Although robo-advice will contribute to financial inclusion and helps financially less literate households to be able to invest, it is still not a replacement for financial literacy.
Investopedia defines robo-advisers as digital platforms which provide automated, algorithm-driven financial planning services with little to no supervision. If this sounds too simple to be true, you share the views of Chris Sacca, a well-known American start-up investor, when he first heard about the first robo-advisor proposition from Betterment back in 2010. “I worry that it’s too simple,” Sacca said. “People don’t always trust it.” Understandably, the words simple and trust are not usually associated with investments because they have traditionally been complex and too hard to understand for the average person.
Most investment products come with the risk of losing your money and many people may not fully understand what this entails. Back in 2008, a lot of homeowners struggled because they did not expect the value of their home (asset) to decrease so sharply that it would be worth less than the money that they borrowed in order to buy it (mortgage). The value of a house fluctuates due to various factors, but back in 2008, there was a widespread decrease in house prices. However, at the same time, there was an increase in mortgage rates which made monthly repayments more expensive and unaffordable for many. As a result of these two factors, people couldn’t sell their house to repay the mortgage that they owe (because the asset is now worth less than the loan) which led to foreclosures and bankruptcies.
Since the amount of risk is usually proportionate to the amount you could make, one has to make a call where in that spectrum they would like to be. Usually, younger people can take more risk because they don’t need to access the money straightaway. For example, if you bought Tesla on February 28, 2014, the share price was worth 244. It dipped 2 years later to 151 on February 12, 2016. However, the price has been over 300 since April 2017. Cashing out now would mean making over 20% return on your money in that scenario. If you had to cash out in 2016 though, you would have made a loss.
What is a robo-advisor?
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A robo-advisor is usually digitally accessed via a website or an app because the goal is to minimise or eliminate the need for human interaction. Typically, there are 3 steps to the robo-advice process. First, an initial investor screening occurs where the client will be asked a series of questions to determine their risk-return profile. Second, the robo-advisor will implement these investment strategies and allocate money to the right types of investments for the client’s profile. Finally, they will monitor and evaluate if the client’s investments are performing as expected and re-adjust as required.
Robo-advice is gaining momentum because the cost for advice is cheaper, ranging between 0.15% and 0.67% (of your investments) in the US and 0.8% on average in the EU as opposed to the 1% that financial planners and wealth managers charge. There is also no minimum investment amount making the service accessible to almost anyone who has savings.
Betterment in the US charges 0.25% for their digital service, including unlimited access to licensed financial experts. FutureAdvisor doesn’t charge for advice, but charges 0.5% annual management fee on assets that they directly manage. With the addition of average expense ratios and trading fees, this results in an all-in average cost of 0.65% per year of assets managed.
To provide diversified and low-cost investment solutions, robo-advisors including Betterment and FutureAdvisor mainly invest in exchange-traded funds (ETFs) which are financial assets that are set up to track and match the returns of reference entities e.g. market index and are considerably less expensive to run than other types of investment funds. To this extent, robo-advisors cannot fully replace wealth managers or financial planners who may be able to give you access to other types of investments.
Understanding risks
Aside from being limited to investing in mostly ETFs, robo-advisors also cannot coach clients out of potentially disastrous decisions like your financial planner or wealth manager would. For instance, in a market event e.g. Brexit terms being announced triggered a loss of value to your investments, you might be compelled to pull out of the investment to prevent further losses.
However, your wealth manager might advise to hold on to the investment if he/she believes that it will recover value in the future. In addition, academic literature suggests that taking financial advice is a key determinant of households’ willingness to invest in risky assets. Potentially, your wealth manager can help convince you to invest in risky assets (where you can stand to make more money) if they explain their rationale in a thorough manner that you can understand.
Not all coaching is helpful though, because human advisors would be better than robo-advisors in convincing clients to invest in fraudulent products. Some wealth managers may offer wealth management products that don’t really exist. China Minsheng is a bank that sold a product that provided a return of 8 percent to 27 percent with advisers claiming that the product was risk-free. The bank even offered free golf events and trips to South Africa and other overseas locales to entice clients to invest a minimum of $145,000. Unfortunately, it appears that bank’s wealth management product was forged and did “not exist.”
In conclusion, although robo-advice will streamline the process of investing and make it more accessible to more people due to its low-cost nature and lack of minimum investment requirements, it is still not a replacement for financial literacy. In order to make the best possible investments, we need technological support as well as human expertise.
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This post is brought to you by eToro. All trading involves risk. Only risk capital you are prepared to lose. This content is intended for educational purposes only, and shouldn’t be considered investment advice.
