The financial sector is constantly implementing new technologies to provide financial services more affordably and effectively.
Mobile payments, blockchain trade finance, and ATMs (automated teller machines) are a few examples of technological advancements in the finance industry. The world of wealth management services is now being disrupted by technology, and robo-advisors, or automated financial advisors, are beginning to compete with human advisors in this market.
Robo-advisors are online platforms that employ algorithms to automatically build and manage clients’ portfolios. They were developed as a low-cost alternative to conventional human advisors.
The popularity of robo-advisors has increased recently, even though they were initially fintech start-ups after the global financial crisis. This is largely because more established financial institutions have begun to offer their robo-advisory services.
Even though they are referred to as “advisors,” robo-advisors frequently offer services beyond straightforward advisory services to include comprehensive portfolio management services that enable people to plan and delegate their investment decisions.
How do robo-advisors work?
Robo-advisors begin by defining each person’s investment strategy based on his or her investment goals and risk profile to assist with investment decisions. Robo-advisors question potential clients regarding the investment’s goal and time horizon.
Robo-advisors provide investment strategies for various objectives, such as retirement, setting aside money for significant purchases, creating a rainy day fund, or generating income to pay for expenses.
Robo-advisors use automated algorithms to generate recommendations for allocating funds among various asset classes based on the goals.
Algorithms can be created to monitor portfolios continuously, spot deviations from the targeted risk, and make initial fund allocation recommendations. The portfolio is automatically rebalanced when deviations are found.
As time passes and the deadline for using the funds draws near, the portfolio can be automatically rebalanced to lower risks. Rebalancing may also occur if the investor modifies their risk appetite or investment objectives.
You can use a robo-advisor without human interaction by opening an account, monitoring, and adjusting your portfolio online.
Many robo-advisors operate entirely automatically. These robo-advisors are frequently less expensive and therefore targeted at the general public. However, some robo-advisors provide a hybrid system with minimal client interaction. Despite having higher fees, these robo-advisors are still less expensive than conventional human advisors.
Benefits of robo-advisors
Compared to conventional services that rely on human advisors, using robo-advisors for wealth management services can have several benefits.
The accessibility of robo-advisors is one benefit of using them. Robo-advisors allow clients to get financial advice and manage investments at any time, from anywhere, with an Internet connection, instead of having to schedule a meeting with an advisor and travel to a physical location.
Low costs of financial advice
Additionally, robo-advisors can lower the price of financial advice. Instead of human advisory firms, Robo-advisors can cut costs on fixed expenses like maintaining physical offices or paying high-priced financial advisors’ salaries. They can lower the minimum investment requirements as a result.
Through “tax harvesting,” using robo-advisors can result in additional savings. Selling assets that experience a loss and using the proceeds to purchase another asset with a comparable risk is known as this practice (keeping the same portfolio risk profile). Taxable income is decreased by recording a loss because it lowers capital gains. Tax harvesting can be challenging; among other things, it entails finding opportunities for harvesting across a portfolio of different assets, locating suitable replacements, and engaging in multiple trades. Compared to human advisors, robo-advisors can perform tax harvesting more frequently and effectively.
Reduced behavioral biases
Additionally, robo-advisors can aid in minimizing a few of the prevalent behavioral biases in financial advisory. Human advisors have a variety of biases, including the tendency to favor products for which they receive commissions, the inability to monitor multiple assets at once, and a preference for domestic securities. Therefore, robo-advisors can reduce some biases by shifting the decision-making process from humans to automated algorithms.
Limitations of robo-advisors
However, biases may still exist even when robo-advisors are employed. Like human advisors, robo-advisors may, for instance, choose particular brokers and other financial institutions not because they are the least expensive but rather because they pay higher commissions. Furthermore, biases are inexorably introduced during algorithm design because humans invariably program algorithms. For instance, robo-advisors might advise clients to keep a sizable portion of their cash investment to reinvest for profit.
Robo-advisors have the potential to improve the availability and cost-effectiveness of wealth management services, but they also carry potential risks. Robo-advisors may be simple and time-saving, but they might not be able to get to know their clients as well as human advisors, can through numerous interactions, customized questions, and closer relationships.
One-size-fits-all questionnaires may be too straightforward and limited to give a thorough picture of a client’s financial situation and needs. These questionnaires also assume that people with similar risk profiles would respond similarly to similar subjective questions, which may not always be the case.
Another crucial component of a client-advisor relationship that robo-advisors lack is helping clients define their financial goals, offering advice during market downturns, or addressing potential life changes.
Lack of a wholistic view
Additionally, a limited risk assessment may not fully picture a client’s financial situation. In addition to other details, robo-advisors may not inquire about a client’s other investments (such as pension funds and real estate), upcoming costs, potential liabilities, spouse’s financial situation, or purchased insurance. Robotic investment advisors may not make the best recommendations if they act on incomplete information.
Robo-advisors may also cause disinterest on the part of customers. In other words, since everything is automated, customers might not even bother to continuously track their investments or try to understand how the service operates. This problem is especially important when robo-advisors are made available to people with relatively less wealth and possibly no prior experience with investment products.