What is robo advice?

Robo advice in the context of the financial services industry refers to automated investment advice available around-the-clock, over the internet. The process typically begins with an information gathering phase – often in the form of an online questionnaire – before which investments are automatically executed on behalf of the client, based on the data they provided. Robo advice is a quick, cheap, and easy way for individuals to manage their portfolios.

With over $18 trillion in wealth due to be handed down globally by 2030 – from baby boomers to the younger generations – robo advice will only become more prominent, as the likes of millennials and Gen Z increasingly seek digital solutions to manage numerous tasks in their everyday lives. This in part explains the explosive growth that is predicted for the robo advisory market. According to Polaris Market Research, the space was worth $7.39 billion in 2023 and will reach $72.00 billion in 2032.

In this instalment of Finextra’s explainer series, we look at how robo advice works, the unique benefits, the limitations, and why it is so important that institutions begin investing in it today to get ahead of the curve.

How does robo advice work?

There are four key stages that users progress through in order to receive robo advice:

1. Information input:

A robo advisor usually gathers information on a prospective investor by asking them questions through an online survey. These questions explore their current situation, financial aspirations, risk tolerance, investment ethics, and so on.

2. Portfolio compilation:

With this information, the robo advisor customises the financial advice and investments are executed accordingly – typically via exchange-traded funds (ETFs) or mutual funds. 

3. Management:

From this point on, robo advisors can automate the management and rebalancing of the portfolio against the prevailing market conditions and the investor's objectives. 

4. Reporting:

To keep the investor in the loop, the robo advisor will regularly share reports on the portfolio's performance.

So, how are these steps carried out on a technological level? Many robo advisors are algorithmic and rely on passive indexing strategies that look to maximise returns by minimising the cost of buying and selling securities. The advisor will then optimise this strategy using modern portfolio theory (MPT) – a mathematical framework for portfolio construction that ensures expected return is maximised for a given level of risk. The downside of this process is that it usually means the investor is unable to manually select specific mutual funds, ETFs, stocks, or bonds to invest in.

Depending on the information entered at the start of the process around investment ethics, some robo advisors can offer portfolios geared toward socially responsible investing (SRI), green investing, halal investing, and so on. It all comes down to the sophistication and flexibility of the advisor in question.

What are the benefits of robo advice?

By automating investment strategies using algorithms, robo advisors offer users access to fast, simple, and around-the-clock financial support that is aligned to their risk tolerance and goals.  

Here are some of the other key benefits that come with robo advice:

• Lower fees:

Since robo advisors require little back-end input from humans, the fees associated are far lower than those of a traditional advisor.

• Accessibility:

In order to receive robo advice, investors only need access to the internet and a bank account. The barrier to entry is lower than the traditional route too, as the minimum investment requirements are not as high.

• Convenience:

As interfaces, online platforms and mobile apps grant 24/7 access to robo advice – enabling investors to tweak their strategies as and when they please.

• Transparency:

The digitisation of financial advice also boosts transparency; enabling users to see on their screens, in real-time, how their portfolio is performing and against which metrics their investments are being executed. There are also pages dedicated to explaining fee structures and investment options.

What are the drawbacks?

As is often the case with financial technology, automation and personalisation sit on either end of a seesaw; when one is built up, the other necessarily suffers. For all the benefits that robo advice offers, there are drawbacks around personalisation and flexibility.

Here are some of the most common drawbacks that come with robo advice when compared to traditional advisors:

• Inflexible:

Digital advisors are not a one-size-fits-all solution to wealth management. Users do not get a say in which specific mutual funds or ETFs are invested in. The buying and selling of individual stocks or bonds are rarely possible.

• Limited in scale:

Advanced and nuanced financial services such as estate or retirement planning, tax management, and trust fund administration, are not typically covered by robo advice. It is best suited to entry-level investors.

• Inadequate for black swan events:

Since robo advice is automated, its strategy can be scuppered by unexpected crises.  Other events that a traditional advisor would be able to spot – such as a large, unexpected expense or job loss – will not be factored in by a robo advisor.

• An impersonal approach:

A study conducted by Investopedia and the Financial Planning Association found that consumers prefer a combination of human and technological guidance, particularly when times are tough. According to the report, 40% of participants said they wouldn't be comfortable using an automated investing platform during extreme market volatility.

• Lack of emotional support:

Studies in the field of behavioural finance reveal  that consumers often invest with their hearts, rather than their heads – whether they realise it or not. Sometimes, this can have a detrimental impact on a portfolio’s performance. Without the ability to spot and understand an individual’s emotional motivations – as can traditional investors – robo advice comes with inherent risks.

Why is robo advice so important?

In-person financial advice is slowly dying out – especially within the millennial and Gen Z segment. Institutions need to start considering how they will interface with the inheritors of their current customers’ wealth. One such potentiality is robo advice; an increasingly popular choice among the younger, tech-forward generation.

So promising is the potential of robo advice that some of the high street’s biggest names have been investing in recent years, including Aviva, BBVA, Goldman Sachs, HSBC, NatWest, Revolut, UBS, Wells Fargo. In the mid-term, many more will follow suit.