What are robo advisors?
At the heart of automated investing, the newest fin tech revolution, is the robo advisor. So what exactly is a robo advisor? Has your advisor truly turned into a robot? Well, it's not quite like that.
Robo advisor - A portfolio management service that takes your personal goals and preferences, combines it with current and historical market data, and using an advanced algorithm, creates an optimal portfolio tailored to your own specific situation without the use of a live financial planner.
Breaking this down into individual components, a robo advisor will:
1. Take your personal goals and preferences - Generally, you fill out a short questionnaire that discusses your goals as well as your risk tolerances and constraints so that the advisor now knows how risky you are, how risky you can be, and what your goals are.
2. Combines it with current and historical market data - To create a well diversified portfolio, the robo advisor needs to know what the market is currently doing as well as what it has historically done to make estimations about future expected returns and risk. At this point, the market knows both your specific situation as well as the macro situation that is the market as a whole.
3. Using an advanced algorithm - Generally, most robo advisors use algorithms based on Modern Portfolio Theory. This is a financial theory that attempts to create an investible portfolio that maximizes returns for a given level of risk.
4. Creates an optimal portfolio tailored to your own specific situation - Essentailly, the algorithm takes your personal information as well as market data to say "I can take on X amount of risk and I have these Y options of investments. What is the best combinations of those options to generate the most return for this level of risk?" Based on current and past maket data, the algorithm spits out the best combination of assets to invest in.
5. Without the use of a live financial planner - Financial planners and advisors have been investing their clients in a very similar fashion for a long time. However, they often use general rules of thumb to create "tailored" portfolios for you that are not as sophisticated as these algorithms. That's not to say that the robo advisor portfolios will outperform - that is not ceratin at all. However, given that there's no expensive advisor to pay a salary to, fees are generally lower.
Check out more articles written here at RoboRiches in our archives.
There are many roboadvisors to choose from; each with distinct characteristics and a wide variety of services offered. We break down the similarities and differences between these firms here at The List.