Roboadvisors, or ‘robos‘ for short, have disrupted traditional wealth management especially for the mass market and retail investors – thanks to their client-centric platforms, ease of access, convenience and low-cost approach to investing.
Aided by technological advances in back-office automation and artificial intelligence, robos use algorithms to help investors select an ideal portfolio tailored to an individual’s risk profile.
Some robos also complement the digital process with a financial adviser for that unique human touch, bringing a hybrid solution to wealth management to meet the increasing demands of today’s retail investors.
In this article, we explore why retail investors should consider using robos to help manage their finances.
#1 – Robos simplify the investing process
Robos simplify the investing process by using technology to help profile an individual’s risk tolerance, determine a suitable asset allocation and offer a diversified range of portfolios for any investor to get started in investing.
The risk profiling stage is important and is usually offered before recommending any product or portfolio because it determines how much risk the investor is willing to take – and correspondingly how much loss the investor can take without selling and realising those losses as financial markets move up and down on a daily basis.
Most robos start off by asking you several questions about yourself – such as what you’re investing for (e.g. is it for retirement or general investing?). Answers to these questions will determine your time horizon for investing – the longer your time horizon, the more risk you can afford to take with your investments.
Secondly, rather than always waiting to get started because you have no idea what you’re doing with your money, robos have the knack to help determine which ETFs or funds to buy based on your risk profile and return expectations and help you invest early – so that you have enough time on your side to accumulate wealth through compounding of interest and dividends.
With custom portfolios (e.g. growth vs conservative) catering to a wide range of investors and experience levels, robos can help with long-term wealth-building for almost any type of investor thanks to their range of product offering.
While some investors prefer selecting their own portfolios, adding regional or sector tilts where needed, robos usually select their portfolios based on algorithms and backtested data to select the best combination of funds that maximise your returns for the given level of risk.
For example, data points such as liquidity, expense ratios, tracking errors and returns can be automatically fed into an algorithm to determine the best choices of ETFs and funds for a given individual.
Robos also allow you to utilize your idle CPF or SRS monies and invest them into a diversified portfolio of funds after accounting for your financial goals – allowing you to earn a higher expected rate of return over the long term – something that conventional fund managers would not be able to do.
#2 – Robos help you manage risk
Risk management is the core philosophy of robos. Traditional investors like us tend to take either too little (e.g. too much cash) or too much risk (e.g. concentrated portfolio of stocks), making us vulnerable to any idiosyncratic or company-specific downsides or negative news events.
The benefit of robos is that they invest in a diversified portfolio of securities in a single purchase – meaning that you can never lose all your money should a single company in the portfolio goes into the ruins.
What diversification does investing your portfolio into a hundreds or thousands of different securities in different asset classes – stocks, bonds, real estate etc. The benefits of diversification can be most felt when the asset classes are uncorrelated to each other, i.e. they don’t move in tandem.
According to the modern portfolio theory (MPT) developed by Harry Markowitz in 1952, diversification is the only free lunch in the world, by de-risking your portfolio significantly while enjoying the upside of expected returns of the market.
Diversification is difficult to achieve on your own. To achieve a diversified portfolio of stocks, excessive trading commissions need to be incurred, which might be a barrier to getting started.
One way to achieve broad-based diversification is through an ETF, or exchange traded fund, which gives you exposure to an index of securities in a single instrument. Of course, some ETFs might still be localised to a specific country or theme depending on the index that is chosen as the benchmark, which may not be sufficiently diversified to an investor.
With robos, you can get exposure to a portfolio of multiple ETFs, meaning even broader diversification than what a single ETF would give you.
Most robos in the market have backtested algorithms for their portfolios. Backtesting helps you analyse how the portfolio would have performed with a certain degree of confidence using historical data, and this allows investors like you evaluate the performance of individual portfolios during different market conditions – including times of crisis.
We have to be careful, however, as backtested portfolios do not give any visibility over the future performance of the portfolio, especially when unexpected economic events do happen and no two recessions are exactly the same.
Most robos have automated risk management algorithms that automatically rebalance your portfolio to the target asset allocation – a phenomenon known as rebalancing.
Let’s say you have an asset allocation of 50% stocks and 50% bonds. When stocks do really well and shoot up in price, the allocation of stocks in your portfolio might increase to 60%, which increases the volatility of your portfolio returns – since stocks do swing much greater in both directions compared to bonds.
What rebalancing does at this point is that it brings your portfolio back to 50/50 by selling stocks and buying bonds, locking in the gains from your stocks and helping you “buy low, sell high”.
Most robos have some sort of auto-rebalancing feature built into their investment algorithms, which means the whole process requires no additional effort your on end – so you can be assured that your risk is always managed properly.
#3 – Robos keep you disciplined
To keep investing and not panic sell when markets crash is a psychologically difficult thing to do – because most investors are risk-averse and they want to cut their losses.
After the 2008 financial crisis, where the US stock market crashed by almost 50%, most investors sold their stock at a low and missed out on almost 400% gains when the stock market rallied afterwards.
Robots keep you disciplined by encouraging you to stay the course, have regular deposits and dollar cost average by continuing to invest regardless of whether markets are high or low at that point in time.
Dollar-cost averaging is a useful tool to increase your portfolio holdings at a lower price, something you want when you are young because you have the ability to wait out the wild fluctuations of the market, in hope that the market will rise over the long term.
Robos also help to reinvest the dividends received from your portfolio into the market, making sure that all your idle cash is put into good use while helping you maintain your target asset allocation.
Conclusion
The world of robots is still in its early stages, given how technology has democratised investing in recent years, we should expect to see further innovations in this exciting space.
Most robots have a free trial for you to explore to see if they are suitable for you. With fees ranging from 0.5% to 1.0% of assets under management per annum, robots quickly get expensive as you invest more with them.
Nonetheless, if you’re looking for a simple and automated solution to manage your wealth, then robots should definitely be in your consideration list.
Editor’s Notes: First, a standard disclaimer. Investing carries risk always. Do not treat this article as an excuse to not do your homework. While robots can control risks to an extent greater than most people, the final product of all investments is yourself. You control your fears, greed, risks far better than any algorithm if you have the presence of common sense. If you are not gifted with it, for it is a gift, allow the machines to run it for you. That has been, and almost always will be, a far better choice vs our own much more flaky commitments.
I will leave you here with an anecdota from “Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors“.
In 2012, Greenblatt (Joel Greenblatt of the Magic Formula) conducted a study into the performance of retail investors using the Magic Formula over the period 1st May 2009 to April 30, 2011. Greenblatt’s firm offers two choices for retail investors wishing to use the “Magic Formula” – a “self-managed” account and a “professionally managed” account.
The self managed accounts allows clients to choose which stocks to buy and sell fomr a list of approved magic formula stocks. investors were given guidelines for when to trade the stocks but were ultimnately able to decide when to make those trades. Investors selecting the professionally managed accounts had their trades automated. the firm bought and sold Magic Formula stocks at fixed, preset intervals.
During the 2 years, both types of accounts were only able to select from the approved list of magic formula stocks.
So what happened?
-Self-managed accounts underperformed, showing a 59.4% return after all expenses vs the 62.7% of the S&P500 over the same period.
-Professional accounts returned a total of 84.1% after all expenses, beating the S&P and self managed accounts both by over 20%.
That’s a huge difference for people who had the same list of stocks to choose from and the same method.
Why was there such a difference?
First, self-managed investors reliably and systematically avoided the biggest winners, many of whom were cheap and probably because they seemed scary at the time.
Second, self-managed investors sell after a period of underperformance – either the strategy underperformed for a period of time or the portfolio simple declined. Making things worse, these investors only bought after the stocks outperformed and had gotten expensive – the equivalent of selling low and buying high.
Learn this lesson well.
If you cannot trust yourself to make uncomfortable, gut-churning, sticky decisions, do not invest by yourself. Learn to use a system or a model. Or use a robo. The choice is yours.