Robo Advisors: Are They Actually Profitable?
Robo advisors have made a big splash in the investing world. But are they really all they’re cracked up to be?
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Robots and automation have changed virtually every sector of the human economy in recent years. From self-check outlines at the grocery to automated Amazon warehouses that select, wrap and ship your purchases, robots have found their way into virtually every sector of the economy.
Robots can be programmed to handle routine mechanical tasks and more advanced AI can detect patterns humans cannot.
AI software has made a very large impact in the financial sector. Financial organizations routinely use automated software to check credit, protect identities, make payment transfers more secure, and assess risk in markets.
Robots have also carved out their own niche in the investment world. Automation tools called robo advisors allow for quick investments, price checks, and quotes on time scales much narrower than humans could manage. According to US News, as of 2018, robo advisors manage more than $224 billion in total assets and that number is expected to increase to over $400 billion by 2022.
As robo advisors garner more attention, many wonder just how well these platforms work and whether they are as profitable as traditional human-directed investment. We’re going to take a deep dive into the world of robo investing and answer some important questions about how effective robo advisors actually are.
What Are Robo Advisors?
Robo Advisors are essentially automated software applications that buy and sell securities based on predetermined user preferences. Robo advisors can be programmed to manage investments autonomously with little to no human input. The user sets their investing preferences, and the algorithm takes care of the rest.
Strictly speaking, the term “robo-advisor” is a bit misleading. Robo-advisors do not actually advise you on your investments—they just automate the routine parts of the investment process. When combined with a proper investment strategy, robo advisors can be a good method to maintain a passive stream of income.
The exact specifics of robo advisors differ from broker to broker. In general, the term refers to management software that handles your investment portfolios. Many robo-advisors are 100% automated but some give access to human advising services too.
Want to know more? – Read our intro guide to robo advisors.
How Do Robo-Advisors Work?
Robo advisors use complex algorithms to invest your money. Now, you might be skeptical at first.
After all, how can a machine reduce the complexities of investing to some step-by-step list of instructions? You would be surprised though.
Robo advisors use algorithms based on cutting edge economic research. Most current robo advisors algorithms are based on Modern Portfolio Theory (MPT), first introduced by Nobel Prize-winning economist Harry Markowitz.
MPT is a mathematical framework used to optimize the diversification of investment portfolios. MPT frameworks judge the suitability of an asset based on how it contributes to overall risk and return.
In other words, robo advisors are built using the absolute best economic models of investing. They are built incorporating key insights of the economic sciences to maximize return on investments.
Robo advisors allow account holders to adjust their individual risk preferences so they can create a custom, automated investment strategy.
Pros of Robo Advisors
Given that they cut out costs by removing the human element of investing, robo advisors have very low fees, much lower than most traditional advisors. Robo advisors usually have no minimum required investment and can have annual account fees between 0.25% and 0.50%.
This comes out to an annual fee of just $25 for $5,000 under management. Most robo advisors have entirely eliminated commission fees on day trades. That means you will not have to pay every time you buy or sell securities.
Removes Human Element
Robo advisors are built using cutting edge models of economics. These models are designed to maximize the return on investment from any investment and how to diversify your portfolio to mitigate risk.
Some may be skeptical relying on mathematical models to make investments instead of human intuition but robo advisors are objective and do not make decisions based on emotion. Emotional behavior in markets can drive negative patterns of buying and selling. Robo advisors stick to the script and don’t let emotions cloud their judgment.
How do robo advisors stack up against traditional advisors – read our detailed comparison.
Low Barrier for Entry
Many younger people may want to get into investing but they lack the requisite funds. Robo advising offers a low-cost way to get into the investing world.
You can open a robo advisor fund with just $50 in your pocket and the low-fees incentivize experimenting with trading and figuring out your ideal investment preferences. Many robo advisors also offer extra human-advising fees for an extra fee.
Contribute to Competition
Like any new product in a market, robo advisors drive competition and growth. The introduction of robo advisors contributes to the development of the field and many larger established investment firms are making changes to reflect this competition.
Many big firms are launching their own robo advising services or incorporating automated tools in their investment strategies. As robo advising brings the demand for investing to more people, we can expect the market to change to follow suit.
Cons of Robo Advisors
Despite the name, robo advisors do not advise you. A robo advisor cannot talk you out of making an unwise investment and it can’t help you determine your financial goals or help put together long term plans for retirement.
A good number of robo-advising firms partner with human experts for advisory services.
Limited to Simpler Investments
Robo advisors do simple things really well which is why they are good for passively managing something like index funds. However, robo advisors, as of this point, cannot engage in more complex investment plans.
No “Personal Touch”
Some criticize robo advisors because they lack the “personal” touch that human investors give. Human investors understand that you have goals, loved ones, and emotions, and can match your investments to follow suit.
Do Robo Advisors Work?
So the big question—do robo advisors work? That is, are robo advisors any more effective than traditional advisory services and can they generate profits?
Robo advising jumped into public perceptions in the wake of the 2008-2009 financial crisis. During that time, market flight discouraged investment, deterring the activity of investors. Companies like Wealthfront and Betterment stepped up and started using algorithms to help investors diversify their assets.
S&P Global Market Intelligence estimates that the total value of assets managed under robo advisors will grow to $450 billion. That is a fair bit of growth considering that the robo advising sector has only really gotten off the ground in the past 10 years.
Moreover, we can look at the individual performance of robo advising firms. Betterment, for example, has historical data about investment performance.
According to their data, Betterment robo advisors would have outperformed the average investor 88% of the time in the last decade. Based on investment data, Betterment robo advisor accounts have managed to outperform the market at pretty much every asset allocation ratio.
Vanguard, another large robo-advising firm, also has calculated their average returns. According to Vanguard data, a $10,000 investment made in 2010 would have grown by more than 150% in the last 10 years.
Vanguard calculates that their average return for a 5 year period comes out to about 7.56%, slightly higher than the average calculated return for Betterment. Going back 10 years these figures become 5.8% and 4.7 percent for Vanguard and Betterment. Wealthfront, another firm, estimated an average return of 4%-6%, depending on your risk tolerance.
Now to be clear, past performance does not guarantee future success, and some robo advising firms have done fairly poorly. No matter how smartly you invest your funds, you can always get unlucky.
The truth is that robo-advisors have not been around very long, and there is a lack of legitimate longitudinal data regarding how effective they are in the long term, or how viable their fee model is compared to traditional money managers. However, based on the data we have, it seems that robo advisors are just as effective as traditional investment services over the same time periods and can secure a return at or above the average rate.
Many experts claim that robo advisors will become more effective once humans get used to the idea of a robot handling their assets. Some firms, like Vanguard, handle the robot controversy head-on and make sure clients always have a human between them and the machine.
Further, new research indicates that people, especially younger generations, are comfortable investing with a robot and generally expect machines to get better returns than humans. This incentive for higher returns could drive more people towards robo advisors which, like a self-fulfilling prophecy, will make robo advisor firms larger and more effective.
Robo advising is a great application of AI software to the financial industry and has made a mark for itself in the past decade. Initial data shows that robo advising is just as effective as securing returns as traditional investment services.
What’s more, robo advisors have generally lower fees than traditional investment firms and they allow you to handle your life without having to worry about your finances. Robo advisors can provide that ever-important sense of security you need when investing.