Over the past two years, while much of the world has suffered, the United States stock market has flourished; between the March 2020 lows and at their peaks, the S&P 500 (as measured in this case by the exchange-traded fund SPY) and the Nasdaq (QQQ) are up 108% and 137%, respectively. This phenomenon can possibly be explained in a multitude of ways — an influx of liquidity provided by the United States government, or simply a newfound enthusiasm for equities and appreciating assets (see: GME, AMC, BTC, ETH). However, one thing is undeniable — most, if not all, of these new retail investors (38% (!!) of surveyed households in 2020 claimed to have invested for the first time) involved in the stock market are not institutional or educated investors; they’re young, optimistic individuals seeking either to preserve and grow their savings or get rich quick. For the former many have turned to robo-advisors, a mainstay but growing niche of the Fintech ecosystem. Read on and I’ll review what a robo-advisor is, the largest and most prominent robo-advisors, and pros and cons of deciding to turn to a robo-advisor with your money.
A robo-advisor is most often defined as a “digital platform that provides automated, algorithm driven, financial planning services with little to no human supervision”. For most individual and retail investors, stock picking and asset allocation is based on sentiment and popularity rather than research and systematic decision making; for example, in 2020 “38% of new investors said they asked their friends, colleagues, and family for their stock picks, followed by 37% of new investors who said they consulted the companies’ websites” of 1300 households surveyed. Robo-advisors take away much of the uncertainty involved in making decisions this way through algorithms that utilize passive strategies centered around modern portfolio theory, pioneered by Harry Markowitz. By charging lower fees than their human capital and wealth management advisor counterparts, robo-advisors have become more and more popular in recent years; since 2016, total AUM in the robo-advisor market has grown from 126,100 to 1,348,369 million USD.
Betterment, the first robo-advisor, launched in 2008 with the initial purpose of “rebalancing assets within target-date funds”. While using technology to manage assets wasn’t new in any way, Betterment pioneered the direct-to-consumer model, allowing retail investors to navigate away from the traditional middlemen, financial advisors, and take their financial future into their own hands. Since then, a slew of robo-advisors has emerged on the market, including traditional asset management and financial services firms offering their own version of robo-advising. As of 2015 Charles Schwab controls the largest market share of robo-advisors’ AUM, with Betterment and Wealthfront close behind.
There are many clear advantages to using a robo-advisor; they charge lower fees than traditional financial advisors, are relatively risk-free because of their institutional backing and use of algorithms, and oftentimes have little to no required starting capital. However, because of their de-risked nature, they generally will not outperform indexes such as SPY and QQQ; also, they leave little to no control over what securities to purchase to the client. Robo-advising has become more and more popular with a growing number of retail investors flooding the equities markets; however, whether it is best for you is ultimately subject to your preferences.
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Written by Gregory Guo, a second year student at Northeastern University studying Business Administration with a Minor in Data Science