portfolio theory (MPT) (or some variant) tobuild passive, indexed portfolios for their users.

Once portfolios are established, robo-advisors continue to monitor them to ensure that the optimal asset-class weightings are maintained, even after market moves. Robo-advisors achieve this by usingrebalancing bands.

Rebalancing Bands

In rebalancing bands, every asset class or individual security, is given a target weight and a corresponding tolerance range. For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips, and 40% in government bonds with a corridor of ±5% for each asset class.

The use of rebalancing bands means that, given the ±5% corridor, emerging market and domestic blue-chip holdings can fluctuate between 25% and 35%. Government bonds can fluctuate between 35% and 45%. When the weight of a holding moves outside of the allowable band, the entire portfolio isrebalanced to reflect the initial target composition.

Tax-Loss Harvesting

Another type of rebalancing commonly found with robo-advisors—made cost-effective through algorithms—is tax-loss harvesting.Tax-loss harvesting is a strategy that involves selling securities at a loss to offset a capital-gains tax liability.

This strategy is typically employed to limit the recognition ofshort-term capital gains. Robo-advisors do this by maintaining two or more stable ETFs for each asset class. So, for example, if the S&P 500 ETF loses value, a robo-advisor will automatically sell it to lock in a capital loss; simultaneously, it buys a different S&P 500 ETF.

It's worth bearing in mind that the IRS wash-sale rule prevents investors from re-purchasing the same security or a security that is substantially identical within 30 days from its sell date. However, robo-investment platforms should have algorithms in place that incorporate rules like this.

Benefits of Robo-Advisors vs. Traditional Financial Advisors

The emergence of robo-advisors has broken down some of the traditional barriers between the financial services world and average consumers. Because of these online platforms, sound financial planning is now accessible to almost everyone, not justhigh-net-worth individuals.

Robo-advisors are low-cost alternatives to traditional advisors. By eliminating human labor, online platforms can offer the same services at a fraction of the cost.

Most robo-advisors charge annual flatfees of less than 0.4% per specific amount managed, much less than the typical 1% charged by a human financial planner (or more forcommission-based accounts).

With robo-advisors, it's generallyeasier to keep tabs on investments. You can log in 24/7 as long as you have an internet connection.

It takes significantly less capital to start investing when using robo-advisors. One of the most popular robo-advisors, Betterment, has no account minimum for its basic account offering.

Robo-advisors are efficient. Before robo-advisors and online brokerage accounts, if you wanted to execute a trade, you'd have to call or meet with a financial advisor, explain your needs, and wait for them to execute your trades. Now, you can do all of that with the click of a few buttons in the comfort of your home.

Though using a robo-advisor may limit your investment options, this can be beneficial because buying individual stocks or trying to beat the market can produce poor results. On average, ordinary investors often see better results with anindexing strategy.

Limitations of Robo-Advisors

Many in the industry have doubts about the viability of digital advisors as a one-size-fits-all solution to wealth management.

Given their current technological capabilities and minimal human presence, robo-advisorshave been criticized for lacking empathy and sophistication.

Robo-advisors are good entry-level options if you have a small account and limited investment experience. You may find them lacking if you need services like estate planning, complicated tax management, trust fund administration, and retirement planning.

Automated services are also ill-equipped to deal with unexpected crises or extraordinary situations. For example, robo-advisors won't know if you're between jobs or dealing with an unexpected expense—your funds could be drained unexpectedly by automatic withdrawals.

A study conducted by Investopedia and theFinancial Planning Association found that consumers prefer a combination of human and technological guidance, especially when times are rough. According to the report, 40% of participants said they wouldn't be comfortable using an automated investing platform during extreme market volatility.

Robo-advisorsoperate on the assumption that you have defined goals and a clear understanding of your financial circumstances, investment concepts, and potential investment outcomes. For many investors, that is not the case.

Hiring a Robo-Advisor

Robo advisors don't all cost the same amount and offer all the same features. Each one may excel in particular areas, so it's important to do some research first. You may also consider hybrid robo-advisors, which essentially seek to combine the benefits of automated investment with human financial advice. Dedicating a bit of time to finding the right one could turn out to be one of your smartest investments.

Opening a robo-advisor account usually entails completing a short, risk-profiling questionnaire and evaluating your financial situation,time horizon, and personal investment goals. In many cases, you will have the opportunity to link your bank account directly for quick and easy funding of your robo-advisory account.

Target Demographic

Many digital platforms target and attract certain demographics likeMillennial and Generation Z investors who are technology-savvy and still accumulating their investable assets.

Younger population is much more comfortable sharing personal information online and entrusting technology with essential tasks, such as wealth management. Indeed, the marketing efforts of robo-advisory firms typically employ social media channels to reach these investors.

Robo-Advisors and Regulation

Robo-advisors hold the same legal status as human advisors. Accordingly, they must be registered with theSEC and are subject to the same securities laws and regulations as traditionalbroker-dealers.

Most robo-advisors are members of theFinancial Industry Regulatory Authority (FINRA). You can useBrokerCheck to research robo-advisors in the same way that you would a human advisor.

Assets managed by robo-advisors aren't insured by theFederal Deposit Insurance Corp. (FDIC). That's because they are securities held for investment purposes, not bank deposits.

However, this doesn't necessarily mean clients are unprotected. For example, Wealthfront is insured by theSecurities Investor Protection Corp. (SIPC), meaning that if the company goes bust, investors will be reimbursed up to $500,000 of their invested balance. As you research robo-advisors, don't forget to check on the kind of insurance each has to protect your investment.

How Robo-Advisors Get Paid

The primary way that most robo-advisors get paid is through awrap fee based onassets under management (AUM). While traditional (human) financial advisors typically charge 1% or more of AUM per year, many robo-advisors charge around 0.3% of AUM per year.

Another revenue stream ispayment for order flow (PFOF). This payment (typically fractions of a penny per share) results from directing trade orders to a particular market maker. PFOF can potentially result in better execution prices for clients. Typically, robo-advisors bundle various trade orders together into large block orders executed just one or two times a day.

Finally, robo-advisors can earn money by marketing targeted financial products and services to their customers, such as mortgages,credit cards, or insurance policies. This is often done through strategic partnerships rather than advertising networks.

The Bottom Line

Robo-advisors leverage advances in algorithmic trading and electronic markets toautomate investment strategies for ordinary investors.

Often based on modern portfolio theory, robo-advisors are able to optimize investors'risk-return tradeoffs and automatically manage and rebalance their portfolios. Automation also allows for tax-loss harvesting and other strategies that were once too complex or expensive for ordinary investors.

With low fees andsmall minimum balances required to get started,robo-advisors may be a good choice for most long-term investors and may be especially attractive to younger, tech-forward individuals.