Disruption of Robo Advisory

3 Things a Robo Advisor Does With Your Money

A deep dive into how it handles your cash

Prem Kumar
Jun 10, 2020 · 9 min read
Photo by Alex Knight on Unsplash

The Rise of The Robots

According to Kiplinger, Robo-adviser firms have seen 3 times the digit growth from 2012 to 2019 and Cerulli associated reported robo investment has $60 billion in assets and could quickly amass up to 385 billion in the next 5 years. This is truly outstanding.

During the 2008 financial crisis, investors were burnt by considerable losses in the stock market, pushing them to put their wealth into passive investment vehicles that generate returns with the least amount of work. The popularity of passively managed funds soared with the bull run in 2009, as cost-conscious investors sought cheaper fees and rode the growth of benchmark indices.

It was during this bull run that Jon Stein launched Betterment, the world’s first robo-advisory platform, in the US in 2010

Robo Advisor is essentially a digital service that uses highly specialized software to do the job of wealth managers or investment advisors. Those are the people who decide what type of investments you should be making and then tinker with those investments over time by continually monitoring the movements of the market and making rational decisions.

Robo-advisors typically have the users (the investor) to answer some simple questions to determine your risk appetite. By using some propriety algorithms, spreads the cash into a variety of investments. Globally, a new generation of digitally-savvy, self-directed investors has emerged. Although Millennials (1980–1999) and Generation Z (after 1999) investors tend to possess higher digital propensities and competencies, these investors are not limited to a single wealth or age group. Investors from every wealth and age group are increasingly adopting digital sales channels for their banking needs.

Investopedia’s survey of around 1500+ individuals found that 20% of affluent millennials (ages 23–38) use Robo-advisors, compared to only 13% of Gen X respondents. Looking at a younger segment of the population, 31% of those aged 18–22 use Robo-advisors compared with only 9% of investors aged 47–54, suggesting acceptance of digital advisors is increasing with each generation.

Source: Own Image

The other important point of having a Robo advisor is the level of asset diversification that the algorithm provides. Proper diversification will lead to less volatile fluctuations in the portfolio to properly shield the investors from not having too much decline from their original deposit.

“Don’t put all your eggs in one basket” ~ Warren Buffet

Warren Buffet is right.

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a different mix of assets types and investment universe in an attempt at limiting exposure to any single asset or risk. The primary rationale behind this technique is any particular portfolio is constructed of different assets of different volatility in the price for a given period. The collection of diversified assets, on average, will yield higher annual returns over the long-term and lower the risk of any individual holdings or assets. Although diversification plays a crucial role in the algorithm, there are more than meets the eye.

Photo by Chris Liverani on Unsplash

Role of Artificial Intelligence

For the last couple of years, Artificial Intelligence (AI) has been changing many fields and increasing efficiency by using improved datasets. One of those areas where AI has accelerated evolution is the Robo-advisory, which is a field having extensive financial big data to analyze. As more and more data the AI churns, the algorithm adapts to the changes and continuously optimizes itself. Robo-advisors algorithms to automatically perform investment decisions or tasks which are mostly done by human advisors.

To increase efficiency, AI requires vast amounts of data to give more accurate results. The robust analysis of enormous quantities of historical and financial data will uncover opportunities that the traditional analysis by a fund manager or investment specialist would otherwise overlook. This gives the Robo-advisors an edge over passive strategies, and AI can process big data swiftly, allowing Robo-advisors to adapt to changing market conditions and consumer behaviours much quicker to make better investment decisions.

Modern Portfolio Theory — Nobel Price Award

Harry Markowitz and William Sharpe developed one of the most important and influential economic theories dealing with finance and investment called the Modern Portfolio Theory (MPT) and published under the title “Portfolio Selection” in the Journal of Finance in 1952. The duo was awarded Nobel Prize in Economics in 1990 for their groundbreaking research. The theory is based on Markowitz’s hypothesis that it is entirely possible for investors — To design an optimal portfolio to maximize returns by taking on a quantifiable amount of risk. Essentially, investors can reduce risk through diversification using a quantitative method.

A quick check on the white paper produced by Weathfront indicates that their portfolio was built with MPT and many others in mind.

From the paper, it is evident that robust diversification of assets is important and crucial in the long term. Consider this situation: Portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

Markowitz showed that investment is not just about picking stocks — but about choosing the right combination of stocks among which to distribute one’s risk.

Diving Into the Details

The actual workings of a Robo-advisor model are pretty straight forward. It has three things:

  • Asset Allocation — What does your portfolio contain?
  • Tolerance Monitor — How does the volatility affect the assets?
  • Rebalancing — Should the allocation weight be changed?

Asset Allocation — Diversification Strategy

The process of asset allocation is where different ‘weights’ are assigned to asset classes based on the algorithm. These asset classes cover the various aspects of the market and keep a diversified portfolio. Wealthfront sees those asset classes as:

US Stocks, Foreign Stocks, US Bonds, Foreign Bonds, Inflation Protection, Commodity, Gold, Emerging Country Bonds, Natural Resources, Treasury Inflation-Protected Securities, Municipal Bonds, Corporate Bonds, Dividend Growth Stocks and more

Each of the categories above is represented by an Exchange Traded Fund (ETF). The ETF represents the basket of liquid securities that are traded in the market, similar to stocks. The liquidity of a passive ETF reflects the liquidity of the underlying basket of shares. Let’s take a look at the underlying options under the S&P Series portfolio. As the allocations contain more and more US equities, it is said to be volatile. Here, the Robo advisors will allocate the right amount of equities and fixed income in terms of percentages into the portfolio depending on the risk level of the user.

Source: https://advisors.vanguard.com/iwe/pdf/FASINVMP.pdf

Tolerance Monitor — A Smart Watchful Eye

The tolerance, in this case, represents the individual weight that is allocated to each of the stocks. This is done by first calculating the current allocation. This is the value of a position against the total value of the portfolio. If any position has a weight that is X per cent greater or lower than the allocated weight amount, then the portfolio will trigger something called ‘rebalance’. The main objective of the rebalancing is to buy or sell the current stocks such that the original weight is allocated. The asset weight monitoring does not happen every hour — because investing is and should be for the long term.

Rebalancing — Maintaining the Right Asset Allocation

Throughout the year, the market value of given security will likely see some fluctuation. In the case that the market value of an asset drastically increases due to a significant market or economic shift, its allocated weight in a portfolio will rise above its targets. To maintain the target allocation or balance, the system adjusts the portfolio so that it returns to its designated asset allocation. This practice is known as rebalancing.

You’ll find that some of your investments will grow faster than others. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk so that the level is not breached. If a particular stock has breached its weight threshold, the algorithm will then sell all the current shares; then once all cash available is gathered, necessary purchases are made. To calculate how much to sell, use the target allocation of cash (weight * portfolio value), and see the number of shares that result from that cash. The difference between the number of shares currently held and the target level of shares is the amount to buy/sell. This is also automatically done by the Robo advisor to protect the portfolio from breaching the risk level.

In the past, this type of rebalancing has been frowned upon by asset management companies and portfolio managers because it can be time-consuming and generate significant transaction fees. However, with Robo-advisors, this is both automatic and virtually no-cost.

“Automatic rebalancing of assets in a portfolio stands in as one of the most attractive traits of using a robo advisor to invest your money”

Final Thoughts

Robo advisors genuinely are changing the traditional asset management as we know it. With 24/7 accessibility and automation of Robo-advisors, the companies that run these Robo advisors such as Wealthfront, Betterment, SigFig, Ellevest, and others operate entirely online — meaning signing up, depositing money, checking balance, withdrawal, etc., all without getting out of your pyjamas.

Source: https://gph.is/2d3OrHK

Regardless of which Robo-advisor you choose, it should be easy to get started and maintain an investment portfolio. Just be sure to do your homework first to determine the fees you’ll be paying and find the best Robo-advisor to help you reach your investment goals. I have listed down some of the top startups and companies that are currently offering Robo advisory services below.

Wealthfront

Disclaimer

I do not provide personal investment advice, and I am not a qualified licensed investment advisor. I am an amateur investor. All information found here, including any ideas, opinions, views, predictions, forecasts, commentaries, suggestions, or stock picks, expressed or implied herein, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. While the information provided is believed to be accurate, it may include errors or inaccuracies. I will not and cannot be held liable for any actions you take as a result of anything you read here.

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Prem Kumar

Written by

Machine Learning Engineer | Data Enthusiast | Learner

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +786K followers.

Prem Kumar

Written by

Machine Learning Engineer | Data Enthusiast | Learner

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +786K followers.

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