What is a robo-advisor?
A robo-advisor is a virtual financial advisor powered by artificial intelligence (AI) that employs an algorithm to deliver an automated selection of financial advisory services. Typically offered by brokerage firms, such as Charles Schwab, Fidelity Investments and E-Trade, robo-advisors are a type of expert system optimized for financial services, specifically for investing and portfolio management advice.
A robo-advisor is one example of a software robot, not a physical robot. However, the software supporting robo-advisors functions similarly to the AI that might drive a robot. Investors communicate with their robo-advisors through smartphone apps or over the web.
How do robo-advisors work?
There are more than 200 different robo-advisor services available. Most follow this basic work structure:
- When a new client registers for robo-advisor services, they must complete a brief questionnaire containing demographic and cognitive questions. Usual questions include the client's age, gender, income, investing goals, liabilities, current assets and degree of risk tolerance. These data points are used for asset allocation in a portfolio and to predict how a person responds to stock market ups and downs.
- Robo-advisors use an algorithm and sophisticated software to process these responses and create a diversified portfolio of exchange-traded funds or index funds. Typically, a financial or investment professional selects the investing options.
- Once the funds are invested, the software automatically rebalances the portfolio to ensure it remains close to the target allocation.
- Some robo-advisors offer live consultations or access to a licensed human financial planner who can help prioritize objectives and make suggestions for achieving them. Users can connect to their investment accounts to monitor progress, make changes or continue pursuing their objectives.
Robo-advisors can make customers money
Robo-advisor software can choose stocks for portfolios according to the balance desired by clients and provide limited financial advice. Similar to other expert systems, robo-advisors use AI technologies in conjunction with a knowledge base to simulate the judgment and behavior of an experienced human with specialist-level knowledge in a particular field.
Financial institutions can save money by employing virtual assistants to deal with relatively simple requests and pass on more complex requests to human advisors. Human agents often use robo-advisors to respond more quickly to customer requests.
Given that financial advisors are typically well-paid, the software is relatively inexpensive to acquire and maintain. Many in the financial sector also see robo-advisors as a means of getting investing advice to the masses, with associated cost savings.
It's also thought that robo-advisors could promote financial literacy because investors might take more time to explore portfolio options without feeling pressured to decide, which might happen when dealing with a human.
Types of robo-advisors
Depending on their level of technical capabilities, scope or revenue model, robo-advisors can be divided into the following three categories.
Robo-advisors based on technical competency
These robo-advisors are classified as either simplistic or comprehensive.
Simplistic robo-advisors use traditional profiling to build a portfolio. Potential investors are required to complete a brief questionnaire to assess their risk appetite. The investor's goal while building a portfolio is taken into consideration when evaluating this information.
Comprehensive robo-advisors use AI and data to gain a deeper understanding of the investor profile and forecast behavior in addition to the typical risk profile questionnaire. The data informs the robo-advisor about the user's current net worth, commitments, spending patterns and behavior in various settings and circumstances, while the AI learns about the user and the best investment for their profile.
For instance, INDmoney, which is a full-stack personal finance platform, uses machine learning to instantly offer customers highly tailored advice in real time.
Robo-advisors based on the revenue stream
While some robo-advisors receive a commission from the product's manufacturer, others charge investors an advising fee. The former poses a conflict of interest because its pricing might affect its recommendations. But the latter is free from any such conflicts because it doesn't rely on the manufacturer for its revenue. Hence, the investor is its only allegiance. The advising fee might range from 10 to 50 basis points -- a standard measure for interest rates and other financial aspects -- while an advisor normally charges a commission of 100 basis points.
Robo-advisors based on the scope
Based on the extent of their functionality, scope-based robo-advisors can be classified in several ways. While some robo-advisors might only offer advice on mutual funds, the majority can guide investors on a wide range of financial products and assets.
Advantages and limitations of robo-advisors
Robo-advisors have made prudent financial planning and investment management available to all people, not just the wealthy. The following are some advantages and limitations of robo-advisors:
Advantages of robo-advisors
- Low-cost. Robo-advisors are an inexpensive alternative to traditional financial advisors. Online platforms can provide the same services for a low advisory fee by removing or limiting the need for human involvement. Robo-advisors generally charge low portfolio management fees and offer a range of services.
- Accessible. When compared to human advisers, robo-advisors are typically more accessible because they offer a platform that's available around the clock, all year round. Investors can access robo-advisors from anywhere at any time if there's an internet connection.
- No financial expertise is required. Robo-advisors are an excellent choice for beginners in investing. Even without the financial expertise required to make wise decisions, a person can start investing quickly.
- Time-savings. Robo-advisors are a great option for people who don't have the time to do investment management and would prefer to put their portfolios on autopilot. Once a robo-advisor account and automated deposits are set up, there's little to no interaction needed from the investor.
- Comprehensive services. Robo-advisors provide a wide range of services that handle all aspects of financial planning. These services include retirement accounts, tax-strategy plans and portfolio rebalancing. The robo can manage the portfolio, ensure the investor is on track to accomplish their financial goals and lower any liabilities, all from one platform.
- Less capital required. When using robo-advisors, it costs far less money to begin investing. A typical baseline for minimal assets is between $3,000 and $5,000 USD. One popular robo-advisor, Betterment, waives the minimum amount of money required to open an account for its basic offering.
- Efficient. Before robo-advisors, if someone wanted to execute a transaction, they would call or meet with a financial advisor, explain their needs and then wait for the advisor to execute their trades. All of this can now be completed by pressing just a few buttons.
Limitations of robo-advisors
- Non-specific investment options. If a person has specific ideas, they can't tell their robo-advisor to buy a particular stock they want to invest in. Instead of giving specific information, it might, for instance, offer a wide range of possibilities or ask a potential investor whether they want to take risks or be conservative. As a result, robo-advisors might not be ideal for those who want to make their own financial decisions.
- Insufficient for complicated financial needs. Robo-advisors are a good starting point for people who have a small account and no prior investment knowledge. However, people looking for more advanced services such as estate planning, tax management, trust fund administration or retirement planning might find robo-advisors insufficient for their financial needs.
- Limited access to human advisors. Some robo-advisers solely provide human support for technical and account-related issues, leaving no one to address inquiries about one's investments. Others use a hybrid methodology that allows them to consult with investment advisors. However, in most cases, a user may be required to maintain a minimum account balance or pay higher management costs, and even then, a specialized advisor may not be available.
- Incomplete view of financial assets. The robo-advisor can recommend and manage an account based on the information it has, but it won't have a complete view of the various assets and investments that the client may have. While some systems let users connect all of their financial accounts, they may still not receive the same amount of individualized guidance as they would from a financial advisor who understands the complexity of their financial situation.
- Lack empathy. Robo-advisors have come under fire for lacking complexity and empathy given their limited human interaction and existing technical capabilities.
Regulations of robo-advisors
The legal standing of robo-advisors is the same as that of human advisors. They're required to register with the U.S. Securities and Exchange Commission and are bound by the same rules and laws regarding securities as conventional broker-dealers.
Most robo-advisors are also members of the Financial Industry Regulatory Authority (FINRA). Anyone can use BrokerCheck, which is a free tool FINRA provides to investors to help them research robo-advisors just as they would a human advisor.
The Federal Deposit Insurance Corporation doesn't insure assets managed by robo-advisors because they're investments in securities rather than bank deposits. However, this doesn't automatically imply that clients are unprotected. For instance, the Securities Investor Protection Corporation provides insurance for Wealthfront, a well-known robo-advisor in the U.S.
Robo-advisors offer a wide range of financial services:
- Portfolio management.
- Automated rebalancing of investment portfolios.
- Investment performance tracking.
- Financial planning tools, such as retirement calculators.
- Tax-loss harvesting and other tax-strategy offerings on taxable accounts.
- Goal setting and tracking.
- Personalized investment recommendations.
- Socially responsible investment strategies, such as using principles of ESG investing.
- Access to human financial advisors for additional support and guidance.
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