Explained: What are robo-advisors and should you use one for your investing decisions?

• Since robo-advisors automate the process of arriving at investment decisions; it leads to cost savings and removal of human bias.
  
• The choice between a human financial advisor and a robo advisor depends on an individual's specific needs and preferences.
  
• For comprehensive financial planning, especially for complex situations, a human advisor may be more suitable.
  

The term robo-advisor is self-explanatory- it is s robot that gives investment advice. But while it may conjure up the notion of a robot, to put it simply, a robo-advisor is an automated, online financial platform that utilises algorithms and data analysis to provide investment advice and manage portfolios for individuals.

Robo-advisors: Still at a nascent stage in India

Robo-advisory services are still in their nascent stages of development in India. In terms of usage, they are primarily embraced by a limited group of early and tech-savvy adopters.

“In terms of coverage, robo-advisory seems largely restricted to listed equities for now with limited coverage around ETFs and other products as well. Most robo-advisors offer quantitative or algorithm-based portfolio management services,” says Nirav Karkera, head, research, Fisdom, wealth tech platform.

How they work

Robo-advisors are digital platforms that help you invest your money. First, they ask you questions about your financial goals and how comfortable you are with risk. Then, they use computer algorithms to recommend where to invest your money.

They also manage your investments over time and adjust them as needed. It's like having a smart computer friend who handles your finances.

“Using information you provide, the robo-advisor algorithm chooses a diversified array of assets, including ETFs, stocks, and mutual funds, and subsequently, autonomously readjusts the portfolio to sustain the target asset allocation,” says Rachit Mehta, head, product strategy, IIFL Securities.

Do robo-advisors lead to cost savings?

No frills robo advisory tools could translate into cost savings for the do It yourself (DIY) investors.

“These tools automate the process of arriving at investment decisions without human involvement; it leads to cost savings and removal of human bias,” says Abhishek Kumar, founder and chief investment advisor at SahajMoney, a financial planning firm.

Robo-advisors are cost-effective because they automate the investment process. “They have lower fees compared to traditional advisors since they don't require in-person meetings or offer personalised financial planning. This cost efficiency can lead to higher net returns for investors over time,” says Mehta.

However, Sadique Neelgund, founder and director, Network FP, a membership organisation for personal financial advisors, has a more nuanced take.

“The answer is both yes and N\no. Yes, if you are able to generate 1% to 2% higher returns by doing it yourself viz. a viz. working with a professional human advisor. This is really tough considering the majority get trapped by investment biases. No, if you are unable to perform better investing directly through robo-advisors,” he says.

That being said, given the early stage of robo-advisory adoption in India and the fragmented nature of robo-advisory offerings, it is difficult to carry out a standardised comparison between robo-advisory and traditional advisory approaches.

What kind of investors are robo-advisors suited for?

Is a robo-advisor suited for you? “DIY, tech savvy investors with uncomplicated, simple and small portfolios are best suited for robo-advisory,” says Renu Maheswari, co-founder and principal advisor, Finscholarz Wealth Managers.

Robo-advisors are a great fit for cost-conscious investors who seek an automated investment approach. They work well for individuals with moderate risk tolerance, favouring a hands-off, diversified investment style. However, robo-advisors may not be the right choice for those in need of intricate financial planning or highly personalised investment strategies.

“Considering the early phase that robo-advisory is in today and the fact that most such models are yet to undergo major macroeconomic, business and market cycles, most robo-advisory services may be suitable to informed investors who are aware about the principles, commitments and possible shortcomings of such platforms,” says Karkera.

Early adopters may also try to allocate some part of their portfolio to be managed through a robo-advisory to be able to eventually compare the effectiveness and efficiency of such a platform and eventually make an informed decision.

Should you use a robo-advisor?

The choice between a human financial advisor and a robo-advisor depends on an individual's specific needs and preferences.

“For comprehensive financial planning, especially for complex situations, a human advisor may be more suitable as they provide personalised guidance,” says Maheswari.

However, for investment portfolio management, a robo-advisor can be cost-effective and efficient, particularly for those who have clear investment goals and are comfortable with a more automated approach.

A word of caution

Modern portfolio theory (MPT) is a framework for constructing investment portfolios that aim to maximise expected return for a given level of risk. However, MPT has its limitations, as it relies on the assumption that investors are rational and risk-averse, which may not always accurately reflect real-world investor behaviour.

“As we have seen in the past in volatile markets not all investors behave in a rational manner hence the performance of robo-advisory tools built on MPT will also suffer due to investors' irrational behaviour,” says Kumar.

So investors are advised to exercise caution and first understand the workings of robo-advisory before using it for their investments.