How Robo Advisors are Changing the Way We Invest

February 8, 2022

Did you know that robo advisors will soon manage more than $1 trillion of Americans’ wealth?

It used to be that only the wealthy could afford to pay a financial advisor, but these days, robo advisors are flipping the script on accessible investments. They’re also changing the way we invest. Whether that’s a good thing or a bad thing depends on what type of investor you are and what strategies you benefit from.

Here’s a closer look at how robo advisors work, and how they’re changing the way average investors build their wealth.

What is a Robo Advisor?

In order to understand how robo advisors are changing the way we invest, you have to understand how robo advisors work—the changes they’re making are inherent to their design.

A robo advisor varies from firm to firm, but generally, it’s a type of brokerage account that automates the investment process. They provide little to no human engagement and instead rely on an algorithm to make investments on behalf of the client. The client provides key information like their goals, risk tolerance, and investment timeframe, and the algorithm builds a portfolio for you.

As long as you have the initial investment handy, you can set up most robo advisor accounts in just a few minutes.

Depending on the firm, some advisors allow you to set up sub-portfolios with different asset allocations based on your financial goals, such as an income-oriented option for retirement.

How Robo Advisors Work

The whole premise of a robo advisor is simplicity. It all comes down to the “robo” part of the name.

The whole process is automated, starting from the moment you sign up. The robo advisor walks you through a questionnaire to figure out your current financial situation, your goals, and your investment preferences, including your degree of risk aversion (the extent to which you’re willing to lower returns to reduce uncertainty or raise uncertainty to boost returns).

From there, the advisor uses your data to craft a portfolio. This is heavily based on your goals and timeframe, though it isn’t 100% personalized—the advisor keeps a roster of potential portfolio options and offers you the best match based on your replies.

Once the advisor constructs your portfolio and you set up your investment deposits from a linked account, the advisor manages the portfolio for you. You don’t give the advisor any input—it makes all buying and selling decisions on your behalf. You couldn’t tell the advisor to invest in a specific company. Instead, the algorithm chooses the best options for you (based on what it’s been taught and the options it’s allowed to seek).

Regardless of the portfolio or your risk level, robo advisors rely on passive, indexed portfolios. Even aggressive investors will get a more aggressive iteration of a passive indexed portfolio.

Portfolio Rebalancing in Robo Advisors

Most robo advisors use modern portfolio theory (MPT) or some variation of it. MPT is an investment theory that allows investors to construct a portfolio that maximizes returns for a given risk level.

In an MPT-based portfolio, every asset is given a target weight and corresponding risk tolerance range. This creates rebalancing bands, which the advisor uses to automatically rebalance the portfolio to achieve an optimal asset allocation based on your data.

Another common technique is tax-loss harvesting, which is a technique of selling securities at a loss to offset capital gains tax liability. To do this, most robo advisors keep a stable of two or more exchange-traded funds (ETFs) for each asset class, and if one loses value, it automatically sells that ETF to offset capital gains liability while also purchasing another ETF of the same type (such as replacing an S&P 500 ETF with a different S&P 500 ETF).

Typical Investments

Because of how they’re designed, robo advisors almost always rely on a stable of low-cost ETFs over individual stocks or mutual funds. This offers low-cost, rapid diversification while allowing the advisor to quickly rebalance as needed, depending on the rebalancing strategy the advisor uses.

Typically, robo advisors follow an index fund or a similar passive approach that allows speedy, low-cost diversification. The firm offering the advisor backs it using its own market research, often in MPT, so that the algorithm knows how to make decisions.

How Robo Advisors are Changing the Way We Invest

Here’s the thing: because robo advisors are designed for a very specific function (low-cost, hands-off investment options), their investment strategy is largely consistent across advisors. That also means that investors who rely on their strategies have adopted them, with a noticeable impact on investment decisions.

First and foremost is the rise of passive investing. Robo advisors are designed for passive investing—the whole point of robo advisors is to provide affordable investment services, often to people who don’t know much about investing. But the only way to successfully automate without personalization is to rely on passive strategies.

That’s not necessarily a bad thing, but it does mean that investors are relying on more conservative strategies than they did in the past. In fact, active investments are at an all-time low.

On the flipside, this also means that investors are moving away from personalized strategies in the name of automated investing decisions. That’s not a bad thing either, but it also means that your options are limited to the ETFs and investment assets the firm provides through your robo advisor.

Smart Alternative Investments for Savvy Investors

For smart investors, robo advisors are a good way to build a conservative baseline for your investments. But when you’re ready to grow beyond what you can achieve with a robo advisor, it’s time to branch off the beaten path and invest in strong stock market hedges.

That’s where we come in. Here at Masterworks, we make it possible for members to purchase shares in authenticated blue-chip artwork, sort of like buying shares in a company. We handle most of the hard work for you—like researching high-growth artist markets with the highest potential risk-adjusted returns with our partners at Citi Bank and Bank of America—so all you have to do is read up on shares that excite you and purchase the right ones for your portfolio. Ready to invest for your future? Fill out your membership application today to learn more.

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