How does a Robo-advisor work?
Our ultimate goal is to build a Robo-advisor, so we must begin to unpack the concept into its constituent parts. We will dedicate lots more time to this question in Chapter 2, What Makes Up a Robo-Advisor?, and beyond, but to set the stage, let’s establish some basics. The core features of any Robo-advisor include:
- An app or website user interface
- Questionnaires for profile information, risk appetite, and Know Your Customer (KYC)
- Portfolio modeling, construction, and recommendation
- Automated account opening, management, and transfers
- Automated order management, execution, and rebalancing
- Performance modeling and monitoring
- Reporting and statements
Fundamentally, what makes a Robo-advisor a Robo-advisor is the element of automation. It’s not simply making investing digital, as that has been done before and is being done today. If there are just humans on both sides of the screen making all the decisions, then it’s not considered a Robo-advisor. Mind you, you can have something called a hybrid Robo-advisor, which is just to indicate that there are different degrees to which this automation can be done. Initially, the plan was for Robo-advisors to be fully automated. Effectively, the customer using the Robo-advisor would be interacting with nothing but technology and algorithms making investment decisions. The later addition of hybrid implies a higher degree of human involvement in the form of a financial advisor. Both flavors of Robo-advisors continue to exist and thrive today.
The core investment decision being made is what to invest in. Such questions are traditionally highly regulated by government entities whose exact roles and guidance vary by country. This guidance has been clarified over the past decade as it relates to how Robo-advisors are allowed to operate in their decision-making. For example, you might imagine that some fancy artificial intelligence is making the investment decisions inside of a Robo-advisor. I used to get that question a lot, myself. The regulations tend to forbid that explicitly in favor of clear rules on how investment decisions must be made based on risk scoring. The most common form of risk scoring is a simple questionnaire. Depending on how a customer answers this questionnaire, they will be placed into conservative, moderate, or aggressive investments. These terms simply indicate the amount of risk a customer is willing to accept when making investments and is then the basis for the Robo-advisor allocating customers to specific investments matching that risk score.
We’ll get into all of that in much more detail later when we get hands-on, but before that, let’s go back to the beginning to understand how this all started.
