Here is a simple explanation of how robo advisors work.
Why should a Robo Advisor be better than a human financial advisor?
If you are you wondering why to use a Robo Advisor to invest money, here is a fast guide about the new way to get financial advice online safely.
Table of Contents
Simple Definition of Robo Advisor
The origin of the term Robo Advisor comes from combining the English words robo (robotic) and advisor (advisor), i.e. automated or robo-advisor.
Robo advisors are also known by the term “robo asset manager”, as they actually manage your money for you as well as advising you. A Robo Advisor is therefore a type of financial advisor that offers an online portfolio management service using algorithms, automation and usually the supervision of a team of expert investors.
Robo advisors make it easier to create investment portfolios that are customised for each individual and tailored to their capabilities.
The creation and maintenance of portfolios is fully automated.
So, why Robo Advisors instead of human financial planners?
The automated financial tool does it all:
- Builds your plan according to your situation and goals
- Optimises your portfolio on an ongoing basis
- It invests for you with strategies from expert investors or advanced algorithms
- Make changes when necessary
- Manage your additional contributions
Thanks to its automation, this new wealth management alternative offers investors lower costs and, consequently, higher returns.
The most common characteristics of robo advisors are:
- Investing automations
- Delegated portfolio management
- Accessible with little capital
- Use of passive instruments
- Low cost
The first robo advisors appeared in 2008 in the U.S.A.
They were born with the aim of offering an automated service to make investing:
- simple
- smart
- more diversified
Before the arrival of Robo Advisors as we know it, human financial advisors would use wealth management software to automate the work with a commission of 1% and 3% of investable assets.
Due to their great success in the US market, they were introduced in the UK market in 2011 and in the rest of Europe a few years later. Although they have not yet achieved the same success in the European market as in the US, robo advisors are making a strong presence in the financial market and are expected to grow significantly in the coming years.
Can Robo advisor offer the best investment ever?
Let’s find out!
How do Robo Advisors work?
Let’s see now how Robo Advisors work in practice and what they can do for investors.
The typical investment process of a Robo Advisor consists of 3 main steps:
- The client takes a test to find out what their financial objectives, financial situation, investment knowledge and investment psychology are.
- Once the user’s investment profile is known, the Robo Advisor assigns an investment portfolio adapted to the investor’s risk profile.
- Finally, the investor opens his account, makes the transfer of the capital to invest and the Robo Advisor takes care of the rest,
- Periodically the tool will carry out rebalancing and optimising the investment through algorithms.
Here is a short video that explains how robo advisors work:
The most important robo advisors in the UK market are:
- MoneyFarm
- Scalable Capital
- Nutmeg
- MoneyBox
- Investengine
- Wealthify
Some of the Robo Advisors in the above list do offer services in most European countries. For instance, Moneyfarm is available in most of Europe (here is the MoneyFarm Review).
The most important robo advisors in the US market are:
- Betterment: the largest independent robo
- Wealthfront: approximately $9.5 billion under management
- Wealthsimple: with $1.9 billion in assets under management
In the European market the biggest is Scalable Capital: it has €1 billion in client assets, with more than 30,000 clients and growing.
Myths about Robo Advisors
Some investors are reluctant to use a Robo Advisor as an investment vehicle as they think it is a just a silly robot that decides where to invest.
However, this is not true.
In reality it is humans, expert investors, who have programmed the tool and who decide where to invest. They are usually guided by long-term strategies. The robot automates everything that can be automated in order to avoid mistakes, save costs and simplify the investment process.
Although more and more people avoid having to go to their bank branch to do business, another myth about robo advisors is that they cannot offer a human touch. However, this statement is not entirely correct either.
It is true that a robo advisor will not be able to offer as personal a face-to-face service as a traditional bank. Indeed, if it did, it would not be able to offer the low costs it does. However, behind the phone, chat, video call etc., you will always have a real person ready to help you.
Most of the time that person will be a certified professional financial planner.
This is to say that we are talking of highly automated services, but the human touch will always be there.
Here is a funny video about why trusting a Robo advisor to invest:
What type of people invests with Robo Advisors
Robo advisors are accessible to all types of clients, although the user profile that stands out the most in them are people who like the whole digital world, technology, engineering, computer science and finance.
People who seek the services of robo advisors are generally looking for personalised advice, to improve the profitability of their portfolios and their savings.
What is most striking is that the majority of users are men, and the number of women seeking this type of service is very low.
Why?
One reason is that, unfortunately, men have historically received higher salaries than women. However, it is expected that, as society equalises salaries between men and women, the number of women investing with robo advisors will catch up with men.
On the basis of age, the predominant age group is between 25 to 50 years old. Most of them live in large cities and have an average income of +50,000 euros per year (source: Statista).
In short, automated Robo Advisors are ideal for people who:
- do not have time to manage their investments
- prefer to invest for the long term
- want to start investing with little capital and with diversified portfolios
Investing long-term through a Robo advisor is considered a safe investment compared to stock picking, like investing in Amazon shares.
Robo Advisors for Tax Optimization
Robo Advisors generally apply similar strategies to traditional services when dealing with taxation:
1) Using assets that themselves provide tax advantages, e.g. (transferable) investment funds and ETFs.
2) Using instruments that are specifically designed to obtain tax deductions, e.g. pension plans.
3) To a lesser extent by applying specific tax optimisation techniques.
In most cases, there is not much to optimise.
Why Robo Advisors to invest Long Term
In general, all robo advisors invest for the long term and are not recommended for investors who want to achieve high returns in short periods of time.
In fact, we never recommend investing capital that is going to be needed in the next 3 to 5 years as the market can be very volatile in short periods of time.
Robo-advisors invest for the long-term as this way they can take advantage of the upward trend in the markets and can offer a higher return vs. the speculative investor.
Numerous studies say that a great formula for success in the investment world is to create a systematic plan with a long term view.
In addition, thanks to the long term, the investor can benefit from compound interest, the “magic” formula that allows returns to increase exponentially as time goes by.
The last benefit of long-term investing with robo advisors is the reduction of costs.
By doing less buying and selling, the robo advisor will be able to offer lower costs than those offered by traditional management services.
How the Algorithm work
One of the great characteristics of robo advisors is their automation.
Such automation is often based on algorithms. Using algorithms, the robo advisor can perform more quickly, efficiently and economically all those tasks where a person does not add value.
For example, the algorithms of a robo advisor are in charge of:
- creating the investment portfolio (previously established by an expert investor) according to the parameters of each client: level of risk, time horizon…
- applying the necessary rebalancing to keep the portfolio in line with the original distribution.
- managing purchases and sales to improve the taxation of a portfolio.
- assisting in strategy change operations or tactical adjustments according to the market situation.
In summary, we don’t really need a human to create an optimal portfolio that is suitable for someone who gave information about his objectives and risk tolerance.
It is even more easy for an algorithm to rebalance. portfolio, since this is just about doing some math.
Why Robo Advisors use ETFs
Many robo advisors use ETFs rather than mutual funds to create portfolios that are tailored to the risk level of the investor’s profile, investment horizon and financial goals.
They use ETFs for several reasons:
- Because of the high diversification, i.e. when the investor buys an ETF they are actually buying many stocks or other bond investments.
- They are very transparent, so the investor will know what assets the ETF is holding at all times and whether it is doing its job.
- Another reason is that they are passive, so it tries to get the same results that the stock market offers by allowing the investor to get the same return as the market without the additional costs of beating the market.
- They offer low commissions.
- They are easy to buy and sell.
These features allow the strategy employed by the robo advisor to work and, on average, they performe better than ETF portfolio created by beginners or real estate Investments made without a clue.
Robotic Vs. Human Financial Consultancy
One of the positive aspects of using the Internet to find a financial advisor is that you can work with someone who meets your needs, wherever he is in the world. This can be a huge advantage because we are able to invest through someone that is good at its job, even if far away form our location.
The best financial planner may live far away form where we live.
Consider whether you prefer a human touch or an algorithm
One way that online financial advisors (Robo) keep costs low is by using intelligent technology to provide various recommendations for asset allocation and planning. You may receive a series of slightly personalized recommendations, but they are not truly tailored to your individual situation.
Robo Advisors create strategies for those with similar needs to yours, not specific to you.
For some, this may be acceptable. However, if you desire human interaction or the personalized insights of a human advisor, look for an online advisor that provides human professionals for the services you need.
Increasingly, robo-advisors are adding the option to speak with a human over the phone or through video, as consumers are seeking a more personal touch.
Before evaluating online financial advisors, try to understand if you value the human element, then make informed decisions.
