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Putting Robo Advisers To The Test (Robo Investing Explained)

The Decade Of The Robot

It would not be inaccurate to call the next upcoming 10 years the “decade of the robot”.

Robots and AI software have changed the landscape in virtually every industry from science to advertising. They allow simple, repetitive tasks to be automated and more complex AIs can make lightning-quick decisions and see patterns that humans can miss.

One area where robots and AI software have made a huge explosion in is the financial industry. AI applications in the fintech industry include using AI to make quicker credit assessments, managing risk in businesses and markets, preventing fraud and protecting use identities, and give easier more accessible ways to make/receive payments and handle finances.

Robots have also made a splash in the investing economy. While the idea of robots making investments in the market may sound strange, robo-advising is becoming a viable service in the financial industry.

What Are Robo-Advisers?

A robo-adviser can be defined as an online wealth management system that invests funds with little to no human input.

Robo-advisers give you a fully automated way to invest your wealth. Simply put in your risk preferences, connect your accounts, and your robo-adviser will automatically invest funds based on algorithms and mathematical analysis of markets. It can be viewed as a form of passive investment.

Read more: 5 Passive Income Ideas Strategies That Work In 2019

Robo-advisers are part of a new trend towards more efficient wealth management. Unlike traditional investment firms, robo-advisers save on costs by cutting out the human element and having a sophisticated machine do the investing for you. The best part for you is that now you do not have to shell out large amounts of money to advisers or a professionally managed portfolio to have competent financial oversight.

The Growth of Robo-Advisers Has Been Staggering

Robo-advisers first hit the market in 2008 after the financial recession, in part ushered in by the growing need for people to personally manage their assets.

2010 saw the launch of Betterment, one of the first robo-adviser investing firms, which caused robo-advising to quickly grow in popularity. Robo advisers are perfect for DIY investors who want to get into investing but lack the funds for an expensive, traditional financial adviser.

By 2015, over 100 companies worldwide were using robo-advisers, managing more than £47 billion in assets.

Interestingly, robo-advisers do not use any new or groundbreaking software.

The software they use has been available to financial advisers since the year 2000, but it has only recently become publically available. Add in advances in AI learning, and robo-advisers have really taken off in the past decade or so.

It is estimated that the total amount of robo-adviser managed funds in the world will skyrocket to over £2.4 trillion in 2020. At this point, it is safe to say that the robo-advising business is here to stay.

In some ways, the term “robo-advising” is a bit misleading. Robo-advisers technically do not “advise”; they just automate the investing process. In contrast, a human investment adviser can give you advice about which investments to make and can better understand what you want out of your investment. It is likely that the future of investing will be a robo-human hybrid; where machines do the legwork of making daily investments and adjustments while human advisers help visualize and realize long term financial goals.

How Do Robo-Advisers Work?

Robo-advisers work by using algorithms to make investments. An algorithm is just a set of steps one takes to complete some task. Google, for example, uses a search engine algorithm and Uber uses algorithms for its map data.

Robo-advisers uses computer algorithms to invest money. This may sound a bit fishy at first. After all, investing is a complex business that seems hard to reduce to a set of steps that a computer can blindly accomplish.

In actuality, the majority of robo-advisers use a set of algorithms developed by Nobel Prize Winner Harry Markowitz’s Modern Portfolio Theory, which describes a method to maximize investment returns and minimize risks at each level of the investment process.

All this goes to show that robo-advisers excel at making well-diversified portfolios according to sophisticated algorithms that are based on our current best understanding of how markets operate. That was a mouthful so here it is in simpler terms; robo-advisers are built to invest like experts who have years of experience in the field. They leverage the top empirical models in the economic sciences to maximize gains potentials in markets.

An Example Of A Robo-Adviser In Action

Let’s look at a specific example to see how exactly robo-advisers stay on top of your portfolio. Say you initially set your asset allocation to 60% stock and 40% bonds. Next, assume that your stock grows quicker than your bonds which changes your allocations to 70% stock 30% bonds.

Your robo-adviser will automatically sell some stock and buy bonds to return back to the pre-determined allocations of 60% stock and 40% bonds This kind of rebalancing is offered by all robo-advisers.

Several advisers also offer tax-loss harvesting and will sell off falling investments and buy new ones to lower your tax bill. There are many different kinds of robo-advisers which offer different services. It’s all about finding the one for your needs.

So, How Do You Set Up A Robo-Adviser Account?

To set up an account with a robo-adviser, all you have to do is access the online investment service and answer 10-15 simple questions related to your investment goals and risk preferences. You get will get sorted into an appropriate investment basket based on your response and, once you link your bank accounts, you let the robo-adviser handle the rest.

What Fees Are Involved With Robo Investing?

Thanks to robo investing, the barrier of entry to investing is lower than ever. By cutting out the human middleman, robo-advising costs very little and can see very big returns.

In traditional firms, account managers normally take their fee as a percentage of assets under management. The same is true for robo-advising, but the fees are generally much lower.

Robo-investing fees start at free for some platforms like Wisebanyan, and range from 0.15% up to .87%. In general, firms that offer more services charge more for robo-advising. So for example, a £5,000 deposit at a 0.38% service fee rate comes out to just over £19 per year. This is a much lower barrier to entry than traditional financial advisers who generally charge higher rates. Several providers offer extra services such as human adviser consultations for extra fees.

Robo-advising also tends to have lower minimum amounts than traditional firms. While traditional firms may require deposits of a few thousand pounds, robo-investing allows investments as low as £500 and as low as £100 in some cases. This makes investing much more accessible as you do not have to have tons of spare change lying around to invest.

You also normally do not have to pay any transaction fees while using a robo-adviser. Standard brokerage accounts incur a commission for buying and selling investments and depositing.withdrawling money. Robo-advisers normally waive these fees.

What Kinds of Investments Are Used?

Most robo-advisers work in mutual funds and exchange-traded funds (ETF), not individual stock. Passive investing is the name of the game with robo-advisers. The goal is to minimise risks by choosing the most stable growing funds. These investment strategies are based on modern portfolio theory research.

When setting up you robo-advising you will be asked to specify your initial allotment. From there you can decide upon underlying stock asset and bond asset classes (long-term, short-term, etc.). The best part is the software does the hard calculations for you and give you the most important relevant information.

Typically, robo-accounts must be funded with cash.

If rolling over investments is allowed, then they will likely be sold off to fit with the robo-adviser portfolio model. If these investments are not in tax-deferred accounts, any capital gains or losses on them will be reported. This means that one may see a larger than normal tax bill in their first year switching to robo-investing.

Robo-Advisers VS Financial Advisers

So by this point, you are probably asking, what are the benefits of picking a robo-adviser over a regular financal adviser? In fact, how do robo-advisers attract customers?

In general, the choice of which option is better depends on your specific investing needs. Some advantages of a robo-adviser over a human adviser include:

  • Cost: Robo-advisers typically cost much less than a personal financial adviser. The automation takes out a lot of the legwork so less is spent on labor costs. For instance, the median fee for human advisers is about 1% of managed assets. In contrast, most robo-advisers charge 0.5% on managed funds. Also, robo-advisers typically have lower minimum investments amounts so the barrier to entry is lower.
  • Availability: Robo-advisers also have the advantage that they are always available. You may have to wait and schedule appointments with a personal adviser when they find the time. With a robo-adviser, it is always available for consultation. Many hybrid-robo adviser firms have risen that combine human expertise with robo-advising.
  • Accessibility: Robo-advising also just makes investing easier and more natural to get into. First-time investors can be overwhelmed by the different kinds of investments and technical complexities. Robo-advising simplifies everything so you can focus on the bottom line.
  • No conflict of interest: In many ways, robots are the perfect investors. They are logical and don’t have greed. Robo-advisers also are guaranteed to only make investments that you want them to. Human advisers may be distracted from their fiduciary duties by the pressures of the job.

That being said, a human adviser excels in some areas that a robo-adviser falls short. Advantages of a human adviser include:

  • Personal touch: While robo-advising is efficient, human advisers are better at making plans and accomodating big life changes. Even 60% of people who use robo-investing admit that human investing is superior; and only 13% of robo-investors say that robo-advising does a better job than human advising. Human advisers are perceived to be better at coping with unexpected changes in the market, so having a human on the other end of the line can allay fears and prevent you from making a rash decision.
  • Complexity: The more time spent investing, the more complicated clients’ portfolios become. While robo-advising is a great way to handle the day-to-day transactions, it sometimes takes a human point of view to help with more complex tasks, like planning an estate, saving for college, buying a house, and so on. HUman advisers excel at making long-term financial plans.
  • More expertise: Robo-advisers are built using the latest research from economic theory, but they are not omniscient. Robo-advising only accounts for a small portion of people’s fund and it cannot see everything at once. Sometimes human expertise is necessary to see the forest through the trees. After all, playing a market is primarily a psychological game; you have to know how people think and how they will react to changes in a market, Unfortunately, robots are still not particularly good at predicting human behavior so you need a human with a wealth of human experience.
  • Accountability: Without accountability, results are hard to come by. Traditional advisers hold their clients to commitments and help them achieve their financial goals in a more personal manner. Computers can invest and send you info on your funds, but they cannot really help you stay accountable to your goals.

Hybrid human-robo investment firms show great potential for growth in the coming years. Hybrid-robo investment firms combine the best of both human and robo-avising so you can get the best of both worlds.

If you cannot decide if you want a robo-adviser or a personal financial adviser, here are some tips to make the decision a bit easier.

When is a Robo-Adviser the Best Strategy?

  • You don’t know where to start: Robo-advising is incredibly user-friendly and easy to get into, making it a perfect choice. You begin by taking a small questionnaire an specify your investment goals, risk preferences, and time scale, and the robo-adviser handle the rest for you. You don’t have to choose individual investments or periodically rebalance your accounts, the robot does all the heavy lifting. Just fund the account and you are good to go.
  • You want to moderately invest: Robo-advising is not as flashy as high-risk high-reward stock buying, but it is a solid way to accrue continually growing and stable funds. While some investors prefer going all out to get rich, if you want a steady return on your investment, robo-advising is a good bet. Robo-advisers diversify your funds into a mix of exchange-traded funds that get invested in stocks.  The diversification keeps your returns high during drops in the stock market by shielding some money in bonds. The result is steady predictable growth.
  • Not a lot of money to invest: Most mutual funds have at least a £1,000 minimum in investing and often £3,000 more. If you are a beginning investor odds are you do not have that kind of money lying around. Many robo-advising services require little to no money upfront to begin investing.
  • No time: It might be the case that you do know about investing but between your other responsibilities you do not have time to do it. Or you may just find the investment process boring but still want to find a way to reap its benefits. If you find yourself at a lack of time, then a robo-adviser could be a good investment (pun intended). You can do what you want all while knowing your funds are being competently managed.

When is a Financial adviser the Best Strategy?

  • You want more control over your funds: The downside of automation and simplification is that it can take the nuance out of investing. Not everyone will readily turn their funds over to a robot that operates on algorithms and follows a routine. A personal financial adviser can give you more explicit control over your individual accounts as they have a better eye for all the nuances and intricacies of investing.
  • You have many complex investments: One shortcoming of robo-advising is that it gets much more difficult to efficiently handle client’s funds when their investment portfolios become very complex and layered. Robo-advisers are great for handling the minutiae of rebalancing accounts and trading losing investments, but they are not as effective at managing complex funds and making long-term financial plans.
  • You need tailored service: Robo-advisers are cheap compared to financial advisers because they offer streamlined automated services. While these are great, they carry a lot of inherent limitations. Robo-advisers are somewhat built on a “one-size-fits-all” approach when it comes to investing, which may not be every investor’s cup of tea. A personal financial adviser modifies their services for your individual needs and gives specific attention to your unique financial situation.

Robo-advisers Vs Index Funds

An index fund is a type of passive portfolio that is designed to track the performance of some specific market over a certain period of time. These index funds are normally gauged with reference to some financial market index, most often the Standard & Poor’s 500 Index (S&P500). The key feature of index funds is that they stay on their benchmark index regardless of the state of the market.

Index funds are considered best for retirement accounts as they provide good market coverage and are relatively safe investments. Instead of an individual choosing when to buy and sell securities, the fund manager constructs a portfolio that mirrors the state of a particular index. So an index fund that tracks the S&P500 would invest in the same large 500 companies that make up the index.

Currently, index funds may be the biggest competition for robo-advising. As it stands, robo-advising have a lower expense ratio compared to the average 0.78% expense ratio of a target date fund, for example. Even adding in the pay management fees, robo-advising fees come in at about 0.20% to 0.55% per year.

So which is better, a robo-adviser or a traditional index fund? As of now, the market is still silent on the issue. While no doubt some individuals find a superior experience using robo-advising versus traditional fund management, it is still too early in the technology’s lifecycle to make a solid statement on which is superior.

It also depends on the kind of account that you have. If you are investing in a 401k, then you will probably need to go with a traditional fund adviser. The simple reason being that most robo-advisers do not handle 401k accounts. So with a 401k, a hands-off index fund may be your best bet.

Are Robo Advisers Worth It?

Let’s recap: robo-advisers are investments services that use computer algorithms to trade and invest funds.

Robo-advisers operate on a passive income approach and are built using the best economic models available to maximize returns while minimizing risks. Robo-advising offers a simple automated way to diversify your portfolio and reduce your tax bill. Robo-advising offers numerous advantages over traditional financial advising, including:

  • Increased flexibility
  • Lower costs
  • Automated buying/selling
  • Constant availability

Robo-advising is a great way for a novice to get into investing or for an experienced investor to get a new perspective on the process. Most importantly, robo-advising offers a lower barrier for entry into financial markets, which opens up opportunities for more people. If you are a person who values flexibility, freedom, and a DIY approach to investing, then robo-advising may be the right choice for you.

About author

Fully qualified CISI Investment adviser for 6 years. Managing high-net worth private client portfolios as well as whilst providing Equity insight for numerous publications. Brains behind Spotlight.
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