Robo-advisors

Robo-advisors are digital platforms that utilize algorithms to provide automated investment advice and manage portfolios based on an investor's financial information and risk preferences. This innovation marks a significant shift from the traditional reliance on financial advisors, who have historically guided investors in constructing and managing portfolios through personal insights and market analysis. Robo-advisors emerged prominently after the 2008 financial crisis, gaining popularity for their cost-effectiveness and efficiency, appealing particularly to younger generations comfortable with technology.

Unlike human advisors, robo-advisors operate round-the-clock without personal biases, offering a streamlined process to execute trades and monitor investments. This approach democratizes access to investment opportunities, allowing individuals with smaller amounts of capital to engage in the market. However, concerns persist about the absence of human judgment in navigating market volatility, as robo-advisors lack the emotional intelligence and nuanced understanding that human advisors bring. The regulatory landscape for robo-advisors is also evolving, as oversight becomes critical in an environment where financial technology continues to expand rapidly. As these platforms become increasingly influential, they represent a transformative movement in the investment industry, balancing the benefits of automation with the traditional values of personalized financial guidance.

Published in: 2021

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Subject Terms

Robo-advisors

Abstract

Robo-advisor is the name that has been given to an information platform that will process specific financial information provided by a would-be investor and can, in turn, make appropriate choices that will actually invest the monies. Using carefully constructed algorithms, these robo-advisors provide a customized portfolio for the investor, entirely eliminating the longstanding cornerstone relationship in the investment field: the dynamic between an investor and a financial adviser—that is, a knowledgeable human agent able to respond with directed advice about a client's investments.

Background. For generations, those with disposable income interested in investing money in the market would seek the financial counsel of an in-field agent trained in money management and risk assessment to help guide their investments. Together, the would-be investor and this financial advisor would construct a viable portfolio that would reflect the goals and psychology of the investor. Investors approaching retirement, for example, may be cautious, as a downturn in the market, without sufficient time to recover, can result in serious losses. The advisor's direction will be different for the investor willing to engage in high risk, often short-term (or quick strike) investments against those who would prefer less aggressive, safer long-term investments to secure a steady income stream.

Together, the investor and financial advisor would direct the investments, and together they would monitor the market, evaluating the security status of the investment, regulating the market booms and busts to determine when, if at all, the investor would be smart to pull out of the investment and either reap the benefits of a smart investment or minimize the financial impact of an unwise investment. In either case, the relationship between the investor and the financial advisor over time became one of the most respected and established traditions in the investment field.

People with the income sufficient to afford such specialized advice (most often with six figure investment monies to risk) and able to pay for such professional direction essentially came to rely on the role of the financial advisor. These advisors, educated in market dynamics and gifted with unteachable financial intuition, would ultimately be responsible for providing the investor with the best possible advice for the distribution of investment monies. For that advice, the financial advisor would receive a considerable stipend, often based on commissions from investments that paid large dividends.

If a family had inherited wealth to pass down, they would often come to rely on the same firm of financial advisors generation to generation. Confidence and consumer loyalty was a measure of the trust and respect the financial advisor and his or her firm was able to earn, and this dynamic was critical to the sense of stability that would help direct the family's investments through the inevitable cycles of boom and bust in a free market. The advisor would advise on when to pull out from an investment, specifically when to panic and when not to panic. An advisor could follow indicators on an approaching bull market and could counsel patience during a bear market. In turn the relationship between the investor and the financial advisor evolved into a complicated psychology in which the financial advisor assessed not only the market and its strengths and vulnerabilities but also the strengths and vulnerabilities of the investor. The advisor understood the investor, understood the investor's hopes, dreams, financial goals, and even family history.

Part psychologist, part free market analyst, part economic wizard, and part prognosticator, the financial advisor for generations became an integral part of the investment world. "[T]he best financial advisors don't just manage investments: They build relationships and help their clients negotiate all of life's financial and emotional challenges" (Eule 2015). Occasionally, cases arose in which trusted financial advisors committed fraud, traded on illegally obtained information, or embezzled the monies to which they were entrusted, but on the whole this relationship shaped the investment paradigm.

Digital Age Investing. With the advent of computer technology in the late 1980s, the investment field was completely transformed by the sheer accessibility, efficiency, and affordability of information available on the Internet. Using the familiar model of online shopping, an investor with a modest amount of money set aside to play the market could decline to set up an appointment with a financial advisory firm and save the costs of investing through an advisor and simply go online to any one of dozens of Internet investment sites.

With online investing, the investor completes a confidential application, which includes critical financial information as well as an indication of the range of risk the investor is willing to take. A computer platform uses sophisticated algorithms to create a customized investment portfolio and in turn transfers the monies to make the necessary investment. The site, until programmed to do otherwise, continues to monitor the monies and to report back to the investor the progress of the investment.

This digital advice market was introduced in 2008 by the computer financial (or FinTech) firm of Betterment, headquartered in New York City. Betterment was able, through the reach of its website investment opportunities, to become a global investment brokerage firm. The firm was registered through the Securities and Exchange Commission (SEC) much like a more conventional brick and mortar investment firm, but its advice was generated entirely by a computer program, which based all of its decisions on basic financial information, risk analysis, and market data.

The digital, or robo-, advisor had certain advantages for the investor over its human equivalent—it never took a day off, never had an off day, never took a long lunch. A decade later, the interest in computer-generated investment advice skyrocketed in the wake of the catastrophic 2008 global recession, widely perceived by many financial market analysts as directly caused by poor investment management by financial advisors more interested in personal wealth than in either general market soundness or their clients' financial status.

In 2010, industry estimates placed the volume of investment monies going through robo-advisors at $70 billion, a relatively modest percentage of an investment field that trades nearly $35 trillion dollars annually. The move, however, toward robo-advisors is evident. By 2020, investment industry experts predict, more than $500 billion will be moving through information platforms rather than through conventional financial investment institutions (Maxfield, 2017). Not surprisingly, venerable investment and financial planning firms soon began moving to embrace robo-advising. Major firms, among them Fidelity, Charles Schwab, Legg Mason, and BlackRock, created a significant online presence as a way to maintain a competitive edge (Salinger, 2017).

Applications

The movement toward robo-advisors is largely a metric of two strikingly different generations separated ironically by only a few years but a vast difference in the perception of the reliability of machines and the value and appeal of the human factor. The baby boomers—that is, those born roughly between 1940 and 1955, and their children account for just about a third of the U.S. population. Given their longevity and income levels, they control nearly 90 percent of the wealth in the country. This generation grew up with the concept of the financial advisor; indeed they rely on the counsel and advice of actual people who, in turn, make it their business to understand their financial histories, their family histories, their short- and long-term goals, and their tolerance for risk. These two generations were dubbed the "tweenies"—in that they occupied the middle ground between the postwar period and the explosive impact of computers in the 1970s. They were present for the revolution in digital information but typically remained skeptical of entirely trusting a machine.

By contrast the so-called generation Xers and, most prominently, the millennials, those born at the cusp of the information age and raised within the age of the computer and smart technology, were raised to be comfortable with the concept of machines and at ease with learning and using machine technology. Given the dual generations' comfort with machines, cultural psychologists began to note that these same generations were, in turn, increasingly awkward with basic social skills, less engaged by interaction with people, in fact finding that interaction suspect, distracting, and even counterproductive. As these two generations moved into careers and began to enjoy the rewards of disposable income, they naturally sought out the ease and efficiency of digital advice in their financial planning and investing.

In addition, the concept of creating and sustaining a high volume financial portfolio entirely through the advice and monitoring of a complex computer algorithm brought with it a kind of hipness that those of a certain age embraced. Digital financial planning was initially done on a personal computer, but by 2012, smartphones enabled on-the-go investment management. By 2030, as the financial clout of older investors inevitably wanes, the financial clout of digital natives is expected to dominate the national financial picture. Reliance on the function of information platforms to direct investments will grow exponentially (Lake, 2017).

Robo-advising has transformed the financial investment landscape. Whereas the traditional expectations of the dimensions of disposable wealth able to be directed into planning and investing ranged in the six figures, robo-advising, with its accessibility and its ease of transaction, invites a higher volume of investors with relatively smaller amounts of available investing monies. The average investment account balance of those under the age of 40 now runs as low as $20,000 and seldom pushes much over $100,000. That makes for a far more fluid market and offers far more opportunities for significant evolution in what might have seemed a generation ago far riskier investments in a variety of both conventional and start-up businesses. In turn, the robo-advising market creates opportunities for what are termed limited horizon investments—that is, for an investor in their mid-thirties to set aside a relatively small amount of income to invest in short-term goals, such as a house or a vacation or time off during which a career move can be made—as well as more traditional long-term investment goals, such as a comfortable and secure retirement nest egg (Accenture, 2015).

Issues

The financial world is itself only slowly coming to terms with the long-term implications of machines directing investments based on data and projections rather than the traditional use of intuition and market savvy. Not surprisingly, opinions on robo-advising tend to divide along generational lines, though the pros and cons are fairly established. For those who embrace the technology, robo-advising offers financial decisions uncluttered by individual bias and uncomplicated by personal preferences, hunches, and intuition. Robo-advisors can help track short- and long-term investments efficiently. More to the point, software apps and information platforms do not have conflicts of interest or an incentive to apply pressure to encourage investment because algorithms do not work for commission. The method for forwarding the investment monies themselves is cheap and easy; investments can be executed at home or anywhere an investor has access to a smartphone or tablet. The online software avoids entirely the fees charged by financial advisors, the cost of which as many as one in four investors finds prohibitive (Meinart, 2017). For those who embrace the technology, the idea of a computer making millions of decisions every second in order to create a sound direction for investment portfolios is reassuring, especially as computer advice is seen as smarter than human judgment and, in turn, far more reliable (Spectrem, 2017).

Potential for Market Instability. Robo-advising technology is barely a decade old, and in that time the international markets have remained largely quiet. There have been no tectonic shakeups, no precipitous drops into the kind of bear market that defined the global financial markets during the first decade of the twenty-first century. During such a pitched and volatile period, financial advisors were called upon to evaluate and respond to a market that at times appeared to careen out of predictable paths. Market watchers and researchers question how a computer application designed specifically not to indulge emotion-like reactions will respond to the impact of a downward spiral in the market. A toaster will keep toasting bread and never actually recognize it is on fire. To date, technology lacks the pivot logic built in to human decision making (Levine & Mackey, 2017).

In addition, because robo-advising involves such a high-density volume of trading—literally millions of transactions from thousands of investors per minute—there is no sharply defined and entirely reliable method for oversight to ensure federal regulations are met, transactions reflect actual monies, and that decisions are not driven by illegally obtained information. The SEC is, therefore, scrambling to construct an appropriate oversight platform. Even as the investment industry comes more and more to rely on digital transactions, the ever-present possibility of criminal trespass into the digital platforms persists, and cyberhacking presents the risk of injecting unprecedented panic to the investment markets.

Perhaps the most persistent objection to robo-advising comes from those who identify the human factor as the core of the investment industry. Skeptics argue that investing is not a matter of crunching numbers but rather a matter of assessing personalities, taking the measure of an investment potential, and searching for the implications in the data rather than simply relying on the data itself. The software application that drives the investment portfolio cannot learn about the investor, cannot assess the investor's psychology, cannot pause sufficiently to consider potential options that are not driven by the logic of probabilities.

Terms & Concepts

Algorithm: A set of coded language designed to be strictly followed by a computer to achieve a particular and designed end.

Cyberhacking: The illegal process of modifying and/or redirecting computer directives and/or invading computer records to create an end that the original computer program was not designed to perform.

Human Factor: Term used to describe the influence of particularly human emotional and intuitive responses not expected from technological constructs.

Platform: A digital construct that uses a hard drive and a system of software applications to create a secure and stable network for storing and/or retrieving data.

Portfolio: The full extent of investment currently maintained by an individual or a company.

Risk: In investments, the assessment of uncertainty, that is the potential for losing that investment should the investment be made

Securities and Exchange Commission: The federal agency responsible for monitoring all activities of financial professionals as a way to ensure fair, equitable, and transparent transactions.

Bibliography

Eule, A. (2015, May 23). Robo advisors take on Wall Street. Barron's.

Lake, R. (2017, June 9). What human advisors do that robo advisors can't. U.S. News &World Report.

Levine, M., & Mackey, J. (2017). Human versus ROBOTS: Who to turn to for investment advice. CPA Journal, 87(5), 6–7. Retrieved on November 15, 2017 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=123536633&site=ehost-live

Maxfield, J. (2017). Would you trust this robo advisor to manage your money? Bank Director. Retrieved November 15, 2017, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124494651&site=ehost-live

Meinart, M. (January/February 2017). Of investments and algorithms. ABAS Banking Journal, 109(1), 30–32.

The rise of Robo-Advice. (2015). Accenture.

Robo-advisors not just for kids any longer. (2017). Spectrem High Net Worth Advisor Insights, 13(1), 13–16. Retrieved from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=121354373&site=ehost-live

Salinger, T. (2017). Vanguard, Charles Schwab and Fidelity will reign over robo advisors. Onwallstreet, 1. Retrieved November 15, 2017 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=125268546&site=ehost-live

Robo-advisors

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Subject Terms

Robo-advisors

Abstract

Applications

Issues

Terms & Concepts

Bibliography

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