How Does Robo Investing Work?
Many people dream about building wealth and setting themselves up for an easier life with financial freedom. They seek ways to earn more money, invest, and secure themselves for retirement at whatever age they choose. One such opportunity that has emerged to help people spend less money and time on growing their income is robo investing. Robo investing aims to help individuals manage their assets without a lot of specialized knowledge in investment. This method seeks to avoid the need to hire a financial advisor by using AI-powered digital advisors known as “robo advisors.”
Robo advisors are digital platforms that supply automated, algorithm-driven financial planning services with very little human interference. They work by first gathering information about a client via an online survey and then automatically investing for them using data from historic charts via machine learning encoding. They also take data from the customer regarding their portfolio of choice and risk tolerance level, i.e., how much risk they are willing to take when investing. The robo investor then analyzes and uses the results to give valuable tips on which ventures to invest in moving forward to achieve the customer’s portfolio.
This article covers the risks, rewards, and everything you need to know to start with robo investing.
Table of contents
Also Read: Best Robo Advisors in 2022
What is a Robo Investor?
The terms “robo investor” and “robo advisor” are used interchangeably, but has the same meaning. They are used to describe high net-worth individuals who have money to employ financial analysts. The robo advisor platforms run on algorithms that mimic a financial advisor’s services. These platforms give investors access to automated tools that provide efficient strategies to get a diversified investment portfolio, and it does all this with minimal human supervision – hence the name ‘Robo.’
Robo investing platforms differ in their approach towards investing, and these differences depend on the algorithms upon which they built the platform and the user’s preference. It is all about robotic investment management and investment returns based on algorithmic investment selection and data driven investments starting from your initial investment. Robo investors provide investing services that are algorithmic and data driven, these investing services have no to minimum human involvement.
How Do Robo Investors Work?
When you sign up with a robo advisor/investor, the software will ask you some questions to determine:
- Investor profile – Your preferred investment style.
- Investor preferences – The portfolio you hope to achieve.
It will then recommend diverse types of investment from the various asset classes they offer to help achieve your desired portfolio using the data obtained from your responses. They also consider the market conditions while creating your investment portfolio. The majority of robo advisors in use have investment minimums of $500 for each investing goal in your robo-advisor account. They also show the annual return for each investment / Investment funds and are flexible enough to allow users to withdraw emergency funds.
As your account grows and the value of your asset’s changes, your portfolio may fall out of balance. Most platforms perform automatic rebalancing and automatically buy and sell assets to offset the imbalance created when this occurs. Many robo advisors also have features / investment services that allow you to schedule automatic investments and withdrawals and separate your account into different portfolios; each portfolio can have a different investment style and be geared towards other investment goals.
Also Read: Top 10 AI books for beginners
Role of AI in Robo Investment
Artificial Intelligence (AI) cuts across various industries, and the finance industry is undoubtedly one of them. The ability to program machines to access vast amounts of material and learn, almost like humans, has been a huge driving factor in the application of AI in robo advisors.
In traditional investing, the human advisor accesses the client’s assets and offers professional advice from their experience with various financial tools. They also perform financial planning to develop a financial strategy to achieve the client’s desired portfolio and prepare for any possible financial situation. Artificial Intelligence plays the same role in robo investing, creating intelligent portfolios. The AI accesses every piece of data it attains from the user and uses machine learning to determine the best investment journey for the user.
AI has access to historical price charts of various financial tools, and it has codes that analyze these charts and quickly predict future price trends with its ability to learn. After going through the investor profile, it offers financial advice and becomes more familiar with the investor’s preference from many investments over time. In essence, the AI replaces the traditional advisor only to an extent, as human supervision is still essential in its function. However, this need for human intervention might not be the case for long given current trends in machine learning.
Traditional investors normally take days to go through a huge amount of data. They are also more prone to error in their work. The AI on the other hand is much faster in its analysis. It can process substantial amounts of data within minutes and be more efficient than the traditional adviser.
Benefits of Using Robo Advisors
- The main advantage of robo investing is that it’s beginner friendly. You do not need to know much about the stock market or be an experienced investor to get started. The platform does the work based on the information you provide. Robo advisors are also easy to access; all that is required is access to an internet connection. Also, with their relatively inexpensive fees, robo advisors are a strong choice for investors over traditional advisors. Though financial advisors offer similar services, they are much more expensive than robo investment platforms.
- Robo advisors can help reduce taxes. They do this by offsetting any investing profits you have made with losses to minimize your tax liability (a process known as tax-loss harvesting). However, this is quite tricky as tax-loss harvesting is not always profitable. In some cases, the after-tax returns would be less, thus the investor should never compromise their goals in pursuit of tax savings.
- As explained earlier, robo advisors also help to rebalance your portfolio as you make new deposits and withdrawals from your account. They also help diversify your account, each having a distinctive style or goal. Robo investment platforms are devoid of human bias, making them more valuable than traditional advisors who tend to be blinded by an unconscious bias towards a particular financial tool.
How Robo Investors Make Money
Robo investors are money managers; thus, they make money via robo-advisor fees based on the Assets Under Management (AUM). The costs usually range from 0.25% – 0.75% of the AUM with these values depending on the complexity of the strategy and the amount of money invested with them. These charges are cheaper when compared with traditional financial advisors, who usually charge 1% AUM. They also make money via order flow. Ample funds are accumulated from deposits and interests and executed as a few high-volume orders daily, giving them more favorable terms and profits. They also charge a small commission from clients per trade opened.
Robo advisors also market financial products to their customers. They serve to advertise their products such as investment advice calls, or they can advertise services like insurance for other companies.
Can You Lose Money with Robo Investors?
As with all investments, there is a risk of money loss; however, with robo investors comes the added risk of losing money with rebalancing, costs, investment fees, and tax-loss-harvesting. Robo advisors are also mostly geared toward smaller accounts and limited investment experience. This limited experience means that they are likely to lack advanced services like estate management, tax management, and retirement planning, potentially leading to the loss of money.
The limited range of assets offered by robo-advisors is a concern because you want to diversify your investment portfolio. The diversification issue makes one more susceptible to manipulations in these few financial assets that are tradeable with them and thus more likely to lose money. Also, using robo-advisors limits your investment options as you cannot choose which mutual funds or Exchange-Traded Funds, ETFs, to invest in.
Money can also be lost through a poorly managed portfolio. There is no guarantee that robo advisors would manage your portfolio effectively as they are only as good as the algorithms they were built upon. This is worsened in cases where the client has a high-risk tolerance. The robo advisor might be willing to take a lot of risk on volatile assets in search of higher returns and slight changes in market price against its prediction can wreck the client’s portfolio.
Robo investors are a great option for many (especially novice) investors. Their advanced tools may also be attractive to more experienced investors. However, these services are not free, and robo investing may not be best for every investor. Robo advisors are algorithms, and over time they have been criticized for their lack of empathy and complexity, which users should take note of when working with them. However, this attribute benefits their ability to function appropriately without bias.
Most importantly, always keep track of how much money you invest and how much it amounts to overtime. Always consider fees and taxes when calculating your investment profit.
Robo-advisors are a significant milestone in the democratization of financial services. They operate using algorithms based on modern portfolio theory, aiming to provide an optimized asset allocation tailored to an individual’s financial goals and risk tolerance. This strategy focuses on maximizing returns for a given level of risk by investing in a mix of assets, each representing a different asset class. It does away with the need to pick individual stocks and, in the process, reduces the likelihood of human bias affecting investment decisions.
The operation of robo-advisors starts with the user answering a series of questions. These inquiries generally revolve around financial goals, investment horizon, risk tolerance, and other pertinent aspects of an individual’s financial circumstances. Based on the responses, the robo-advisor constructs a diversified portfolio, often made up of low-cost ETFs, to fit the user’s profile. The target allocation is usually revisited periodically, ensuring that the investment strategy remains aligned with the user’s changing financial landscape.
From a cost perspective, robo-advisors typically have lower management fees compared to traditional investment management companies, mainly because they automate many tasks that would typically be performed by human portfolio managers. Advisory fees may still apply. Some robo-advisor services even offer a low or no minimum investment threshold, making investment accounts more accessible to a broader segment of the population.
In the grand scheme of things, robo-advisors represent a significant evolution in financial services. They offer an efficient, cost-effective means for individuals to invest and manage their wealth, particularly those who may not have the knowledge or time to handle these matters on their own. While robo-advisors may not entirely replace human financial advisors or portfolio managers, especially for more complex financial needs, their rise signifies a significant step forward in the accessibility and affordability of investment advisory services.
Chishti, Susanne, and Thomas Puschmann. The WEALTHTECH Book: The FinTech Handbook for Investors, Entrepreneurs and Finance Visionaries. John Wiley & Sons, 2018.
MBA, Dan Keppel. Best Robo-Advisor: Ultimate Automatic Wealth Management. Createspace Independent Publishing Platform, 2016.
Ranin, Aki. Robo-Advisor with Python: A Hands-on Guide to Building and Operating Your Own Robo-Advisor. Packt Publishing Ltd, 2023.