What is a Robo-advisor?

Today, Robo-advisors take many shapes and forms, but fundamentally, we are talking about a digital investment platform. An individual investor, such as yourself, uses a Robo-advisor to manage investments on your behalf. While there is no formal or legal definition for a Robo-advisor, a typical Robo-advisor will help you make investment decisions using a digital app or website. To make investments, you will be required to transfer real money into an account managed by the Robo-advisor. Consequently, that money will be placed into some form of investment product, most often into an investment portfolio of Exchange Traded Funds (ETFs). While in certain scenarios it may be possible to use other products, such as stocks or mutual funds, ETFs are the main products powering Robo-advisors due to their low cost, diversification, high liquidity, and daily price transparency.

Such a seemingly simple tool is helpful to investors for several reasons:

• Access: Traditionally, to make investments, you would have to have a physical interaction of some sort with a financial institution. Initially, this would be done by walking into a branch office, but later by getting in touch with such an institution over the phone or via email. Either way, the inconvenience of these interactions is greatly improved by digital tools such as apps or websites. Further, this access was traditionally limited to the wealthy. To justify a human financial advisor spending time on a customer to manage their investments, significant fees had to be incurred by the customer. This is equally true today, and due to inflation, the time of a professional investment manager has never been more expensive. Further, this cost, which was a percentage of assets, meant that to open an account, you had to start with large sums of investible cash – up to 7 figures for premiere advisors from private banks. Most Robo-advisors have minimum account sizes of just a few hundred dollars, making them accessible to regular people without huge existing savings. In between, some banks and wealth managers may offer so-called hybrid advice, which combines digital platforms with limited human management.
• Convenience: While anyone could learn to invest on their own, most people choose not to. If you’re a busy professional, or simply have better ways to spend your time than reading annual reports like Warren Buffett, then you don’t have the time to not only research the market but learn the tools of the trade used by professional investors. Apps such as Robinhood have made it easy to make investments, but at the end of the day, are you comfortable making those decisions on your own? If you stick with index funds, then which ones do you buy, and in which ratios? Even simple investing involves a huge amount of decision-making. Robo-advisors simplify the process of investing by abstracting away things such as portfolio and order management and instead ask you about how you feel about risk. The rest is taken care of on your behalf.
• Cost: Robo-advisors typically charge a small percentage of your total assets on the platform as an annual fee. Compared to traditional investment advisors, who might charge as high as a few percent per year at the high end, or typically around 1%, a Robo-advisor might charge you a fraction of a percent. This is, again, largely driven by automation – there is simply less human cost required to manage your account. On paper, if you already know what you’re doing, you could save even more by building a portfolio of ETFs on a low-cost online broker. It just means you will have to also invest the time to track performance and perform rebalancing, and that time is money too. To further justify their fees, many Robo-advisors offer additional conveniences such as tax reporting and optimization.
• Psychology: If you’ve never invested before, you may not yet be familiar with this problem. This has been an area of research for decades, and there are many known traps that investors fall into when they manage their investments. These include the sunk cost fallacy and the loss aversion bias. Humans aren’t all the same, but all of us have our own set of biases and quirks that make it very challenging to remain objective when it comes to making decisions about money. The benefit of a Robo-advisor in this regard is that it simply removes a lot of this decision-making from you, instead relying on compound interest, some simple math, and time to produce a return on your investment.

These are just the fundamental principles behind the design of the first generation of Robo-advisors. Many of these platforms now also offer other services and products, such as debit cards, loans, and the ability to trade single stocks and crypto. Over time, your financial life may increasingly revolve around your Robo-advisor.

Now that we have an idea of why Robo-advisors were created, we should look into how they work, and the various components that are required to build one.