How Do Investing Robo-Advisors Work
5 minutes for reading
This overview is devoted to financial robo-advisors, which are modern, swiftly developing services for automatic management of investments. Let us try to tell you in as many detail as possible what robo-advisors are in the stock market, how they work, what types they have, as well as what advantages and drawbacks they can demonstrate.
What is robo-advisor
A robo-advisor is a software solution that is based on AI technology and provides financial advice or manages investments with minimum to no human interference.
Based on the input data from the investor, robo-advisors help to form an investing portfolio. Investing robo-advisors are chiefly meant for private long-term investors.
First such services for individuals appeared in the US in 2008. According to rating agencies, market leaders in terms of the money volume in management are such large US robo-advisors as Vanguard Personal Advisor Services, Schwab Intelligent Portfolios, Wealthfront, and Betterment.
Today, services for automatic investment management are developing fast, and popular robo-advisors start to accumulate more and more money.
How robo-advisors work
Financial robo-advisors use special mathematical algorithms for assessing and forecasting preferences, risks, and goals of investors. As a rule, investors file in the input data as a questionnaire: they answer a set of questions that help to create a portfolio based on the preferences of each user.
A robo-advisor analyses the investor's age, size of investment, and risk profile, then suggests a portfolio based on this info. An important task is to organise optimum distribution of assets depending on investing goals, horizon, and the client's attitude to risk.
At the same time, in most cases, robo-advisors do not use individual shares but rather concentrate on assets accessed via index instruments.
Normally, a portfolio consists of ETFs that provide for due diversity of investments and an optimum risk-to-profit ratio. The user opens an account via a robo-advisor, deposits it, and the algorithm automatically creates and sustains an optimum portfolio.
Depending on the market behaviour, a robo-advisor may rebalance the portfolio from time to time, optimise it by buying and selling instruments in the exchange.
Types of robo-advisors in market
Looking into robo-advisors, we may not do without mentioning the two types of such software — simple and complex advisors.
- Simple robo-advisors use a standard set of main questions and financial instruments for creating a portfolio. Potential investors need to fill out a short questionnaire that assesses their risk profile. The data is then analysed and certain assets are recommended for the portfolio, based on the investors' goals.
- Complex robo-advisors are more complicated algorithms that create detailed investing portfolios thanks to AI and a whole load of various data. AI keeps analysing input data, such as the size of the capital, current liabilities, spending, risk profile, investing horizon, etc. Based on this, it selects the most suitable assets for the portfolio.
Why robo-advisors different from financial advisors
Though robo-advisors are becoming more and more popular among stock market investors, they are much less popular among wealthy people with large portfolios or capitals. The latter type of investors are more likely to trust experienced financial counselors, especially in an unstable market.
However, robo-advisors are more affordable, which is their main advantage. For example, before robo-advisors appeared, an investor had to call or personally meet a financial counselor, explain their needs, and wait for the order to be finally executed. All this can now be done online from home.
Still, robo-advisors provide a limited number of investing options: as a rule, such services have a certain set of financial instruments, and no others can be used. For example, an investor may not buy stocks or bonds on their account separately. A financial advisor has a more flexible approach to the portfolio. Such an advisor might be a better choice if the investor has peculiar preferences, so that each decision has to be discussed in person.
Advantages of investment robo-advisors
- Constant availability online, high speed of transactions, relatively small commission fees — all this makes robo-advisors so attractive for investors.
- The work of a robo-advisor is chiefly based on a certain algorithm, making the instrument unbiased and free of human passions. Even a most competent counselor might be blinded by their bias towards certain assets or their estimation methods.
- Professional complex robo-advisors offer a wide range of services that help the client out with financial planning: for example, pension planning, tax strategies, investment tracking and automatic rebalancing.
Drawbacks of robo-advisors
- Not all robo-advisors use up-to-date AI and machine learning technology for creating and managing a portfolio. Some services are based on simplified calculation methods that provide for quite ambiguous investment perspectives.
- The work of a robo-advisor is based on back-testing and certain math models, so there is no chance for caring for the whole spectrum of factors that influence the market. Hence, even the most modern software solutions have some limitations and cannot guarantee investment success in a turbulent market.
Bottom line
Investment robo-advisors are a big step in the development of the financial industry. They have made personal money management services available not only to wealthy investors but to ordinary people.
Today the service of robo-advisors in the market is developing fast and acquiring popularity. This means that robo-advisors accumulate more and more money under management
However, about robo-advisors one should remember that these modern facilities have equally advantages and drawbacks. For now, investors may choose whether to opt for a robo-advisor or a professional financial counselor.
