Man against machine
Robo advisors: The Pros and Cons
What does our blog have in common with The Terminator, Blade Runner and The Matrix? All deal with the question “will robots prevail or do humans stand a chance?” In order to find an answer for our area of expertise, we look at the pros and cons of robo advisors and list both assets and drawbacks of this new form of portfolio management.
What are robo advisors?
The buzz word “fintech” subsumes novel technologies and business models in the financial services industry. They all have the common goal of using innovation to offer new, better or more cost-effective financial services. In asset management, robo advisors represent this development.
Robo advisors are automated online investment services. As part of the onboarding process, investors answer a couple a questions regarding their financial situation, risk tolerance and investment goals. Based on this data, an algorithm defines an investment strategy and invests the funds accordingly.
So now investors have a choice: man or machine, who should manage your assets? Who does a better job? In order to find an answer, we look at the pros and cons of robo advisors and list both assets and drawbacks of this novel form of portfolio management.
Let’s review the arguments
Robo advisors make no mistakes
The idea is to get rid of the source of error that comes with human imperfection. People make mistakes, robots don’t. A human financial advisor could make a slip or careless mistake, such as a typing error when buying a stock or buying more or less of a stock by mistake. Well, a robot won’t make a typing error, so that’s a plus. However, human errors still cannot be ruled out entirely even with robots. After all, a robo advisor is nothing but a computer programmed by a human. If something went wrong when the code was written, there is a risk that a robo advisor produces a systematic and therefore recurring error.
Robo advisors rely on the latest investment theory and investment portfolio research
So do human financial advisors, or at least they should, and most will. The difference is that a person can apply theories and research in a more flexible way than a robot. A robot will stick to the theory no matter what, while a human financial advisor can adjust it to the market situation at hand.
To give an example: It is a generally accepted principle of investment theory to divide assets between asset classes such as stocks and bonds in order to achieve a risk spread. Robo advisors will apply this principle regardless of the circumstances. In the current market environment, interest rates are very low or even negative, so bonds yield a negative return after fees and stamp duty. In other words, you lose money by buying bonds. A human would prefer to just leave the funds in an account, as a zero interest rate is still better than operating at a loss.
Robo advisors are not guided by emotions
Have you ever overpaid for a product or bought something you didn’t need because of attractive advertising or peer pressure? Emotions can lead people to make irrational decisions, including investments that bring a loss. People are sometimes led by emotions, robots are not.
Take herd instinct. Herd instinct describes a phenomenon that brings individuals to do what a large group of people (the herd) is doing. For example, the hype around Bitcoin and other cryptocurrencies and their price rallys show that many people have been buying “cryptos” (hence prices went up), so you start wondering, are you missing out on something big if you don’t buy? Then you buy too, feeling reassured as part of a group. This many people can’t be wrong, or can they? Our example works the other way round as well – oh no, now everyone is selling their Bitcoins, I need to sell as well, the devil takes the hindmost. Maybe buying is a smart move, maybe selling is. The point is that the decision might have been influenced by the herd, not the facts. Robo advisors are impervious to herd instinct (unless they have been otherwise programmed).
Robo advisors are more cost-effective
To find out if this argument holds, you can simply compare the costs of a human financial advisor and their robo alternative. The idea is that a robo advisor needs to be developed once and will then do the work of many human financial advisors. Hence cutting labour costs, so the company can offer investment services at a better price. Programming a robo advisor is time-consuming and cost-intensive, so it might take a while and a large number of clients to generate cost benefits and pass them along. However, it is very likely that the services of a robo advisor cost less than human financial advice.
Robo advisors offer a tailor-made solution for every client
Robo advisors can take certain investment preferences and characteristics such as risk tolerance or investment horizon into account, but they offer mostly “off-the-shelf” investments with limited options to customize. If you have special requirements, such as excluding certain companies for their corporate behaviour, you might be better off with a financial advisor.
Robo advisors don’t interact like real people
No, they don’t and it is for the individual client to decide whether this is an asset or a drawback. Some are happy to interact with a computer as they prefer an automated, somewhat anonymous process. Others like to have a counterpart, a “go-to person” they can consult with. While a financial advisor can answer many questions related to asset management, such as “How does it work with the taxes?”, “Does it make sense for me to pay into pillar 3a?” robo advisors only know and do what they have been programmed to.
So who wins? Man against machine – a summary
Human financial advisor
- Pro/Con: no systematic errors, careless mistakes are possible
- Pro: better in adjusting the investment strategy to the current market environment
- Con: might fall prey to emotions
- Con: more expensive
- Pro: better in taking individual preferences into account
- Pro/Con: human interaction
- Pro/Con: no careless mistakes, systematic errors are possible
- Con: adjusting the investment strategy to the current market environment
- Pro: not led by emotions
- Pro: more cost-effective
- Con: customization is limited, cannot take all individual preferences into account
- Pro/Con: no human interaction
Should you use a robo advisor? The bottom line is – it depends. We listed some pros and cons, but the way they are evaluated is very personal. The decision remains yours.