What are Robo-advisors?
Robo advisors are digital tools that provide automated, algorithm-driven financial planning services and decision making with very little human supervision and at a much lower cost. Robo-advisors are growing in popularity as they tend to charge a fraction of what a traditional investment manager would whilst getting the same, but if not better portfolio at the same time. Low fees are maintained by using technology to automate the investment process often use passive investment strategies such as investing in ETFs, which aim to match the returns of the market, keeping costs low.
The alternative is actively managed investing, which various strategies are applied in an attempt to outperform the market. Higher fees are associated with actively managed investments to compensate for the extensive time researching and allocating investors money to different investments. The extra fees impact the overall net returns and on average, do not work very well for the majority of active investment managers in beating the market. See related article - Active vs Passive Investing
“Robo-advisors were born out of the confluence of the financial crisis and the rise of the smartphone,” – Caleb Silver, Investopedia Editor in Chief.
How do Robo-advisors work?
Robo advisors work by automating the investment process to build and maintain a diversified portfolio. Information is collected from investors about their financial situation, goals, risk tolerance, time horizon through an online questionnaire. With this data and information, a suitable investment portfolio is created to fit investors specific needs. Once an investment portfolio is established, Robo-advisors continue to monitor these portfolios to ensure that the determined optimal asset class weightings are maintained whilst taking into account market movements.
The asset allocation and portfolio management principles are based on Modern Portfolio Theory (MPT), which is considered to be the best approach to investing and is one of the most important and influential economic theories dealing with finance and investment. Modern Portfolio Theory aims to provide the greatest opportunity for return with the lowest amount of risk and Robo-advisors maintain this through target asset allocation (i.e. 70% stocks, 30% bonds) and automatically rebalancing throughout the year. This type of rebalancing used to be time-consuming, but with Robo-advisors, this is both automatic and for minimal cost.
Who is best suited for Robo-advisors?
The main benefit of Robo-advisor platforms as they do not require minimum investment amounts making it possible for investors with small amounts to access financial services and products that were usually available to the rich.
Robo-advisors are best suited for investors who want to get active portfolio management (rebalancing of the portfolio) but who also want to set and forget their investment and spend very little time. Robo-advisors also suit some experienced investors as the low fees, and automated features do make it ideal for long-term investment goals.
Advantages and Disadvantages of Robo-advisors?
The key benefits of using Robo-advisors as part of your investment strategy are:
Low cost – Portfolios are built using ETFs and Robo-advisors utilise technological efficiencies making fees much lower than portfolios built using active management (0.2-0.5% compared to 1-2%) which can significantly impact your returns over time.
Ease – being a digital platform means that signing up can be done in a matter of minutes via your phone.
Accessibility – as most Robo-advisors do not have a minimum investment amount it allows everyday investors access to professional-level management.
Removes poor decision - rebalancing is performed automatically by the platform this takes away investor behaviours to sell as the market drops and buy when the market is rising. (Related article: Dollar-cost averaging - when is the right time to invest?).
Personalised advice - As Robo-advisors develop, they are expanding their services to provide personalised advice based on the client’s individual needs.
The key disadvantages are:
Personalisation is limited – Robo-advisors are built using more of a one-size-fits-all model so they may not be able to provide the personalisation required. Furthermore, they do not allow you to select individual asset class’ or stocks.
New product – Robo-advisors arose as a result of the global financial crisis in 2008; therefore do not have long historical data to see how they will react to different scenarios. They have fared well in 2020 as a result of the COVID pandemic and the impact it has had on the financial markets.
Relies heavily on technology – If the programming behind the Robo-advisor is not written well or cannot process the types of scenarios then this may have an impact on performance over time but as technology improves these should go away over time.
See related article - Active vs Passive Investing
Are you interested in investing in Robo-advisors? See the link here and here to a Robo-advisor comparison site. Your options will depend on where you have residency or hold a passport.
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
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