Jul 28, 2017 by Dwaipayan Bose
Some of our readers may have heard about and even used robo-advisors for making mutual fund investments. Robo-advisors are now very popular in developed countries like the United States and though robo-advisory is still a relatively new concept in India it is gradually gaining popularity. If you follow discussion threads related to robo-advisors in the social media and other online discussion forums, you will see that there are conflicting opinions both in favour and against robo-advisors.
I have seen that, views expressed in online discussion forums (including social media) are usually based on individual preferences, experiences or vested interests. For example in discussion you will notice two very divergent assumptions with regards to mutual funds investors. One assumption is that, all investors barring HNIs are naive and need hand-holding in making investment decisions. The other extreme assumption is that, all investors are mature enough to make investment decisions and execute them. The reality is that there are investors with varying degree of maturities, experience and knowledge. In Advisorkhoj we recognize the diversity (in terms of maturity and knowledge) in our investor population and try to critically analyze different perspectives keeping the diversity in mind. In this post, we will discuss about robo-advisors and there suitability for different investors.
What is a robo-advisor?
As the name suggests robo-advisor is robot giving you financial advice. However, this robot is not like a walking, talking robot we see in movies. A robo-advisor is essentially a computer algorithm where you can input your investment needs and get investment recommendations. Many robo-advisors also offer online mutual fund transaction capabilities. They are available online on the websites of wealth management firms / mutual fund distributors and registered investment advisors.
How does a robo-advisor work?
Most robo-advisors follow a standard process flow that has four broad steps. In the first step, you are required to input details like your age, investment goals (including investment horizon), risk capacity and investment amount. Most robo-advisors ask investors to fill in an online questionnaire to assess their risk capacity. Once you input all the necessary details the computer algorithm will determine your optimal asset allocation (e.g. debt and equity) and asset sub-category allocation (e.g. large cap equity, midcap equity, long term debt, short term debt, money market etc). Some robo-advisors give investors the option of fine tuning the asset allocation.
Once the asset allocation is determined, the robo-advisor then generates fund recommendations for the investors. The final step is the actual execution, which includes KYC (Know your Client) checking and e-KYC if required and then online purchase of mutual fund units. Some robo-advisors may stop at the third step (fund recommendation), but most reputed robo-advisors offer online transaction capabilities.
Misconceptions regarding robo-advisors
Some investors think that, online investment automatically implies investing in direct plans. If you are investing through robo-advisor offered by a mutual fund distributor then you will be investing in regular plans.
Some investors think that, they have to pay a fee for using robo-advisors. If you are using robo-advisor solutions offered by mutual fund distributors then you do not have to pay to use the tool because mutual fund distributors get their commissions from the Asset Management Companies (AMCs). However, if you are using a robo-advisor solution offered by a Registered Investment Advisor (RIA), then you will have to pay a fee to the RIA because using the robo-advisor solution of an RIA, you will be investing in direct plans of mutual fund schemes.
Some investors think that they are susceptible to online frauds when investing through robo-advisors. You should know that, the robo-advisor is not all involved in the financial transaction of the mutual fund purchase. Your money will be routed straight from your bank account to the asset management company (AMC) which will allot you mutual fund units.
Advantages of robo-advisors
Many people prefer to do things themselves instead of relying on another person. DIY (do it yourself) gives people a sense of control over their work and is an increasingly becoming a popular trait especially among technologically savvy and younger sections of the population.
Careers are becoming increasingly busier. Some people may not have the time to meet with a financial advisor and explain their requirements to the advisor. Mobility has also increased and people are constantly on the move. So they may not want to be tied with in an advisor in a particular location. Robo-advisors give investors the flexibility to make investments from any place, at any time (even at the middle of night).
Most of the robo-advisors are very user friendly and require only basic computer knowledge to use. However, the user interface and experience will differ from solution to solution. Some robo-advisors are very sophisticated and others are fairly basic. You can choose a robo-advisor based on the kind of interface and experience you like.
Many people value judgement which comes from experience, but judgement can be subject to understanding, personal biases and human errors. Since Robo-advisors are algo based, it takes out subjectivity from investment decision making and makes the exercise objective.
Psychologists say that humans can never be bias-free. Even if a financial advisor works in the client’s best interests, there can be biases in his or her recommendations. Robo-advisors, being algorithm based, claim to be totally unbiased.
Robo-advisors are paperless. More and more people are concerned about environmental issues and robo-advisor transactions are certainly more eco-friendly than offline mutual fund transactions.
Disadvantages of Robo-Advisors
I had mentioned earlier that, robo-advisors are essentially computer algorithms. An algorithm is essentially a set of rules working on a set of assumptions coded in the algorithm. When we are working with a set of rules, customization will always be limited to a certain extent. If your investment needs are fairly common with the investment needs of large number of investors, the robo-advisors can provide you good investment solutions. However, if you have very specialized investment needs, you may need the services of an experienced financial advisor who will better understand your specific requirements and suggest the best possible solution.
Robo-advisors are devoid of any human interaction. Some people prefer human interaction and hand-holding. Knowing a financial advisor, who can be trusted, to help him or her can give some investors more confidence in making investments.
Though theoretically machines are bias free, machines are built by humans who may have vested interests. Therefore, unless you have access to the source code of the robo-advisor algorithm you will never know if it is truly bias-free. The other approach to test the bias of a robo-advisor is to analyze a large sample of robo-advisor recommendations and see if they are biased towards particular AMCs or schemes. Unfortunately no such tests are available in the public domain and therefore, you may have to rely on the reputation of the robo-advisor.
Equity investment is not always a walk in the park. Stock markets are volatile and at times may cause emotional distress, when you see your hard earned money making a loss (even if the loss is temporary). Machines have no empathy and cannot help you in emotional distress. On the other hand, speaking with a financial advisor who has experience of helping their clients in bear markets can be quite helpful in such situations.
Considerations in choosing a robo-advisor
If you are a new investor and have absolutely no knowledge of investing and mutual funds, you may want to invest through a financial advisor because you are likely to have questions and doubts, which the advisor can clarify.
If you are new investor and have even basic knowledge of investing and mutual funds, you can invest through a robo-advisor because they are fairly simple to use and some of them provide good information which you may find useful. You should try different robo-advisors available online (Google and you will find content on the popular robo-advisors on the web). Choose a robo-advisor based on your user experience.
You should see the different investment features offered by different robo-advisory solutions. Some robo-advisors only offer plain vanilla lump-sum and systematic investment plans, while the more advanced robo-advisory solutions offer sophisticated features like Systematic Transfer Plans, switches and Systematic Withdrawal Plans.
The quality of robo-advisory will depend on how sophisticated and robust the algorithm is. How many scenarios of investor goals and risk profiles are coded in the algorithm? Larger the number of scenarios, better will the robo-advisor output. What is the fund selection methodology? Are funds for each recommended from a static list or a dynamic list? If it is a dynamic list, at what frequency it is refreshed?
These are some of the questions that investors need to ask in order to get a sense of how sophisticated and robust the robo-advisory algorithm is. Unfortunately, there is little or no description of methodology available on the robo-advisor web pages. It will be more helpful, if you speak with a sales representative of the robo-advisor in order to understand how the robo-advisor is making investment recommendations.
If you know a friend or colleague, who has used a robo-advisory solution, you should speak with him or her to get his or her feedback on how good the robo-advisor is.
Finally, you should always enquire about the customer service support of the robo-advisor, so that if anything goes wrong, you can get the desired support them.
Conclusion
In this post, we have discussed what robo-advisors are and how they work. We have also discussed the pros and cons of robo-advisors, and the various factors you have to consider in choosing a robo-advisor. Today more and more people are using online banking, online shopping and online bill-payments because it is more convenient. Online investment is also a part of the same evolution in technology adoption and over a period of time, will gain more popularity with investors, once they realize the benefits associated with the use of technology.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Some of our readers may have heard about and even used robo-advisors for making mutual fund investments. Robo-advisors are now very popular in developed countries like the United States and though robo-advisory is still a relatively new concept in India it is gradually gaining popularity. If you follow discussion threads related to robo-advisors in the social media and other online discussion forums, you will see that there are conflicting opinions both in favour and against robo-advisors.
I have seen that, views expressed in online discussion forums (including social media) are usually based on individual preferences, experiences or vested interests. For example in discussion you will notice two very divergent assumptions with regards to mutual funds investors. One assumption is that, all investors barring HNIs are naive and need hand-holding in making investment decisions. The other extreme assumption is that, all investors are mature enough to make investment decisions and execute them. The reality is that there are investors with varying degree of maturities, experience and knowledge. In Advisorkhoj we recognize the diversity (in terms of maturity and knowledge) in our investor population and try to critically analyze different perspectives keeping the diversity in mind. In this post, we will discuss about robo-advisors and there suitability for different investors.
What is a robo-advisor?
As the name suggests robo-advisor is robot giving you financial advice. However, this robot is not like a walking, talking robot we see in movies. A robo-advisor is essentially a computer algorithm where you can input your investment needs and get investment recommendations. Many robo-advisors also offer online mutual fund transaction capabilities. They are available online on the websites of wealth management firms / mutual fund distributors and registered investment advisors.
How does a robo-advisor work?
Most robo-advisors follow a standard process flow that has four broad steps. In the first step, you are required to input details like your age, investment goals (including investment horizon), risk capacity and investment amount. Most robo-advisors ask investors to fill in an online questionnaire to assess their risk capacity. Once you input all the necessary details the computer algorithm will determine your optimal asset allocation (e.g. debt and equity) and asset sub-category allocation (e.g. large cap equity, midcap equity, long term debt, short term debt, money market etc). Some robo-advisors give investors the option of fine tuning the asset allocation.
Once the asset allocation is determined, the robo-advisor then generates fund recommendations for the investors. The final step is the actual execution, which includes KYC (Know your Client) checking and e-KYC if required and then online purchase of mutual fund units. Some robo-advisors may stop at the third step (fund recommendation), but most reputed robo-advisors offer online transaction capabilities.
Misconceptions regarding robo-advisors
Some investors think that, online investment automatically implies investing in direct plans. If you are investing through robo-advisor offered by a mutual fund distributor then you will be investing in regular plans.
Some investors think that, they have to pay a fee for using robo-advisors. If you are using robo-advisor solutions offered by mutual fund distributors then you do not have to pay to use the tool because mutual fund distributors get their commissions from the Asset Management Companies (AMCs). However, if you are using a robo-advisor solution offered by a Registered Investment Advisor (RIA), then you will have to pay a fee to the RIA because using the robo-advisor solution of an RIA, you will be investing in direct plans of mutual fund schemes.
Some investors think that they are susceptible to online frauds when investing through robo-advisors. You should know that, the robo-advisor is not all involved in the financial transaction of the mutual fund purchase. Your money will be routed straight from your bank account to the asset management company (AMC) which will allot you mutual fund units.
Advantages of robo-advisors
Many people prefer to do things themselves instead of relying on another person. DIY (do it yourself) gives people a sense of control over their work and is an increasingly becoming a popular trait especially among technologically savvy and younger sections of the population.
Careers are becoming increasingly busier. Some people may not have the time to meet with a financial advisor and explain their requirements to the advisor. Mobility has also increased and people are constantly on the move. So they may not want to be tied with in an advisor in a particular location. Robo-advisors give investors the flexibility to make investments from any place, at any time (even at the middle of night).
Most of the robo-advisors are very user friendly and require only basic computer knowledge to use. However, the user interface and experience will differ from solution to solution. Some robo-advisors are very sophisticated and others are fairly basic. You can choose a robo-advisor based on the kind of interface and experience you like.
Many people value judgement which comes from experience, but judgement can be subject to understanding, personal biases and human errors. Since Robo-advisors are algo based, it takes out subjectivity from investment decision making and makes the exercise objective.
Psychologists say that humans can never be bias-free. Even if a financial advisor works in the client’s best interests, there can be biases in his or her recommendations. Robo-advisors, being algorithm based, claim to be totally unbiased.
Robo-advisors are paperless. More and more people are concerned about environmental issues and robo-advisor transactions are certainly more eco-friendly than offline mutual fund transactions.
Disadvantages of Robo-Advisors
I had mentioned earlier that, robo-advisors are essentially computer algorithms. An algorithm is essentially a set of rules working on a set of assumptions coded in the algorithm. When we are working with a set of rules, customization will always be limited to a certain extent. If your investment needs are fairly common with the investment needs of large number of investors, the robo-advisors can provide you good investment solutions. However, if you have very specialized investment needs, you may need the services of an experienced financial advisor who will better understand your specific requirements and suggest the best possible solution.
Robo-advisors are devoid of any human interaction. Some people prefer human interaction and hand-holding. Knowing a financial advisor, who can be trusted, to help him or her can give some investors more confidence in making investments.
Though theoretically machines are bias free, machines are built by humans who may have vested interests. Therefore, unless you have access to the source code of the robo-advisor algorithm you will never know if it is truly bias-free. The other approach to test the bias of a robo-advisor is to analyze a large sample of robo-advisor recommendations and see if they are biased towards particular AMCs or schemes. Unfortunately no such tests are available in the public domain and therefore, you may have to rely on the reputation of the robo-advisor.
Equity investment is not always a walk in the park. Stock markets are volatile and at times may cause emotional distress, when you see your hard earned money making a loss (even if the loss is temporary). Machines have no empathy and cannot help you in emotional distress. On the other hand, speaking with a financial advisor who has experience of helping their clients in bear markets can be quite helpful in such situations.
Considerations in choosing a robo-advisor
If you are a new investor and have absolutely no knowledge of investing and mutual funds, you may want to invest through a financial advisor because you are likely to have questions and doubts, which the advisor can clarify.
If you are new investor and have even basic knowledge of investing and mutual funds, you can invest through a robo-advisor because they are fairly simple to use and some of them provide good information which you may find useful. You should try different robo-advisors available online (Google and you will find content on the popular robo-advisors on the web). Choose a robo-advisor based on your user experience.
You should see the different investment features offered by different robo-advisory solutions. Some robo-advisors only offer plain vanilla lump-sum and systematic investment plans, while the more advanced robo-advisory solutions offer sophisticated features like Systematic Transfer Plans, switches and Systematic Withdrawal Plans.
The quality of robo-advisory will depend on how sophisticated and robust the algorithm is. How many scenarios of investor goals and risk profiles are coded in the algorithm? Larger the number of scenarios, better will the robo-advisor output. What is the fund selection methodology? Are funds for each recommended from a static list or a dynamic list? If it is a dynamic list, at what frequency it is refreshed?
These are some of the questions that investors need to ask in order to get a sense of how sophisticated and robust the robo-advisory algorithm is. Unfortunately, there is little or no description of methodology available on the robo-advisor web pages. It will be more helpful, if you speak with a sales representative of the robo-advisor in order to understand how the robo-advisor is making investment recommendations.
If you know a friend or colleague, who has used a robo-advisory solution, you should speak with him or her to get his or her feedback on how good the robo-advisor is.
Finally, you should always enquire about the customer service support of the robo-advisor, so that if anything goes wrong, you can get the desired support them.
Conclusion
In this post, we have discussed what robo-advisors are and how they work. We have also discussed the pros and cons of robo-advisors, and the various factors you have to consider in choosing a robo-advisor. Today more and more people are using online banking, online shopping and online bill-payments because it is more convenient. Online investment is also a part of the same evolution in technology adoption and over a period of time, will gain more popularity with investors, once they realize the benefits associated with the use of technology.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
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