Rise of the Robo-Advisor: 4 Advantages to Automated Advising

July 20, 2016
DMD Staff

Algorithms can process huge amounts of data in order to come up with predictions about future market trends. Does this mean they can replace human financial advisors?

Editor's Note: This is the first of a two-part series on "robo-advising." Check back next week for Part 2.

The machines are coming, and like Terminator 2’s terrifying, shape-shifting T-1,000, they use complicated technology. They’re called robo-advisors, and while they aren’t looking for Sarah Connor, they do use advanced programming to manage and administer investment portfolios. An industry shaken by a new Department of Labor “conflict of interest” rule and some recent market volatility is turning to them to redefine—and automate—financial advice.

First, what is a robo-advisor? It’s an automated, algorithm-based wealth management service that uses large quantities of data to try and predict investments that will outperform the market. Think of it like playing chess against the computer. Wait, on second thought, don’t think of it like that. Chess, though it has millions of variations, is ultimately a finite series of moves. Stock performance, though typically associated with less variation than chess, has the potential for infinite variation. Think of robo-advisors, instead, like meteorological models; using past and current data to predict future performance.

For now, robo-advisors are being used only in predicting investment performance, and not in more personal avenues of financial advice, such as tax planning, assessing insurance needs, or estate planning. Like almost anything else, the use of robo-advisors has its pros and cons. (Bacon is the exception; it has only pros!) Here’s a quick look.

Advantages of Robo-Advisors

Low(er) fees: Fees eat away at investment performance, so the lower they are, the better off you generally are as an investor. Because the algorithms used by robo-advisors can be developed and then customized, they are cheaper than human labor, and the fees range from practically free (Charles Schwab’s innovative service) to a fraction of professional investment assistance.

Legitimate—and powerful—algorithms: The move to robo-advisors isn’t about replacing human labor like the shift from bank tellers to ATMs. It’s about algorithms that have literally won Nobel Prizes for the economists who invented them. If the idea of a machine picking stocks seems impersonal, consider that robo-advisors are built to control for both market randomness and human emotion. It’s a little scary.

Access for all: Investors of lower net worth can rarely work with the top advisors, who work mostly with high net-worth investors. Robo-advisors even the playing field, allowing easy access and lower fees for investors at all levels.

Customization: You might think the algorithm by its nature means robo-advisors are limited in the kinds of investors they work for and the kinds of investment advice they offer. That’s not the case at all. You can customize investment planning for certain sectors of interest, and even set some limitations. For example, some investors prefer to steer clear of “sin” stocks such as tobacco and liquor companies. Robo-advisors are customizable in many ways for many different tastes.

While robo-advisors have substantial and positive attributes, you won’t be at all surprised that there are significant drawbacks as well. They include the fact that robo-advisors, unless they are truly advanced, won’t consider your overall long-term financial goals in accordance with your circumstances and other issues that may influence your investment decisions.

We’ll cover this in more depth, along with some common misconceptions about robo-advice, in Part 2.

We’ll be back.