Technological innovation in the financial industry has reached the wealth management services industry where automated financial advisors, known as robo-advisors, are starting to compete with human advisors. In a new policy brief, we examine the benefits and limitations of robo-advisors, as well as their potential to foster financial inclusion.
The main feature of robo-advisors is that the entire process of portfolio investing (from opening an account to monitoring the portfolio) can be performed online with no human interaction. Robo-advisors start by conducting an online short questionnaire to assess a client’s investment goals and risk profile. Based on a client’s responses, robo-advisors use automated algorithms to make recommendations on how to allocate funds across different assets. Robo-advisors typically offer low cost, diversified portfolios by offering to invest in exchange traded funds (ETFs) and index funds. Besides recommending an initial allocation, algorithms are generally designed to monitor deviations from targeted risks and automatically rebalance the portfolio.
Robo-advisors can provide several advantages over traditional human advisors. Robo-advisors can be conveniently accessed at any time, from anywhere with an internet connection. Furthermore, because they save on fixed costs (such as salaries of financial advisors or maintenance of physical offices), robo-advisors can reduce minimum investment requirements and charge lower fees. Automated algorithms can also perform “tax harvesting” more efficiently than human advisors and reduce behavioral biases (such as subjectivity, domestic bias, or limited capacity to follow multiple assets). Note, however, that even when robo-advisors are used, some biases might still be introduced during their programming.
The benefits of robo-advisors come at some costs. Client assessment through “one-size-fit-all” questionnaires might be too simple to adequately evaluate a client’s needs. Robo-advisors also lack other aspects of a client-advisor relation, such as helping clients set financial goals and counseling during market downturns. Automation of the investment process can also lead to consumer disengagement because consumers might not make efforts to understand how the service works or continuously monitor their investments. Because robo-advisors are relatively new, their business models have not been tested in the long term and under financial stress.
Because of their low cost and easy accessibility, robo-advisors have the potential to promote more sophisticated investment practices within a population not used to having access to financial advisors as well as allow current investors to build more efficient portfolios. Proper regulation and supervision will be a key determinant of the success of robo-advisors. Policy makers would benefit from establishing good practices that guarantee that robo-advisors are objective, transparent, and provide advice appropriate to each client’s needs.
The robo-advisory industry is still at an early stage and, as such, not much is known about their actual impact on the financial system. As robo-advisors expand and more information on them becomes available, further insights on these topics would help to better understand their true potential and pitfalls.
Abraham F., S. Schmukler, and J. Tessada, 2019. “Robo-Advisors: Investing through Machines.” Research and Policy Briefs No. 21, World Bank.