This article appeared before in Forbes
Whether you’ve been trading stocks for years or are just getting started, you’ve likely heard about robo-advisors. Robo-advising, also called automated investing, is driven by algorithms that passively make investment decisions for you (to design their portfolios, many robo-advisors use Modern Portfolio Theory, or MPT, which seeks to minimize investors’ market risks while maximizing their returns—it’s a theory that’s faced valid criticisms, but I won’t dive into that here).
Automated investing is not a perfect, one-size-fits-all solution by any means. One con is that unlike personalized investing (which you can take on by yourself or through a financial advisor), you can’t direct your investments to specific stocks. Another drawback is that the algorithms that power automated investing don’t provide the human interaction and personalization that financial planners do (and as such, these algorithms take a less nuanced approach to your financial goals and the reasons behind them).
Yet, more and more people are opting for this different investment approach. According to data from Statista, assets under the management of robo-advisors are projected to reach over $1.3 million in 2021 and are expected to show an annual growth rate (CAGR 2021-2025) of 20.11%.
Here’s what to know if you’re considering using a robo-advisor.
Automated Investing Takes Human Biases Out Of The Equation
We humans have emotional biases that come through when we manually invest.
Confirmation bias, for example, drives us to seek and interpret new information to confirm our pre-existing hypotheses. If we find contradictory information, we discount the reliability of the source or just ignore the data. If you’ve invested in a particular company, you’re likely to zoom into the details that paint the company in a positive light.
Another bias we have is that we’re more likely to be familiar with companies near us and gravitate toward investing in those companies. This is called home bias. Chances are that if you live in Texas, an Australian publicly-traded company that’s performing well isn’t on your radar.
Once we do invest, we tend to become attached, sticking with the investment despite losses. This is the disposition effect. Investors are hesitant to sell assets that have lost value and are more likely to sell assets that have gone up in value. Any investor’s mantra should be “buy low, sell high,” not the other way around!
With automated investing, you can avoid these biases. Algorithms have rules but do not take static positions; they don’t get emotionally attached. They’ll vary their positions and might back away from investments if the data steers them that way.
Do remember, however, that with automated investing, you won’t have the level of control that comes with taking investing into your own hands. Generally, with automated investing, the most control you’ll have over what you invest in is via picking a specific general plan, like an “ethical investing” package. If you’re a person who wants particular stocks (and you want to decide exactly how long to stick to them), automated investing might not be the right decision for you.
Automated Investing Navigates the Stock Market Differently
Robo-advisors can navigate the stock market for you. How they navigate it for you in part depends on the type of robo-advisor you choose. There are classic robo-advisors, which use static portfolios that get rebalanced every once in a while. An advantage of these classic robo-advisors is that they’ll maintain the balanced choices you made in the past, meaning, you’ll consistently have firm knowledge of what you have. Then there’s a newer class of robo-advisors that use more advanced algorithms that scour alternative data sources and are more flexible in the choices they make (disclosure: I run an automated investing company that takes the latter approach).
Specifically, the algorithms behind the newer class of robo-advisors comb through an immense wealth of data that would be time-consuming for you to manually do (and even if you did, you might miss key data points).
Using algorithms, next-generation robo-advisors can evaluate millions of data points from various sources, including alternative data sources such as corporations’ website traffic, Twitter posts, and relevant news articles. As a result, they can pinpoint relationships between companies that are hard for people to see. For instance, if a robo-advisor detects an uptick of trading activity for a chip manufacturer that supplies a major tech company, it could figure out that that tech company is about to release a new product and direct your investments there in anticipation of a positive earnings announcement.
Keep in mind that while the algorithms behind robo-advisors can sift through various data points and identify investment opportunities that would be harder for you to determine on your own, it comes with a trade-off—again, your level of control. For example, if you hear about some up-and-coming companies that would potentially be good to invest in, you couldn’t direct the algorithms to those specific stocks.
Automated Investing Changes your Footing in the Stock Market
As reported by CNBC, 2019 estimates from J.P. Morgan revealed that passive investments “control about 60% of the equity assets, while quantitative funds—those relying on trend-following models instead of fundamental research—now account for 20% of the market share.”
Even if you step back and try to find and evaluate the best assets by hand, there is just no way that you and machines driven by statistical analysis can play a fair match.
However, while it’s harder to find and evaluate the best assets by hand—and in turn, level the playing field between you and the machines—you might be more comfortable with making specific investment decisions yourself or turning to a licensed financial planner who can give you customized advice based on your unique circumstances.
Choosing a Robo-Advisor
If you decide that automated investing might be the right option for you, make sure to research different robo-advisors and choose one that best fits your needs. Factors you should consider include management fees, service offerings and whether the automated investing platform uses static rebalancing strategies that maintain the balanced choices you made in the past or a more flexible artificial Intelligence and machine learning algorithmic approach (you can find the answers to these questions by reading the automated investing platform’s website, or directly contacting the company if the information isn’t readily available).
The right robo-advisor can decrease your likelihood of falling to human biases, maneuver the stock market for you and level your playing field—increasing the chance that you’ll make financial headway.
And above all, a robo-advisor will give you time to spend on your family and hobbies instead of trawling through data behind your desk!
I’m ready to invest – Join the waiting list now!
Disclaimer: The information in this article is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.