What Is A Robo-Advisor And How Does It Work? – Forbes

Planning your investments can seem like a daunting task. On one hand is a bewildering array of choices and on the other is the effort required to plan, monitor and adjust one’s portfolio at all times. But what if there were an automated tool that could manage all your investments? In a world where automation has entered every sphere of life, robo-advisors are emerging as a choice to manage wealth.

What Is a Robo-Advisor?

A robo-advisor is a digital financial advisor that provides financial advice or manages investments with moderate to minimal human intervention. Robo-advisors are designed to deliver advice digitally based on inputs received from the investor. Although robo-advisors are meant to work with minimal human input, in practice, this scenario is far from true. Most robo-advisors in India are still quite simplistic and use a basic questionnaire to understand investor behaviour.

How Does a Robo-Advisor Work?

Robo-advisors use algorithms to understand and predict investor preferences, risks and goals. Usually, they do this by asking a set of psychographic and demographic questions that leads to a model portfolio.

The most basic profile questionnaire will include queries on gender, income, liabilities, willingness to take on risk and current asset allocation.

Simplistic robo-advisors will use this information to create the investor profile. Comprehensive robo-advisors look for more in-depth information through AI and data. They use financial transactions including investment, bank and credit card transactions to understand the actual financial behaviour of the investor. These advanced tools help comprehensive robo-advisors judge your financial behaviour and how you are likely to behave in a particular situation.

This enables comprehensive robo-advisors to establish a clear picture of what you actually do, instead of just relying on your claims. In the process, it can reveal information that you may be unaware of, such as higher spending than your estimate, overlooked liabilities or a pattern of cautious decision-making.

Types of Robo-Advisors

There are three ways to categorise robo-advisors: based on their technical competency, revenue structure or their scope.

Technical competency: Robo-advisors are divided into two main categories: simplistic and comprehensive.

Simplistic advisors use conventional profiling to come up with a portfolio. Potential investors have to answer a brief questionnaire that is designed to assess their risk profile. This data is evaluated as per the investor’s goal in designing a portfolio. Comprehensive advisors go beyond the usual risk profile quiz to create a more in-depth understanding of the investor profile, predicting behaviour by using artificial intelligence (AI) and data. In this category, the data tells robo about your actual net worth, current liabilities, spending patterns and behaviour in various situations and scenarios while the AI is constantly learning about you and the most appropriate investment for your profile. For instance, INDwealth uses machine-learning to provide users hyper-personalised advice in real-time.

Revenue stream: While some robos earn income through commission by the manufacturer of the product, others charge an advisory fee from the investor. The former has a conflict of interest as its revenue can influence its recommendations. The latter is free from any such conflicts because it is not dependent on the manufacturer for its revenue. Its loyalty, hence, lies only with you. The advisory fee can range from 10 bps to 50 bps, while the average commission charged by an advisor is 100 bps.

Scope: Robo-advisors can also be divided according to their scope of functioning. While most robos in India today only offer advice on mutual funds, some robos offer advice on a wider class of assets and financial products.

Benefits of Robo-Advisors

Some of the benefits of robo-advisors include:

Easy access: All one needs to access a robo-advisor is an internet connection. Most robos are designed to be straightforward and easy to use. But what makes them more accessible than the average human wealth management advisor is the lower fee. Combined, these traits give robo-advisors the potential to democratise wealth management by making it more accessible to a large number of people.

Free of human bias: One of the drawbacks of taking human advice is the possibility of a bias. Even the most competent advisor can be blinded by their own unconscious bias towards an asset class or their evaluation method when assessing risk.

An AI-based robo-advisor, on the other hand, uses a mathematical algorithm to assess the investor. This makes it impartial and free of bias. However, do keep in mind that free advisors, whether human or robo, who earn revenue through product manufacturers, may not be completely free of bias.

Comprehensive services: Today robo-advisors offer a host of services that take care of your entire financial planning. This can include services such as retirement planning, tax-strategy schemes and rebalancing the portfolio. The robo can manage your portfolio, ensure you’re on track to reach your investment goals and minimize any liabilities on a single platform.

Tracking your investment priorities: A robo-advisor builds your investment goals based on your profile. In the process, it can reveal financial priorities or responsibilities that may not be immediately obvious when you are in pursuit of different goals. Once you set up a robo-advisor account, it will keep nudging you to make responsible decisions that may not seem important right now but may be critical in the future. For instance, long-term goals like retirement planning or priorities like life insurance are often ignored by young investors. Robo advisors like INDwealth, Scripbox, and Paytm Money have in-built mechanisms to help keep track of these goals through timely reminders.

Limitations of Robo-Advisors

One of the biggest drawbacks of robo-advisors is their uneven standard. While some use cutting-edge AI and machine learning to design portfolios, the majority of robos in the market today still use simplistic methods.

Robo-advisors’ lack of human intervention can also be a hindrance. While robo-advisors find ready takers among millennials and GenX, it is less accepted among high-net-worth individuals with a large portfolio or those looking to invest a significant portion of their savings wallet. Such investors are more likely to look for validation through human advice, especially when the markets become volatile.

Should You Go For a Robo-Advisor?

The answer can lie in your own motivations. A human wealth advisor may be the best option if you need validation or a personal discussion before making an investment. However, if you want ease of transaction and ready access, a Robo-advisor is the way to go. With the average fee falling between 10 bps and 50 bps, even the paid robos offer extremely reasonably-priced services. Given the comprehensive range of services, such as investment tracking, robos are indeed well worth this price.

One can safely predict that they will be the future of wealth management. Like all automation tools, they will become smarter, learn our behaviour, be able to predict our preferences and make the most appropriate decisions. They will also find an increasing user base as they establish trust with investors and more people become comfortable with using technology as an intrinsic part of their life.