What Is a Robo-Advisor? How Do They Work?

As big banks adopt automated investment tech, we take a look at three of the ingredients that go into making a robo-advisor.
Quinten Dol
May 12, 2020
Updated: August 7, 2020
Quinten Dol
May 12, 2020
Updated: August 7, 2020

For many members of the Gen Z and Millennial generations, the idea of investing in the stock market has never been very attractive. But sticking with savings exposes your money to the slow devaluation of inflation and is not necessarily a path to financial stability.

Instead, investing in businesses, bonds, commodities and other vehicles can help investors absorb short-term market instability and ride the economy’s long-term growth

Still, deciphering the jargon of the market and predicting its mood swings on your own is no easy feat. It’s not any easier to walk into a financial planner’s office and wave goodbye to hard-earned cash in exchange for advice on buying a house in a decade or two. 

Herein lies the appeal of the robo-advisor, an investment algorithm that augments the services of a traditional financial planner. Popular startups like Wealthfront, Betterment and Robinhood have found success in marketing automated investment services, promising hassle-free investing, eliminating minimum balances and minimizing service fees.

In response, traditional banks and financial service providers have joined in, bringing their own robotic offerings to the market. But designing and building an automated algorithm that can meet a human’s financial goals is easier said than done. Here’s a deeper look at a few of those tools, and the ingredients that go into making them possible: 

 

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Learning From The User

Most people can tell you about their financial situations and goals, but as it turns out, they’re increasingly comfortable turning to algorithms for advice, too. At last count, financial services company Charles Schwab’s robo-advisor technology managed $40.7 billion in assets for around 360,000 accounts. 

Charles Schwab onboards its robo-advisor users with a 12-point questionnaire. The questions are designed to gather data points that feed its algorithm, featuring queries about the user’s goals, familiarity of how stocks and other investment options work, and reactions to specific hypothetical scenarios. (Think: What would the user do if their portfolio lost 20 percent of its value in a single year?)

Using this information, Charles Schwab’s algorithm can present a hypothetical portfolio with allocations to different types of stocks, bonds and commodities, and offer a general forecast on returns. A dashboard slider provides an easy visual tool users can play with to determine how much potential return — and corresponding risk — they’d like to take on. 

The responses inform how and where robo-advisors will make investments. After all, there’s a difference between saving for a down payment, a comfortable retirement, and a blow-out vacation, with each goal requiring a separate investment approach. Income, risk tolerance and timeline also vary widely, with each of these factors acting as an important element in the formation of a successful investment strategy.

 

Righting The Ship

At more than 190 years old, Citizens Bank is not much younger than the United States itself. Belying its age, the Rhode Island-based organization became the first large regional bank to build its own robo-advisor last year. Once users have trained its algorithm, Citizens Bank’s robo-advisor monitors accounts on a daily basis, reinvesting extra dividends, cash or interest and spreading that money according to the user’s original allocations. 

This technique is called automatic rebalancing. It’s designed to counteract the ways in which investments can drift over time. One particular exchange-traded fund might outperform others, for example, while a bond might lag behind. After a few years or so of these fluctuations, with money multiplying or dwindling in different sectors of the economy, the real value of the portfolio may bear little resemblance to its original allocations. 

To preserve the original concept of the robo-advisor — an automated solution that requires little or no input from the user — financial service providers incorporate automatic rebalancing technology into their software. The goal here is consistency, which aims to protect the user from becoming too exposed to — or too dependent on — one type of investment. 

 

Keeping Humans In The Loop

Even still, the rise of robo-advisor technology does not necessarily eliminate the need for human expertise. 

“People love the low fees and automation of robo-advisors, but they struggle with not having an actual human being to talk to when facing big financial questions,” SoFi Wealth General Manager John Gardner said when the company rolled out its own robo-advisor platform in 2017. “That guidance from a live advisor can help give them the confidence they need to start planning for a lifetime of financial success.”

The company said its SoFi Invest platform was the first to combine robo-advisor technology with unlimited access to financial advisors. In the years since, a number of organizations have followed SoFi’s lead, offering financial advice from humans alongside their automated investment options. This means that while algorithms are great for the day-to-day minutiae of investing, the trend is that technology will be used to augment — rather than fully replace — the work of financial planners and advisors.

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