In Robo We Trust.

Investing is one of those concepts that can sometimes sound like it’s a foreign language.  Whether it’s “passive v. active”, “stocks v. bonds”, “mutual funds v. ETFs”, it can get very easy to get caught up in the minutiae of it all.

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The truth of the matter is that investing can be as simple or as complex as you want it to be.  For example, saving for retirement can be as simple as choosing a Target Date Fund (a diversified portfolio that gradually becomes more and more conservative as retirement approaches) or as complex as hand picking stocks and bonds for your portfolio.  The first approach is completely fine if you have one goal in mind and know exactly when that goal is going to occur.  If you’re in your 20’s and know exactly when you’re going to retire and how much you’ll need in retirement, the first approach will suit you just fine.  However, for the rest of us, it might be helpful to get a second opinion.

There’s always professional wealth managers we can hire who can customize a portfolio for you, but those can sometimes require minimums of at least $200,000, $500,000 or even $1,000,000+, not exactly pocket change for those of us in the early stages of our careers.  Or you can schedule a meeting with a financial planner and get a one time second opinion on how your portfolio is organized/structured.  Often times, these traditional wealth managers can charge a fee of 1% to 3% to manage your money, not exactly chump change in the long run.  However, for those of us who are comfortable with an impersonal relationship with the person/team managing our money, a robo-advisor could be the answer.ba-bi057_roboad_g_20150521190606

What is Robo Advising?

Robo-Advisors are a growing class of financial advisors that provide financial advice and/or portfolio management online with very minimal human intervention.  To understand how they work, it’s important to quickly understand a few simple investing terminologies:

Passive Investing: Passive Investing assumes that it is practically impossible to beat the market in the long run.  Rather than trying to earn a relatively impressive additional return (“Alpha”) over the market, the passive investor merely accepts the market return and seeks to minimize costs/fees that can be a drag on performance.  Passive investors typically invest in a portfolio of market index funds such as the S&P 500, Russell 2000, NASDAQ, etc. that have fees between 0.03%-0.25%.

Active Investing: Active investing is the belief that by analyzing either the economy, market or even individual companies, there are securities that are undervalued and can be purchased and perform better than the market on a whole.  This is no easy task and is certainly not cheap.  Typical active management funds charge anywhere between 1% to 2% or even more, which can sometimes offset the additional return that active managers provide over the overall market.

Robo-Advisors typically create a diversified portfolio of passive funds to minimize cost.  They use complicated algorithms that takes into account your risk profile, goals, and individual preferences to design a portfolio of passive funds that suits your unique needs.  The goal is to have as little human intervention as possible to minimize fees.  The result is a customized portfolio that automatically adjusts based on changes to your specific needs and the overall market with a minimum of a little as $500.

Why was Robo-Advising introduced?

For many Millennials who grew up during the Global Financial Crisis of 2008, investing is simply not something that many are eager to jump into, for very understandable reasons.  Many Millennials watched as many of their friends family members lost significant money in the market and have acquired a distrust for the financial markets.  In addition, frauds such as the Bernie Madoff scandal have instilled a sense of disbelief for the finance profession, so trusting a financial advisor with your life saving is simply that much more difficult.

On the flip side, Millennials have also developed a sense of “do it yourself” with the rise of the internet.  Why should I have to pay to have someone invest my money when there is literally thousands and thousands of different articles out there for free with all the information I could possible want.  They are increasingly comfortable relying solely on the internet for banking, so why not investing as well?

Who are the major players when it comes to Robo-Advising?

It appears that Vanguard, Charles Schwab, Wealthfront, and Betterment have been leading the way when it comes to robo-advisors and have the largest assets under management for robo-advising (as of 2/28/17).  Vanguard and Charles Schwab make sense as these are both traditional and well established low cost financial firms.  Wealthfront and Betterment are both relatively new robo-advisors founded in 2008.

Time will tell whether Robo-Advising truly takes off as a major test of an investment product is how well it performs in a down market.  As many of the robo-advisors were formed during the near-bottom of the financial crisis in 2008, it will be interesting to see how these portfolios perform during the next market correction.

 

 

 

8 comments

  1. Great post on a topic that is starting to have a huge impact on the financial industry. I am interested to see how this trend of robo advising will play out… will the robots prove to be more effective passive investors over the long term due to the removal of human error? Will technology eventually improve enough for them to expand into active investing as well? Only time will tell but this is already disrupting the industry as we know it today!

  2. Great post, and certainly something to think about. Robo-advising seems to me as though it has positives and negatives to it. Removal of human error is important, but yet something makes me feel more confident in letting a human handle my money rather than a robot. It will be interesting to see how the Robo-advising will work in a down market, but the fact that one can try it out with as little as 500 dollars makes me think of wanting to try it in the future.

  3. Cool post! I had no idea that this was a technology that’s readily available to the common investor. I like the thought of having a machine running an algorithm handling my money. With a machine, if programmed correctly, you can be guaranteed that they are acting in your best interest in a completely unbiased way. With all this talk about fees for financial advisors and whether or not they have a fiduciary responsibility to investors, its nice to know there is another option.

  4. Good summary of robo financial services and who stands to use their services in the immediate future. Millennials are certainly much more trusting of technology and automation than previous generations, so it’ll be interesting to see the growth of robo advising once we become the highest earning sector of the employment market. The positives of making investing more accessible for people are obvious, but I wonder what types of ripple effects there will be once this is the primary way most people invest? Will there still be a need for human financial advisors or a market for high-fee actively managed funds? I’m not sure.

  5. Really enjoyed reading this informative post with my finance background. I agree with @benschaefer88 in that I had no idea this progressive technology is pretty much available to everyone. I feel like a lot of people will seek out the robot-advising methods when it comes to creating portfolios. However, I feel like many people could be skeptical in trusting a robot with their money due to potential glitches or malfunctions that could possibly be avoided by a human advisor. Great post!

  6. I have to admit, I am not sure if I would be comfortable with robo-investing. That being said, I would NEVER trust myself (without guidance) to invest by myself. So maybe robo-investing is something I should feel less apprehensive about. It is interesting because a robot has quicker access to information and may help make better and safer decisions for this reason. I am also interested to see if this gains popularity in the next few years.

  7. Great post! I do think there is a lot that goes into investing that should be done by a real human given how markets can change on a whim. However, like you mentioned, for someone with no experience with investments and a small budget for fees, robo-investing is a great option to have. It often frightens me to see some of my friends and family members with such little understanding of investing and it’s importance in our lives and futures. I think there should be mandatory classes in high school on investing for retirement and future expenses (college, house-buying, kids, etc.), but since there isn’t and a lot of people don’t understand it, this robo-investing could be a huge asset. Thanks for posting about this!

  8. I think Robo advising is definitely a solid trend that’s here to stay. I’d want to be sure that the robot is paired with a human though, because situations may arise that require manual intervention. The flash crash is a good example of how unsupervised algorithmic trading can go awry. I know that’s not a perfect analogy, but it’s close enough.

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