The Rise of Robo-Advisors

The Rise of Robo-Advisors

The FinTech stakeholders are continuously adopting new technological solutions to make their services more efficient and cheaper. This process sped up after the 2008 financial crisis when traditional banks faced tighter regulations, forcing them to look toward technology-based financial solutions. ATMs (automated teller machines), mobile payments, and blockchain are some examples of these innovations. The latest in the line is Robo-advisors, automated financial advisors providing wealth management services, that are competing with human advisors.

 

Robo-advisors are online platforms that use complex algorithms to automatically build and manage client portfolios. Banks are starting to invest in Robo-advisors as well. America is by far the biggest market for Robo-advisors and is expected to grow to about USD 1.5 trillion by 2023.

 

To help the client with investment decisions, Robo-advisors start by creating a personalized investment strategy based on the client’s investment goals and risk profile. Client provides data, such as the purpose of investment and the time frame, to help the algorithm come up with the best strategy. A Robo-advisor can be programmed to advise for all sorts of investments, including retirement, saving for large expenditures, establishing an emergency fund, or generating a passive stream of income. The Robo-advisor may ask further questions to evaluate the client’s willingness and ability to tolerate risk, their income, and years left till retirement, how they would respond to market decline, or how they would deal with fluctuations in the market. These answers are collected using standard online short questionnaires.

 

Robo-advisors, then, consolidate this information and make recommendations about how to allocate funds across different types of assets using, most of the time, the modern portfolio theory of Bjernes and Vukovic introduced in 2017. This theory is based on the portfolio selection framework first developed by Harry Markowitz in 1952. The theory helps allocate the asset that would bring the highest return where the level of tolerable risk is provided by the client, or, alternatively, given the percentage of return, picks the asset that would be least risky. The ideal portfolio balances the rate of return and poses risks.

 

Robo-advisors can also be programmed to monitor portfolios to check for deviations from the targeted risk or return. Whenever the portfolio deviates, the algorithm can rebalance it. Robo-advisors can be fully automated to operate without human intervention or as a hybrid solution, where human advisors carry out selective tasks.

 

One advantage of Robo-advisors is that clients can manage their portfolios from anywhere in the world without having to wait for an appointment with a human advisor. Robo-advisors are also cheaper than human advisors. There is, also, no need for a physical office. This can help bring down the advisory fee, as well as, the minimum required amount for opening an investment account. Robo-advisors can also save on the administrative fees, charged by human advisors for trades performed, by following passive investing.

 

Tax harvesting means selling an asset that is experiencing loss and buying another asset with the least possible effect on the portfolio. It is a time-consuming and difficult process, but it can help save tax, since a loss in capital gain means a decrease in tax. Robo-advisors can perform this task much more efficiently than humans.

 

Human advisors are prone to behavioral biases; their choice can be subjective, favoring those products for which they receive a commission. Their scope of focus is also limited as there are human limitations to their monitoring capacity. Robo-advisors can remove these biases, however they can be programmed to be biased, for example, they can be programmed to pick assets for which the company gets more commission.

 

Of course, there are also disadvantages to using a Robo-advisor. They cannot replace the human touch, or cannot provide more in-depth insight into the market or guide clients to weather an economic downturn or deal with a personal issue. Also, the portfolio that a Robo-advisor designs is only as good as the information collected from the client. For an accurate assessment of the customer’s needs, the dynamic forms designed to collect information should be extensive, including contextual information such as other investments, potential future expenses, potential liabilities, spouse’s financial condition, etc.

 

The Robo-advisor model is new and has not been tested during a recession. When selecting a Robo-advisor company, it is important to choose a company that is a member of the Securities Investor Protection Corporation (SIPC) that insures each customer up to USD 500,000 in the case of bankruptcy.

 

Due to their accessibility, low cost and low minimum amount to start an account, Robo-advisors attract low-income investors or those living far from urban centers. Younger investors who are more tech savvy are also more likely to choose a Robo-advisory over a traditional advisory firm. Robo-advisors are also slowly making their way into new markets such as India and Brazil.

 

Strict regulation and government monitoring is key to the success of Robo-advisors. The industry should take heed from the recent meltdown of crypto currencies which could have been prevented through proper regulation. Regulators must ensure that Robo-advisors remain transparent and unbiased. For now, regulators lack the required technical expertise to monitor the algorithms of Robo-advisors. They would either have to upskill themselves or hire consultants who know their way around Robo-advisors. Either way, data security and privacy has to be ensured. Customers also have to be educated about Robo-advisors so they can make the right decisions according to their needs.

 

To learn more about robo advisor technology or to get a demo on such platform, email us at contact@croyten.com or call us at 617-477-6888 ext 300

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